Asset allocation – where should you be invested?

Modern Portfolio Theory

Early in the 1950s Harry Markowitz suggested that asset allocation accounted for approximately 90% of portfolio performance on a risk-adjusted basis, a figure that has been borne out repeatedly by subsequent studies, and incidentally gaining him a Nobel Prize for Economics in 1990. This suggestion is called Modern Portfolio Theory. It holds that a diversified range of assets will produce not only more consistent but also better returns over time than contending ways of running a portfolio, namely securities selection and market timing. It is in fact a staggering observation on Wall Street activity that the hundreds of millions of dollars spent annually on stock research and the timing of buys and sells don’t make that much difference to portfolio returns (although they do foster investor illusions and thus public enthusiasm to invest). But Markowitz’s suggestion is that the area really worth concentrating on is asset allocation. In other words the baskets.

A rigorous application of Modern Portfolio Theory will distinguish among kinds of stocks (large cap / small cap; value / momentum; sector), kinds of bonds (high grade / high yield; sovereign / corporate), and both across currencies. This kind of asset allocation matrix makes for a much more thoroughly diversified and therefore durable and efficient portfolio. We can also add into the mix property, both as value (although property values do not always go up, as in the UK in the late 1980s and of course right now) and as income. And then there are commodities, an interesting asset class; as they tend to rise and fall counter-cyclically to the broad stock market – although of course commodities stocks are powered by commodities prices.

Finally, a modern asset class not available to Markowitz at the time is hedge funds, by which I mean disciplined alternative strategy funds that achieve returns in a wide variety of market conditions by hedging out risk.

So let’s have a brief look at the various baskets. 

1.       Market-Neutral/Absolute Return

2.       Capital Guaranteed Market-Neutral/Absolute Return

3.       Equities Market Long

4.       Specialist Equity Theme Funds

5.       Commodities and Precious Metals

6.       Housing

1. Market-Neutral/Absolute Return: funds that seek to provide positive returns in whatever market conditions and thus do not depend on stock or bond prices going up to make money. In an environment where major stock indexes could well be sideways to down for several years, and bond prices are vulnerable to government liquidity pumping, with the attendant threat of inflation, absolute return funds are an attractive asset class. The following suggestions cover a range of volatilities.

2. Market-Neutral/Absolute Return with Capital Guarantees: same as in the above section but there is a safety net underneath the investment provided by an international bank of at least AA- strength. After a specified period you are guaranteed at least your principal, and in some cases more, no matter what the performance of the fund, which provides peace of mind.  All capital guaranteed funds have a limited offer period after which they close. The guaranteeing bank has to know how much it is guaranteeing. Guaranteed funds therefore tend to get offered in tranches, several times a year. A fund past its offer period is retained on this list for illustrative purposes, and is replaced once the details of the succeeding offering have been confirmed.

3. Equities market long – if you have them ride them out, if you are not in equities wait as there are better entry opportunities ahead. Or look to start a regular investment plan and invest into the eye of the current crisis, yes at least 10% in financials. 

4. Specialist Equity Theme Funds; while we are not especially hopeful about the future performance of major stock markets, some (currently) smaller markets and specialist equity funds have provided superior returns and we think they will continue to do so over the coming years. Some of these funds are partially hedged (seeking to capture gains from the fall of weak stocks, as well as from the rise of strong stocks).  Some are macro bets – for example on the rise of the Indian middle class, or on the wealth of Russian resources versus the tiny size of the stock market through which they are capitalized. Of course these funds carry the risk of large loss, but also the promise of large gain.  

5. Commodities and Precious Metals; asset classes go through long cycles of bull markets and bear markets.  Arguably major market stocks and bonds have been through long bull markets and embarked on bear trends. Commodities, led by the precious metals, starting 1999/2001, have embarked on a bull run, after twenty years of bear market, and once underway commodities bull markets tend to last 15-20 years.  The demands of large emerging economies as well as supply and capacity constraints are sending commodity prices higher and will continue to do so for the foreseeable future. We believe investors should overweight investment in this sector, partly in the pursuit of profit, and partly as insurance against the prospect of inflation.   

Jim Rogers, hedge fund manager who wrote the book on the emerging commodity bull market in 1999, says, “Throughout history, bull markets in commodities have lasted a long time. They’ve averaged about 18 years or 19 years. The shortest I could find was 15 years; the longest was 23 years.”

A final thought; Energy prices will rise again and faster this time. Reasons behind this are also very simple, consider that in 1850 it took 1 unit of energy to get 100 units back; this was good and society changed immensely due to the sudden surge of excess energy. The units of energy in the 1990’s went down to 1 unit in to extract 25 units – today we are at a situation where it takes 1 unit of energy to get back 10. This is basically what peak oil is all about, we have used all the easy to get oil, and now the oil we are getting is more energy and cost intensive. This tells us one thing, in the coming years energy will cost a lot more. One needs to start building positions to profit from the coming shortfalls. When one considers all the press about the Tar sands in Canada and how they have more oil the Saudi Arabia it all sounds good but the reality of this is; the energy in of 1 unit only gives back 3, we am quite sure this will reduce in coming decades.  

So the long and short of the market is – we are going through a horrible credit excess and this needs to be purged from the system, markets are down but they will recover in time and if you are looking in the correct places there is much money to be made going forward and we believe this is in hard assets.  (April 2009) 

We look forward to helping you make use of current opportunities that will reward you in the years ahead, please get in touch with your Banner representative 03-5724-5100.

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