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The Asset Allocation Audit

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Distinguishing Features

Several features distinguish the Audit from conventional investment evaluation approaches.

One such feature is the presentation of results in terms of decision outcomes rather than investment return components. The table below accounts for the changes in a fund's value for two different purposes. The process approach, utilized by the Asset Allocation Audit, is far more useful for control and oversight purposes.

Large Pension Fund chart

Another feature is the Audit's presentation of results in the form management is accustomed to using in its cost control function: dollars of increase or decrease from established forecasts and benchmarks. This approach quantifies answers to such questions as:

  • How much extra return have we gained over risk-free, unmanaged alternatives?

  • How much value has our most recent policy change added or lost?

  • How much value has each portfolio added above an index fund . . . net of fees?

  • How much came from market timing and how much from security selection?

  • How much value has advice from our consultant added or lost?

If you are like most decision-makers on the sponsor's side of the table, you don't have the answers to such questions simply because the information has not been generated. Typical reports from managers and custodians don't contain it. Total rates of return won't tell you either.

The Asset Allocation Audit solves this problem by disaggregating the total return along the boundaries of delegated authority and responsibility, greatly strengthening the fiduciaries' control function. It delineates the impact of all decisions from the sponsor's setting of asset class policy to an outside manager's tactical market timing and security selection. Because any decision segment can be replaced with a passive alternative, unproductive components can be eliminated without disturbing the policy or any of the other elements of the investment program.

This makes the Audit especially useful in dealing with outside portfolio managers. By presenting their results in reference to established standards, the Audit enables pension fund fiduciaries to view these portfolio managers much the same as company employees, who are hired to do certain jobs management believes need to be done.

One key feature clearly distinguishes the Audit from conventional performance reporting. That feature is its presentation of results as they develop. Period-based performance numbers are often distorted by the start and end dates for the period being evaluated. A one-month or one-year shift can lead to an entirely different conclusion about the period performance. The Audit reveals the evolution of the period performance, not just the overall result. Its methodology creates trails of monthly data that show how and when the results developed over time. This mitigates period-based distortions, which limit the management value of most other approaches to the presentation of investment performance.

The Audit's "what if" capabilities add a research dimension. Just using that function to analyze prospective managers and the implications of possible future securities markets scenarios can save staff people hundreds of hours each year. It can help answer such questions as: How much value change should we expect from a recurrence of the 1990's . . . or the 1970's?

There are other ways in which the Audit can be expected to earn back its cost many times over. The changes that can be expected to follow the Audit's installation include a clarification of roles and expectations, fewer but more productive active managers, and improved overall results at lower cost. The realities displayed usually argue strongly for a shift of research resources from portfolio managers to the corporate staff and management, who typically make the high-impact decisions.

Until now this system has been accessible only through firms outside the fund sponsor's organization. Now it is installed on an Internet site, making it available to inside analysts who do not need to be securities markets professionals. This enables them to continuously and confidentially support directors and trustees without relying upon outside service providers. Another alternative is to have the Audit installed in-house and operate it independently.

It is worth noting that the input data required by this attribution system are readily available from existing files. A clerical assistant can quickly be trained to build and append these records.

The Audit is especially useful for educational purposes. In that application it can be used to bring a valuable, more realistic, easily understood perspective to fiduciaries who are not investment professionals. It can give them the standards they need to confidently organize their delegations of responsibility and hold their decision-makers accountable for adding value by their efforts.


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