Six decision levels and net cash flow typically account for a
fund's entire change in value over the period selected for analysis.
Level 1 - Risk Free Return
An entire fund theoretically could be invested only in U.S. Treasury
bills. This would offset inflation while accepting no investment
risk whatsoever. Few responsible fiduciaries would support such
a policy, but the value that can be added to a fund, risk free,
provides a baseline for measuring the risk-related returns.
Level 2 - Primary Policy
In order to increase the fund's investment return, directors and
trustees ultimately responsible for investment policy accept some
risk and establish a strategic mix of diversified asset classes
(e.g., stocks, bonds, real estate) as the investment policy. The
expected investment return can be achieved through portfolios constructed
to replicate the very benchmarks used in selecting the policy asset
classes and their percentages. The additional value that would have
been added if the primary investment policy had actually been precisely
implemented is presented at this level.
Level 3 - Tactical Policy
The lead fiduciaries often delegate to management and staff the
authority to depart from the primary long-term policy within a specified
range. They can also allow narrower sub-class indices to be used
in this second tier policy. These tactical decisions cause the fund's
value to deviate from the primary policy outcome. Level 3 shows
the value added or lost by these tactical policy decisions.
Level 4 - Implemented Policy
Various factors can cause the actual mix of asset classes to stray
from the tactical policy as well. These include inconsistent benchmarking
and inefficient rebalancing. This level of the Audit measures the
effects of such departures from the tactical policy mix evaluated
Level 5 - Selection of Managers
Previous decision levels have been evaluated by assuming only index-matching
portfolios were used to accomplish the intentions of the fund sponsor's
directors and in-house management. At this decision level, the Audit
introduces the influence of active portfolio management. The common
use of specialty managers implies an expectation that these managers
can add some value by managing a portfolio of selected securities
rather than by holding all the components of an index fund. This
level measures the value added or diminished in each asset class
by the manager selection process.
Level 6 - Allocation Among Managers
A second aspect of the management of managers involves funding
decisions. For various reasons the sponsoring organization's appraisal
of the managers in any group is seldom neutral. As a result, the
portfolios tend to be assigned varying portions of the assets allocated
to their respective asset classes.
This non-equality produces beneficial results when a manager with
an above-average allocation of assets generates above-average returns,
or when a below-average allocation goes to a below-average manager.
Potential value is lost when under-weighted managers produce above-average
returns and when over-weighted managers fall short. This decision
level measures the outcomes.
The Asset Allocation Audit processes portfolio management results
with the same methodology used to evaluate the management of the
fund as a whole. It separates the values added or diminished by
the four major determinants of a portfolio's return. The effects
of each decision group are presented in dollar terms as value added
or diminished from their passive alternatives.
Passively maintained index funds are vehicles with which sponsors
can achieve benchmark returns. These index returns are the performance
standards against which active managers are measured. The benchmark
component is separated because it is essentially mandated by the
sponsor. It represents the value a benchmark portfolio would have
added without the manager's involvement.
Manager's Market Timing
This level tracks the outcomes from the portfolio manager's decisions
not to maintain the same mix of asset classes as does the benchmark
against which the portfolio is measured. One example is that of
an equity manager changing the portion of a portfolio held in cash
reserves. Another is a bond fund manager's shifting of maturities
in anticipation of interest rate trends. The net dollar effect on
the portfolio's value from these tactical decisions is measured
Manager's Security Selection
Theoretically, a manager could maintain a portfolio of securities
that replicated the benchmark. Instead, the manager uses professional
judgment to select particular securities and weight them in ways
that differ from the makeup of the benchmark index. This attempt
to enhance the portfolio rate of return produces differences that
are measured at this level. They reveal the effectiveness of the
manager's efforts to select above-average investment opportunities
for the portfolio.
The Asset Allocation Audit isolates all fees associated with portfolio
management as a negative component of the total return. The dollar
impact of fees is presented as a separate item in the Value Added