Asset Allocation: Active or Passive?

Thus far in this series, we’ve looked at market efficiency and management styles in a general sense. Yet, investors must examine these factors and make decisions at multiple points, including when they select an asset allocation.

A completely passive asset allocation would mirror the market portfolio, which may look something like the below. Hypothetically, an investor could construct such a portfolio.

http://www.cfapubs.org/doi/pdf/10.2469/faj.v70.n2.1

However, some investors will want a more aggressive portfolio while others will desire a less volatile portfolio. Consequently, they will adjust their allocation weights to produce different portfolios along the efficient frontier. 

Yet, the efficient frontier is not a constant thing. Does it represent a 3-, 5-, 7-, 10-year, or some other time horizon? The efficient frontier will look different for each horizon, as seen below:

https://www.onefpa.org/journal/Pages/Incorporating%20Time%20into%20the%20Efficient%20Frontier.aspx

Once settled on a time horizon, investors face a new decision: should historical data be used or future assumptions? If historical data is assumed, which timeframe should be used? 100 years of data? Or just the most recent 10 years? Or a decade that most resembled our current situation? Each will provide a different frontier.

http://systematicrelativestrength.com/2016/02/17/22738/

If one chooses to use future assumptions, what assumptions should be used? Rarely do people agree on what the future will look like and nobody can consistently predict it accurately. Below is an example of possible efficient frontiers, based on differing assumptions:

https://www.linkedin.com/pulse/too-much-modern-portfolio-theory-fintech-arena-raffaele-zenti

It’s not just average investors that cannot agree on what the future looks like. There is debate amongst the largest asset managers who have vast resources, huge budgets, and large teams of economists, analysts, and researchers. Below are the 2017 capital markets assumptions from three of the largest asset managers:

Regardless of whether an investor allocates to actively managed funds or passive index funds, selecting an asset allocation is an exercise in active management. In fact, allocation decisions will likely be more determinative to a portfolio’s risk and return than whether active or passive managers are used within each asset class.

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