From the March 2006 issue of Wealth Manager Web • Subscribe!

RESTLESS ROTATION

THE DEBATE OVER ASSET ALLOCATION'S ROLE IN PORTFOLIO RESULTS may be unending, as this month's interview with Gary Brinson suggests (see page 66). But in the court of historical returns, verdicts are routinely dispensed, year after year, with a recurring theme: Asset allocation explains a lot, perhaps more than generally recognized.

Assessed one calendar year at a time, the various asset classes tell a familiar story of a pattern generating a wide range of results, as the gatefold chart illustrates. If there's an enduring truth to the business of money management, it's that the winners, losers, and all the shades of gray in between, remain in constant flux. Therein lies the challenge and the opportunity of asset allocation.

That's not to say that market timing and securities selection are meaningless. But if you think trying to pick next year's winning asset class is tough, try figuring out which company is set to become the new Microsoft, or displace Wal-Mart from its retailing perch. But we digress. The point here is that a good tailwind in any particular asset class can do wonders, even for talented stock pickers and market timers. Indeed, as any closet indexer knows, being in the right asset class at the right time--whether by design or luck--is anything but trivial in courting superior returns.

In fact, asset allocation's winds may be responsible for more than the average stock picker lets on. Consider last year's horse race, when the winds from emerging markets stocks blew strongest among the 10 asset classes we track. The MSCI Emerging Markets Index soared by more than 30 percent last year, in dollar terms, according to Morningstar Principia. How high is 30 percent? Nearly five times as much as 2005's total return for the U.S. stock market, measured by the Russell 3000 Index.

With that in mind, perhaps it comes as no surprise to learn that a fair number of the top-performing international mutual funds recently reported above-average allocations to emerging markets stocks, according to the January 2006 edition of Morningstar Principia. The international category casts a wide net, pulling in any fund with an ability to invest in non-U.S. stocks in both developed and emerging markets. The strategies range from investing in a single foreign country to regional funds to global multi-nation mandates that may or may not include U.S. equities. In all, nearly 2,500 portfolios fit the international description, based on Principia's database.

Last year's average return for international funds was 17.4 percent, with the average allocation to emerging markets around 11.5 percent. The top 500 international funds, ranked by 2005 performance, did considerably better, of course, racking up an average gain of 33 percent last year. Suprise, surprise! The average allocation to emerging markets for those 500 was above average, too--running about 34 percent, Principia reveals.

Digging a bit deeper, we used Principia for calculating the correlation between 2005 returns and allocations to emerging markets among the international funds. Running a linear regression on the two variables for the nearly 2,500 international funds spits out an overall R-squared of about 0.44 (1.0 is perfect correlation, 0.0 is no correlation). All of which is a roundabout way of quantitatively advising that 44 percent of international funds' returns can be explained by emerging markets equities. Yes, there's more to explaining international funds' performance than emerging markets, but it's also true that 44 percent ain't hay either (our apologies to Damon Runyon).

Perhaps this is a good place to remind ourselves what should be obvious in any historical review of asset classes doled out in annual performance bites: Glory and ignominy are recurring and fleeting. As such, emerging markets' three-year run of posting first or second through 2005 may be in danger of succumbing to the laws of financial gravity, as exemplified during 2000-2002.

Winners and losers come and go, but asset allocation's influence is enduring. Unfortunately, the endurance prevails in bull and bear markets.

James Picerno (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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