Asset Allocation Inc.
The Asset Allocation Audit

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Decision Levels
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Decision Levels

Total Fund

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 previously.

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.

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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.

Benchmark Return

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 here.

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.

Management Fees

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 Summary.


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