By Michael J. Oyster, Chief Investment Officer, CFA, CAIA
Although frequently attributed to legendary Green Bay Packers coach Vince Lombardi, the quote “winning isn’t everything; it’s the only thing” was first uttered by UCLA Bruins football coach Henry Russell (“Red”) Sanders in the early 1950s. It’s a powerful statement that evokes a level of importance to winning that is all but impossible to understate.
Of all the decisions that investors make, one could argue that only one rises to that level of importance: asset allocation – the process of deciding which broad categories of investments to include in a portfolio and the individual allocation to each.
In our view, some of the most important early work on asset allocation was done in 1952 by a young graduate student named Harry Markowitz*. He deservedly shared in the Nobel Prize for Economics in 1990 for his groundbreaking research on the subject.
Later studies, including several by Roger Ibbotson**, showed that about 100% of the return amount, overall, can be explained by asset allocation policy. Asset allocation typically serves as the primary driver of an investment portfolio’s return. In other words, it’s potentially the “only thing.”
With that in mind, and rightfully so, investors take great care in deciding how to allocate assets.
Portfolios have evolved through time – years ago, many investors who once held only bonds began sprinkling in equities. In some investment portfolios, equities grew to nearly 60% allocations as part of the traditional “60/40” mix between stock and bonds, but it is common to see equity allocations well in excess of that today.
However, with interest rates low and equity valuations high, the expected future return of 60/40 is nearly as pessimistic as it has ever been. We would be foolish to expect investment returns of the future to match those of the recent past. Investors of the future will need to allocate differently to achieve their goals. Drawing upon the power of options-based strategies may provide the solution. But where do they fit within the traditional precepts of investment portfolio asset allocation?
It is often convenient to think of the building blocks of asset allocation in terms of asset categories – stocks, bonds, real assets, and some “catch-all” for strategies that exhibit a low correlation to others is a common starting point.
Where do options fit? Given that options strategies can be constructed to provide a wide range of risk/return profiles, no single category exists in which options will always neatly fit. It can be likened to attempting to categorize mutual funds, with their vastly varied profiles, into a single category. In our view, allocating to an asset should be based upon the asset’s individual risk/return profile and should only be considered if it is expected to improve the portfolio as a result of its inclusion.