Asset allocation thinking

Active versus Passive

There is significant evidence and consensus among experts, that it is very difficult to outperform the market consistently. Therefore one should just hold a balanced portfolio of low cost ETF’s that are non-correlated and perform well in different environments. While we do not think this is bad advice (diversification and low fees are important), we differ on two key items:

1.  We believe that with the proper understanding and measurement of economic cycles and risk, it possible to outperform the market over the long term. Proper classification of cycles enables us to evaluate the risk and return characteristics of each asset class in different economic environments.

2.  It is important to evaluate your allocation with consideration as to how the current macro environment differs from that of the past 40 years on major issues like demographics, the long term debt cycle, and the global investment opportunity set. For example, the available historical return data beginning in 1973 is inclusive of a 30-year bull market in bonds and we are now at the end point of the long term debt cycle. Or, consider that an aging population will almost certainly guarantee lower growth rates than we have seen historically. Yet another point worth considering is the rise of emerging markets which now represent 25% of the global market capitalization versus 5% thirty years ago. Hence we believe that although historical analysis of data provides crucial insight and fundamentals of economic cycles do not change much, it makes sense to plan for the next 30 years bearing in mind how some things have “really” changed.

Getting the big picture right

Asset allocation is the most important investment decision that a long-term investor makes. It is important to try and get the big picture right by starting with a long-vision strategic allocation for each asset class. As follows is our general perspective on each asset class as a future investment, along with our allocation targets  –

Real Estate

Real estate provides income, growth and inflation protection. Measurement of inflation is tricky and somewhat subjective, but from an individual investors’ perspective, it depends on your basket of purchases. In general, many produced items such as phones and televisions that form a part of the consumption basket have benefited from technology innovation that has brought down the cost of these items and kept inflation low.

Real estate is subject to scarcity constraints and has not become cheaper due to technology innovation. A look at home price trends or construction costs will support this. Further, as we point out in this article on the phenomenon of declining company lifespan, the pace of technological change is causing faster company attrition. Under the circumstances, we like the fact that real estate, particularly residential, is one of the basic staples that people will always need and is not likely be innovated out of existence. Lastly, in evaluating the performance of real estate over the stages of the economic cycle, it is the most consistent of all asset classes. Given this, we like the logic of having a heavy real estate component in the portfolio and make a permanent allocation of 17.5% to it.

Gold and Commodities

While we do not usually support buying non-income producing assets, such as gold or commodities, they do offer some diversification value and have performed well during certain stages of the economic cycle. We allocate 7.5% of the portfolio to gold and 5% to commodities but adjust our exposure downward if the environment is not favorable. This reduction is allocated among the stock/bond composite.

Our commodity exposure is implemented by investing in the Australian stock market index.  It has a very high level of correlation with commodity prices over time but it still pays a healthy dividend which obviates our concerns with owning non-income producing assets.

The balance (70.0%-82.5%) of the portfolio is allocated between bonds and equity.

Bonds

Being stuck with bonds for the next twenty years at a yield of 2% is an unsatisfactory solution for most, especially for retirees or baby boomers who will be relying on their investment portfolio for retirement income. Being the most predictable part of the portfolio, we can say with a fairly high degree of confidence that bond returns will be low for the foreseeable future and also carry risk of significant capital losses, if or when, interest rates increase. While our expectation is that rates will remain low for an extended period of time (see our article on this subject here) and therefore reduce the risk of capital loss, we nevertheless still find the 2% nominal return, before inflation, to be an unsatisfactory result.

Bonds can however, generally be relied upon to outperform during periods of economic distress as a flight to safety asset, and so do have a place in our portfolio. However, our goal is to keep our bond exposure to a necessary minimum for safety. The first important step we take is to know exactly what our true bond exposure is, as we describe this article. Next we utilize our proprietary business cycle classification model to determine when the economic environment is worsening and during this stage of the cycle we increase our bond allocation.

Our model had an average nominal bond exposure of 29% over the past 40 years and still outperformed on a risk adjusted basis by more than 40% versus the 60/40 benchmark.

Equities

On a nominal basis, equities provide exposure to economic growth and generally rank among the best performing assets historically. However, they are also volatile and can experience significant draw-down periods. This can be particularly troublesome for retirees relying on their portfolio for income. Periods that are good for equities are generally not as good for bonds and vice versa. The process of tactically adjusting our bond allocation explained above causes a concurrent inverse change in our equity allocation.

The goal of our economic cycle classification model is to take advantage of the time varying nature of performance of these two asset classes relative to the economic cycle. Overall, we allocate between 70.0% and 82.5% to the bond/equity composite, but first we allocate the minimum necessary (based on the economic environment) to bonds for safety and the remainder gets allocated to equities. Our model had an average equity exposure of 45% over the past 40 years