If we accept the argument for an all cap strategy, we need to examine the choices for implementation. There are two: a top-down approach, executed by the plan administrator, consultant, third party asset allocation specialist or portfolio manager, or a bottom-up methodology, driven by the manager. Adding value to market capitalization allocation by using top-down methods presents numerous difficulties.
Structurally, there are three key issues:
1. Who makes the top-down allocation decision? Does the plan administrator do it or does he/she hire an outsider? If the decision is outsourced how is the third party chosen?
2. How are the small, mid and large cap categories defined? Where is the assurance that the definition is accurate?
3. How is the allocation decision implemented effectively? Is it based on past performance or on a multi-factor model where, based on regression, historical data can be used to indicate probabilities ahead?
Implementing the structure raises two further questions:
1. How are allocation weights determined? Should they be benchmark-based or subject to some other criteria?
2. When and how often should rebalancing take place?
Perhaps the greatest challenge to the top-down approach, however, is the volatility of historical performance data. Our research shows that simply looking at past relative performance or aggregate fundamental data is not sufficient to determine allocation weights today.
By way of example, Figure 2 provides a performance comparison between the large-cap core universe and its small-cap equivalent. It shows periods of extreme volatility over the period caused by seemingly random moves. Even with an overlay of fundamental data, it is difficult to use history as a guide for choosing current allocations.
Figure 2: The challenge in top-down allocation is that performance is volatile
Core universe performance comparison; equally weighted monthly returns
Even with an overlay of fundamental data, it is difficult to use history as a guide for choosing current allocations. By way of example, Figure 3 shows the relative performance of large-cap value stocks compared to small-cap value stocks from January 1990 to January 2002. In January 2000, at the height of the market upsurge, both asset classes were expensively priced and the performance variation was relatively small. But in subsequent years that variation widened dramatically as large-cap stocks underperformed.
Figure 3: Can we overlay fundamental data to make an assessment?
Relative performance, large value vs. small value