Morningstar Magazine - February/March 2014 - (Page 43)

Exhibit 1 Improving Total Portfolio Health Asset-Only Approach Value of Liabilities vs. Value of Assets Time Portfolio Health / Funding Costs Time Liability-Relative Approach Value of Liabilities vs. Value of Assets Portfolio Health / Funding Costs Time is, a portfolio containing both assets and liabilities and is referred to as a "surplus standard deviation." Historical Analysis Using the actual historical monthly returns of our set of 20 asset classes, we can determine the asset allocations that would have been optimal in the past. Since we can each now view the past with perfect hindsight, there is no need to perform any type of resampling on the historical data. Simply put, the past was what it was. We are not suggesting with our historical analysis that what has happened over this 20-year historical period will happen again in the future. We are simply providing information about what would have been the optimal portfolio given different asset-allocation approaches and potential liabilities. Time and non-U.S. commercial real estate. Second, we have included at least one U.S. component and one non-U.S. component for each of the three broad asset classes included in the study-stocks, bonds, and real estate. Doing so enables us to investigate whether liabilityrelative optimization leads to a greater U.S. home bias than traditional asset-only optimization. Third, we have split U.S. bonds, which would often be represented by the Barclays U.S. Aggregate Bond Index, into seven subasset classes: short-term government, short-term nongovernment, intermediate-term government, intermediate-term nongovernment, long-term government, long-term nongovernment, and mortgage-backed securities. This granular representation allows us to study the impact of liability-relative optimization on the credit and duration characteristics of the fixed-income allocations. Optimizations We use a single "liability model" in this article: 50% TIPS, 30% nominal U.S. bonds, 10% equities, and 10% commercial real estate. Our tool for comparing the efficient asset allocations that result from the different optimizations is an "efficient frontier area graph." The graphs display the asset allocations of the efficient frontier across the entire risk spectrum. The vertical cross section on the left side of the graph corresponds with the minimum risk asset allocation, while the vertical cross section on the right side corresponds with the maximum return asset allocation. To allow for better comparison, the results between the two optimization types are contrasted using return as the reference point on the horizontal axis, meaning that the optimal allocation is included in the area chart given that target return. For some very low return targets, there are more efficient portfolios (i.e., portfolios with a higher return for a given level of risk). If such a portfolio exists, it is the assumed allocation for that target return. For the asset-only asset-allocation area graph, risk is measured by the standard deviation of the returns of the asset-only portfolios. For the liability-relative asset-allocation area graphs, risk is measured by the standard deviation of returns of the total portfolio-that The historical optimization results are included in Exhibits 2 and 3. Exhibit 2 includes the historical asset-only MVO optimization. Exhibit 3 includes the results of the liabilityrelative optimization. Visually, the two asset-allocation area graphs share some similarities, although there are considerable differences. Regardless of the optimization approach, U.S. long government bonds and U.S. real estate each played large roles. This can be attributed to the superior risk-adjusted returns of these two asset classes over our historical test period (1993-2012). With respect to the liability-relative optimizations U.S. real estate clearly had a dominant role, especially in the more aggressive asset allocations. We also see allocation to U.S. long government bonds. If an investor has a high tolerance for risk relative to the liability, the asset-only and liability-relative optimizations led the investor to increasingly similar asset allocations at higher levels of risk. In practice, investors during their preretirement wealth accumulation periods rarely use liability-relative optimization to develop their asset allocations. However, when investors reach retirement and no longer global.morningstar.com/Morningstarmagazine 43 http://global.morningstar.com/Morningstarmagazine

Table of Contents for the Digital Edition of Morningstar Magazine - February/March 2014

Morningstar Magazine - February/March 2014
Contents
Contributors
Letter From the Editor
Preparing for the Next 50 Years
Morningstar Managers of the Year
Fixing the Trust Deficit
Rethinking the Path to Retirement
Trends
Same Old, Same Old
Global Briefs
The Economic Implications of an Older World
Banking on Performance
Is the Affordable Care Act Healing Health Care’s Woes?70
Baxter Has a Positive Prognosis
Leading Fidelity’s Charge for RIAs
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Moving the Goal Post

Morningstar Magazine - February/March 2014