In a rapidly changing industry, it’s easy for yesterday’s innovation to become tomorrow’s inertia. Today, I believe that observation applies to many financial advisors who have built businesses around “asset allocation.”

In 1995 and 1996, asset allocation was a cutting-edge concept. Many advisors who advocated it gained competitive advantage, while enhancing their investment discipline and client services. Now, a major bull and bear market later, some of those allocation programs haven’t changed much. In many cases, the client profiling process, asset classes, model portfolios, client presentations, and reporting formats have become ingrained.

Some allocations programs still optimize model portfolios based on performance data stretching back to the Eisenhower era, at a time when investors are more concerned about the remarkable market dynamics of 1996-2002. Many “plain-vanilla” asset allocation programs look alike, which has led to “commodization” and pricing pressure.

Today’s financial consumers are the same people who love to shop for new models every year in cars, clothes and personal computers. Many High Net Worth investors have already heard the allocation story several times, and it’s starting to sound old. Is your asset allocation process “plain-vanilla”? Use the checklist at the end of this article to evaluate.

Why Change What’s Working?

Some advisors believe asset allocation is a fundamentally sound concept that will work in any era or environment. “Why change what’s working?” they ask. The answer is that this concept has been applied long enough to evaluate how well it has met investors’ needs. In my opinion, plain-vanilla allocation has occasionally fallen short in a few specific ways:

  • Customization – Some investors don’t fit comfortably inside the five or six model portfolios that the typical program offers. Specifically, they may want exposure to more or different asset classes.
  • Income, tax planning and inflation protection – Asset allocation has not always addressed needs of investors who seek high current income along with growth potential. For non-qualified money, it often lacks flexibility in meeting needs of high-bracket investors who want to minimize taxable income or measure performance by after-tax return. Many profiling questionnaires don’t include a question about investors’ need for inflation protection.
  • Objective monitoring – All asset allocation programs assess the investor’s personal risk tolerance. But few have set objective standards for continuously monitoring and adjusting risk in dynamic markets. If an asset class turns more volatile (as large-cap growth stocks did in 2000-2001), plain-vanilla programs are ill-equipped to detect the change and respond.
  • Cost-Efficiency – Some financial advisors show clients studies claiming that allocation decisions account for 80-90% of the variability in portfolio performance, compared to underlying investment selection. Then, they implement programs with high-cost mutual funds, so that more than half the client’s “total cost” is driven by decisions that account for a small part of performance. If allocation decisions are so overwhelmingly important, shouldn’t investors be given a choice of low-cost implementation through index funds and exchange-traded funds (ETFs)?

If you rely on asset allocation, I urge you to consider it a strong foundation and build on it. Break through the barriers of inertia and make your process more current and exciting. This month, I’ll focus on one of my best ideas-adding a real estate asset class.

Real Estate: The Forgotten Asset Class

Does your allocation process include an option of putting some money into real estate securities? If not, now is a great time to make this enhancement, for these reasons:

  • Real estate is the only asset class that offers a combination of capital growth potential and high current income. Real estate investment trusts (REITs) have outperformed U.S. common stocks over the past decade, while consistently generating dividends in excess of 6% on average.
  • Real estate offers real diversification potential. According to Morningstar, many leading real estate mutual funds perform virtually at random to the U.S. stock market, with Betas and R2 correlations below .20. Most real estate funds also have negative correlation with U.S. Treasury Bonds. Adding real estate to a mix of asset classes usually produces better risk-adjusted returns, which can lift the “efficient frontier” of allocated model portfolios.
  • In the recent bear market, real estate proved its ability to preserve capital when stocks were weak. According to Morningstar, U.S. real estate funds had the best returns of any domestic mutual fund category (13.04% annualized) for the 3-year period ending 12/31/02.
  • Real estate has become a larger and more liquid investment world in recent years. The market capitalization of companies included in the composite index published by National Association of Real Estate Investment Trusts (NAREIT) has grown by more than ten times over the last decade. Including REITs and public real estate operating companies, the market capitalization of this sector is in excess of $500 billion.
  • Real estate is already a familiar and comfortable investment for many Americans. According to the Investment Company Institute, 30% of investors who hold equities (outside of retirement plans) also own investment real estate property. In the bear market’s wake, many investors decided that real estate has been their best overall long-term investment.

As successful as mutual funds have been in almost every other way, they have failed to attract investors to real estate securities. All sector mutual funds combined account for less than 4% of total stock and bond fund assets, according to the Investment Company Institute. Real estate probably claims less than 25% of the sector fund category, which means real estate mutual funds account for 1% or less of all stock and bond fund assets in the U.S. However, interest in real estate securities is being driven by two new exchange-traded index funds (ETFs). Many mutual funds in the category also are reporting increased sales.

