By Jonathan Chevreau National Post FP Funds Section Monday, April 26, 2004

"Of course asset allocation is not meaningless," Levi Folk now says, clarifying a piece he wrote in this space last Monday.

Casual readers and investors may have gotten the opposite impression from the original version of the article, appearing at Folk's FundLibrary.com. It's headlined Asset Allocation Explains No Part of Portfolio Returns.

Internet pundits and financial advisors take issue with the apparent message that investors should ignore the conventional wisdom on asset allocation -- i.e. , spreading investments across stocks, bonds, cash and other asset classes reduces volatility and provides optimum returns with less risk.

Some accused Folk of "data mining," since he zeroed in on data for Canadian markets for the 10 years ended March 31. It so happens over that time period returns of Canadian bonds and equities were identical: 9.02%.

Based on that one period, Folk declared asset allocation was therefore "effectively pointless." But he says he did so to make a point: It "was meant as hyperbole to show how silly the original study was."

The study to which he's referring is an often-misunderstood academic treatise on asset allocation known as Brinson Hood Beebower.

What Folk thought he was refuting was the "accepted wisdom" flowing from the study that asset allocation accounts for more than 90% of portfolio returns.

But here he fell into a common error many journalists and even some advisors often make.

As I explained four years ago (April 20, 2000) in this newspaper, Brinson et al. analyzed pension funds and found that, on average, asset allocation accounted for 93.6% of the variation over time in portfolio performance. It's that critical word variation (not to mention the qualifer, "on average") that often gets omitted in off-the-cuff interpretations of this study.

Financial advisors I respect still believe asset allocation is critical for dampening down volatility of clients' portfolios.

This is especially true for retirees on fixed incomes , says Jim Rogers.

Because asset allocation reduces portfolio volatility, it's "absolutely critical" for retirees, Rogers says. Otherwise, for a retiree drawing income from a portfolio, significant volatility in returns will exacerbate the loss in the value of their portfolios, he says.

Rogers says investors need look no further than the Easy Chair portfolio or the Rip Van Winkle portfolios (described in earlier columns) for evidence on how asset allocation smoothes the investment journey.

Another Vancouver-based advisor, KCM Wealth Management's Adrian Mastracci, remains a firm believer in the merits of asset allocation. "The headline said asset allocation explains no part of returns. To me that means zero, and I can't buy into that thesis. Perhaps he [Folk] can submit his position for scrutiny to AIMR [Association for Investment Management and Research.] "

Warren Baldwin says a proper analysis of the returns from asset allocation should include international and after-tax data.

Fund companies are just as adamant about the importance of asset allocation. "It is wrong to suggest that asset allocation is of no or relatively minor importance," says Karen Bleasby. "While asset allocation is important for determining portfolio return, it is even more important for determining portfolio risk."

She agrees returns of stocks and bonds in Canada were virtually identical over the last 10 years, but says asset mix had a large impact on returns over shorter time spans over that decade.

Thus in 2003, the return on the Scotia Capital Universe (bonds) was 6.7%, while the S&P/TSX returned 26.7%. In 2002, the Scotia Capital Universe returned 8.7%, while the S&P/TSX returned -12.4%. "Obviously, one's mix between bonds and stocks had a huge impact on return in each of these periods. "

Furthermore, over each of the last four decades, the return on the S&P/TSX ranged from 10% to 12.2%, while the range on bond returns was 3.4% to 13.2%.

The critical point is asset allocation reduces overall portfolio risk. "Bonds experienced lower volatility of returns than stocks and the portfolios with a higher bond content experienced lower volatilty of returns than those with a higher equity mix."

Folk also came to the convenient (for him) conclusion that security selection was more important to portfolio returns than asset allocation. Here he was on somewhat more solid ground. Bleasby agrees stock selection can be "an important determinant of return. It is for this reason that the asset allocation programs offered by Mackenzie incorporate actively managed funds."

But believers in low-cost investing have another view. Norman Rothery says Folk would have been better off attacking over-diversification of active funds rather than asset allocation.

In a parody of what he thought Folk should have written, Rothery summed the issue up nicely on another Web site: "Using active funds to form a diversified portfolio is a high-cost way to poor performance. A well-diversified portfolio of active funds will result in a portfolio that looks very much like the market portfolio. However, the cost of such a synthetic market portfolio is many times that of buying the actual market portfolio with low-fee index funds."

Rothery suggests smart investors should do one of three things: Exchange high-cost active portfolios for low-cost passive ones; accept less-diversified portfolios in the hope well-chosen active funds can outperform; or use a core passive portfolio with some select active funds.

NOTE: The information provided above is intended for general informational purposes only. It does not constitute advice for anyone's specific situation. Everyone should always first consult directly with their advisors to determine the appropriateness of any information contained above before taking any action. KCM Wealth Management Inc. assumes no responsibility for any loss or damage arising from the use of, or reliance upon the above information.