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Ibbotson Says Asset Allocation and Diversification Held Up

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While many investors and advisors believe that asset allocation and diversification failed during the markets and economic crisis of 2008-2009, Roger Ibbotson begs to differ. In a keynote speech delivered during the Morningstar Ibbotson Asset Allocation conference on March 4, 2010, in Orlando, the founder of Ibbotson Associates and the current chairman and CIO of Zebra Capital argued for a more nuanced understanding of the benefits of asset allocation and diversification. Asking himself that very question–Do asset allocation and diversification still work?–Ibbotson said that “in newspaper-speak, the short answer is yes.”

Using the data to back up his argument, Ibbotson noted that in 2008, about 25% of U.S. listed stocks lost at least 75% of their value, “but only four of the more than 6,600 unlevered open-end mutual funds available for sale lost more than 75% in 2008–so diversification does work!”

In his speech and in a two-part article he is co-authoring in the CFA Institute’s March/April 2010 Financial Analysts Journal (along with Morningstar/Ibbotson’s James Xiong, Tom Idzorek, and Peng Chen), Ibbotson revisits the Brinson-Hood-Bebower contention that asset allocation accounts for 90% of a portfolio’s return, arguing instead that the sources of variation of returns from a portfolio are around 75% from the overall market, with the remainder about equally split from portfolio-specific asset allocation policies and from individual securities in the portfolio, along with the timing of trades, and fees.

Ibbotson argues that there are five drivers of portfolio performance over the long term–what he calls the “Big Five”:

o Risk/Return

o Diversification

o Liquidity and styles

o Alpha and active management

o Taxation, costs and fees

The liquidity driver, he says, is where one can find the most alpha, since the less liquid the investment, the greater the chance of it appreciating. “We all want more liquidity and less risk,” he acknowledges, but by the same token, Ibbotson says that “if you buy any asset in its most liquid form, you pay the most,” what he calls the “liquidity premium.”

While Ibbotson says he has been looking at the liquidity issue “since the 1980s,” it’s only more recently that he and his associates at Zebra, notably Zhi Wu-Chen, have applied a liquidity measure to the public markets. Zebra is now building portfolios that include such a measure.

At the Morningstar Ibbotson conference itself, which attracted 335 attendees and is an oasis for investment advisors thirsty for top-level content, Morningstar founder and Chairman Joe Mansueto noted that the firm had cut costs over the past difficult year, but said “we didn’t cut back on staff,” since, he said, “research is the engine that drives Morningstar’s growth.” One of those staff members, Chief Economist Michele Gambera said he was concerned about the effects of long-term unemployment on the American worker–”they’re learning how to be unemployed.” Speaking before the February unemployment report released on March 5, which showed the jobless rate remained flat at 9.7%, Gambera said “something has to be done, and soon,” to decrease unemployment, and fretted that “No one addressing this issue, except the folks who are really good only at pork-barrel politics.”