How to Add a Real Estate Asset Class

There are two ways to add real estate to your asset allocation process:

  • Substitution – Offer clients the option of substituting real estate for the allocation percentage of another class. Most real estate mutual funds have average market caps of about $2-3 billion and a forward P/E ratio of about 9-12. That puts them in the mid-cap value “style box.” So, you could substitute a 10% real estate weighting for an equal amount of value or small/mid-cap U.S. stocks.
  • New Model(s) – Create one or two new model portfolios designed for investors who want: 1) real estate exposure; 2) more current income and inflation protection; and/or 3) less short-term volatility. The combination of stocks, bonds and real estate can create a model that historically (over the last decade) has produced about 90% of the U.S. stock market’s return with less than 50% of its volatility and double its current dividend income. That profile looks very attractive to many bear-market weary investors.

Implementing Your New Model

Although the pool of real estate securities keeps expanding, you will find that most real estate sector mutual funds invest in the same few major REITs or real estate operating companies. You also will find that (with a few exceptions) their performance falls in the same range. What isn’t consistent is operating expense ratios. They range from Vanguard REIT Index on the low end at 0.28% to more than 3.00% on the high end. In many funds, high costs are created by a small base of assets.

It’s important to select cost-effective funds for asset allocation programs because you want your real estate asset class to achieve performance near (or above) the asset class benchmark. Also, if you are charging a wrap or RIA fee for allocation-related services, you want the investor’s total cost (wrap + management fees and expenses in underlying funds) to be reasonable.

If your asset allocation program is funded with front-end commissions, the Morningstar database currently includes four actively managed funds that offer a combination of sizeable assets, economical costs, attractive yields, and strong performance (ratings of 3 stars or better).

Real Estate Mutual Fund Assets in $ million Operating Cost Ratio Dividend Yield Morningstar Rating Max. Sales Charge
Cohen & Steers Equity Income A 414 1.41% 6.46% 4 stars 4.50%
Security Capital U.S. Real Estate 181 1.24% 4.75% 4 stars 4.75%
First American Real Estate Securities A 142 1.04% 5.49% 3 stars 5.50%
Wells S&P REIT Index A 94 0.99% 5.93% 3 stars 4.00%

Data is from Morningstar as of 12/02.

For advisors who work through fee-based relationships and wish to emphasize low-cost, high-yielding choices, three passively-managed choices are attractive:

Real Estate Fund Assets in $ million Operating Cost Ratio Dividend Yield Benchmark Index Tracked
iShares Cohen & Steers Realty Majors Fund (ETF) 154 0.35% 6.32% Cohen & Steers Realty Majors
iShares Dow Jones U.S. Real Estate Fund (ETF) 149 0.60% 6.11% Dow Jones U.S. Real Estate
Vanguard REIT Index 2,057 0.28% 6.40% Morgan Stanley REIT Index

Data is from Morningstar and Barclay Global Investors as of 12/02.

The fundamental underlying concepts and benefits of asset allocation are timeless. But plain-vanilla asset allocation won’t set you apart in today’s market and may not be very attractive to sophisticated High Net Worth investors. Set a goal of making at least one major enhancement to your allocation program every year. A great way to upgrade this year is to add a real estate asset class and let your prospects and clients know about it now.

Is your asset allocation process “plain-vanilla?” Use this 11-question quiz to assess.

  1. Do you use an investor profiling process that includes personal factors or preferences obtained via in-depth interview?

    No | Yes

  2. Do you offer seven or more model portfolio choices?

    No | Yes

  3. Do you implement model portfolios with any of the following asset classes: real estate, commodities, currencies, precious metals, market-neutral equities, arbitrage strategies, or emerging market securities?

    No | Yes

  4. Do you dynamically change asset class weightings within models based on current market conditions or outlook?

    No | Yes

  5. Do you offer clients a choice of rebalancing frequency and tolerance levels?

    No | Yes

  6. Do you set objective standards for overall portfolio risk, and then monitor them regularly?

    No | Yes

  7. Do you offer one or more model portfolios designed for investors seeking tax-efficiency, and then measure performance on an after-tax basis?

    No | Yes

  8. Do you offer one or more model portfolios for investors who want to emphasize a combination of high current income and growth potential?

    No | Yes

  9. Do you offer one or more model portfolios for investors who wish to pursue growth potential without high exposure (correlation) to the U.S. stock market?

    No | Yes

  10. Do you offer one or more model portfolios for investors who want to emphasize cost-efficiency in underlying investments or funds?

    No | Yes

  11. Do you often suggest changing or replacing managers because they failed to meet pre-determined standards for risk-adjusted performance, style consistency or asset attribution?

    No | Yes

Add the number of “yes” answers. If your total is 5 or more, congratulations! Your asset allocation process has gone beyond “plain-vanilla.”