Understanding Asset Allocation
By Victor Canto
Prentice Hall, 2006
336 pages, $34.99
Reviewed by Nelson Freeburg
How does a portfolio manager achieve superior returns while methodically reducing risk? Consider the theoretical precepts and empirical findings of Victor Canto. Canto is a discerning student of price behavior and an analyst well-schooled in economic fundamentals. With a Ph.D. from the University of Chicago and wide experience as an investment manager, Canto brings scholarly insight and practical perspective to this text, which seeks to help managers maximize risk-adjusted returns through systematic asset allocation.
Canto derides the well-known “Fed Model,” which links stock prices with trends in bonds but ignores the tax structure. He attributes increased P/E ratios to the secular decline in tax rates through the last few decades more than by changes in bond yields.
Another principal finding pertains to the rotation in market leadership between large-cap and small-cap stocks. Canto finds that small-cap stocks outperform when: inflation is accelerating; taxation is expanding; and/or government regulation is intensifying. Large-cap stocks do best when these constraints on growth are subsiding.
Canto goes on to specify conditions that favor one asset class over another. He examines a range of economic fundamentals including the inflation rate, real interest rates, the dollar and other key variables. He then identifies the governing conditions that favor T-bills over
T-bonds, equities over fixed income, value over growth and other asset pairings. The discussion would be better if Canto furnished more quantitative documentation.
The most riveting points pertain to the tension between active and passive investment management. Advocates of active management cite the benefits of buying low and selling high. Partisans of passive management say that market timing doesn’t work, in part because of higher transaction costs.
Canto doesn’t bite on the argument, stating there is a time for both active and passive management. Canto shows that active managers outperform when small-caps are dominant while indexing prevails when large-caps gain favor.
He concludes with a composite allocation structure that divides the investment universe into 16 asset classes. The asset mix encompasses equity, fixed-income, and non traditional portfolios, divided into sub-groups according to market-cap, investment style, duration and geographic exposure.
Nelson Freeburg is the editor of Formula Research, a financial letter that builds and tests quantitative timing models for stocks, bonds and commodities. It serves systematic traders and institutional money managers in 27 countries.