Kaplan, Frontiers of Modern Asset Allocation

Frontiers of Modern Asset Allocation (Wiley, 2012) could be subtitled “the collected essays and interviews of Paul D. Kaplan, quantitative research director for Morningstar Europe.” In 27 chapters, most previously published as journal articles in the last decade, Kaplan analyzes a range of issues that both academics and practitioners have found worthy of debate.

The book is divided into four parts: equities; fixed income, real estate, and alternatives; crashes and fat tails; and doing asset allocation. Some of the chapters, such as “Updating Monte Carlo Simulation for the Twenty-First Century” and “Markowitz 2.0” are technical and require quantitative skills. Others, such as those dealing with indexing, will be of interest primarily to academics and those who structure products. Still others are accessible to both financial professionals and investors with some background in statistics. The interviews with such noted figures as Roger Ibbotson, George Cooper, Benoit Mandelbrot, Harry Markowitz, and Sam Savage combine serious—mainly quantitative—discussion and debate with the occasional personal anecdote.

Let’s look very briefly at a 2000 paper written by Roger G. Ibbotson and Kaplan, “Does Asset-Allocation Policy Explain 40 Percent, 90 Percent, or 100 Percent of Performance?” for which the authors received a Graham and Dodd Award of Excellence. The authors raise three questions: “How much of the variability of return across time is explained by asset-allocation policy; how much of the variation among funds is explained by the policy; and what portion of the return level is explained by policy return?” (p. 257) They examined ten years of monthly returns of 94 U.S. balanced mutual funds and five years of quarterly returns of 58 pension funds. Fast forwarding to their conclusion: “asset allocation explains about 90 percent of the variability of a fund’s returns over time, but it explains only about 40 percent of the variation of returns among funds. Furthermore, on average across funds, asset-allocation policy explains a little more than 100 percent of the level of returns.” (p. 265)

Kaplan’s book will not appeal to the average individual investor. However, for those whose job it is to think seriously about asset allocation—whether theoretically or in practice—it offers a wealth of information.