Michael Krause with AltaVista Independent Research sent over his latest report and we have included it here.
It’s the Asset Class, Stupid!
The real reason ETFs are soaring in popularity among individual investors
Retail investors have replaced institutional investors as the primary source of new inflows into exchange traded funds (ETFs). And with all the media hype surrounding ETFs it’s little wonder. But of all the benefits commonly touted as reasons for the funds’ soaring popularity—including their low fees, tax efficiency, and ability to trade throughout the day—many commentators miss one of the most important reasons of all: ETFs are the perfect asset allocation tool, and asset allocation is the most important decision an investor can make.
A landmark study published in 1986 by Brinson, Hood and Beebower concluded that even professional money managers were able to add very little value by their selection of individual stocks or attempts at market timing. Rather, the vast majority of variation in returns – 93% in the funds examined by the study – could be explained by asset allocation.
Asset allocation is the process of deciding how much of your portfolio to invest in each asset class, however they are defined. Broad asset classes include stocks, bonds, and cash; as well as commodities, real estate, collectibles, foreign currencies, and some would argue derivatives.
Investment professionals and academics alike work themselves into a tizzy debating the merits, nuances, and implications of the Brinson study. But we know from practical experience that:
• Professional managers add little value by security selection or market timing, which is why so few are able to consistently outperform their peers (or a benchmark) within the same asset class
• Allocation among the various asset classes, however they are defined, is exceedingly important in determining investment performance. That’s no guarantee you’ll get the asset allocation decision right, but that’s where you should focus your effort.
As with everything in the world of investing, it gets more complicated. Broad asset classes can be subdivided in a variety of ways. Stocks are usually broken down by sector, market cap, style or geography (domestic/int’l); bonds are broken down by issuer type, credit quality, and more. And so on for the various asset classes. Academic studies since Brinson have largely reached the same conclusion: however the asset classes are defined, the allocation of funds among them is the most important decision an investor can make, not in picking individual investments within the class.