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.       Income Funds

7.       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.

Man AHL Diversified (Guernsey). AHL Diversified is Man’s flagship fund and has produced annualized returns of nearly 18% p.a. since inception in 1990. AHL invests in futures markets around the world, where it can go long or short and thus make profits in falling as well as rising markets. Diversification comes from the range of contracts traded: 140 markets across 9 asset classes. AHL Diversified (Guernsey) is based on AHL Diversified plc, which has returned 19.1% p.a. since inception in 1996.  

Man AHL Diversified (AUD). Man’s flagship fund newly available in Australian dollars.  AUD is a commodity currency and thus has been benefitting from consistent appreciation for the last seven years, a trend we think likely to continue.

Thames River Warrior Fund; a long-running fund of hedge funds with a slight long bias, it has an excellent track record and had the distinction of one of its classes making money in August 2007, during the beginning of the credit crunch. Recent returns 2006 +15.67%, 2007 +27.35%, YTD -2.38

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.

Dawnay Day Quantum Protected Commodities Accelerator X & Protected Commodities Dynamo II. These investments give you respectively 125% and 150% exposure to a basket of energies, metals and agricultural contracts (in USD, and GBP), enabling you to participate in the commodities boom. At the same time there is a capital guarantee under your investment, giving you the opportunity to profit but with limited or zero risk of loss: the protection underneath the two investments is, respectively, 100% and 90% from a AA bank. The first Protected Commodities Accelerator has returned 182.65% since November 2004.

Man IP 220 Series 6 has returned 16.5% p.a. over the last 12 years, often delivering strong returns when traditional investments are falling.  In the last market downturn in late 2000 through early 2003 the Man IP fund range seriously outperformed world stocks; this is now happening again since mid 2007 – Since the beginning of the credit crisis, world stocks have fallen -17.3% while Man-IP 220 Limited has returned 20.2%.  This is also available in Australian dollars with the OM-IP 220, 2008 which was first launched in 1997 and so far has achieved a total return of 482.2% as of June 30, 2008.

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.  

Russian Federation First Mercantile Fund; Two stories here: One, Russia’s economic progress will make available vast mineral wealth; currently the total Russian stock capitalization is tiny and it could easily grow 20 times. Two, the manager is a Russian brought up in the US who has a real insider’s view and knowledge, as well as substantial equity in the fund.

FMG Middle East North Africa Fund; A new fund investing in the stock markets of the Arab region.  The rising oil price has meant renewed oil riches, which are trickling down to the corporate level.  Valuations are low compared to growth.  Will benefit on its fundamentals and on being ‘discovered’ by foreign money seeking returns. 

Hexam Global Emerging Markets; Invests into a concentrated portfolio of emerging market stocks, mainly but not all large capitalization, with principal exposure to Brazil, Russia, China, S. Korea and Taiwan. 

FMG Rising³ Fund; The FMG China, FMG India and the RFFMF (with two other Russia managers) all in one fund for diversification.

FMG Special Opportunity Fund; FMG’s ‘best ideas’ fund. Invests into a Swiss Bio-med manager, China & Macao (e.g. movie company; gaming companies), a Saudi property company, some mining stocks, a Russian mid-small cap fund and deep value/pre IPO companies in India. No particular target return but seeks concentrated risk, eyeing opportunities that will yield between 100% and 1,000%; will sell out when the yields are realized, or they think the investment is not going to work out.

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.   

Most investors are wondering if the bubble has burst or if this is just a correction. Frankly, I don’t blame them. Downturn has been sharp and a lot of portfolios are a lower than they were just two months ago. In our view the recent commodity correction is just that: a correction. But it’s for a reason that we hardly ever hear about. It’s been an ugly couple of months and investors are naturally getting nervous. But now, when other investors are anxious, irrational, and running scared, it is the time to start wading back in to commodity stocks.  We all know the basics. China, India and other “emerged” markets have seen their economies grow at a double-digit rate, for years. Meanwhile, the mining industry has suffered from a 25-year spell of under investment. There aren’t enough mines. Demand has remained strong and supply continues to lag in most base and precious metals, agriculture commodities, and energy.

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.”

Investec Global Gold; Invests in the shares of un-hedged gold producers around the world, thus providing leverage on the gold price. They may also invest in the shares of other precious metals and minerals miners. 

Investec Global Energy; Invests in the shares of energy explorers, producers and refiners, predominantly in North America. 

JPMorgan Global Natural Resources; Invests into a range of companies traded principally in the UK, Canada and Australia, investing into precious metals, base metals, energy and soft commodities.

3A Commodity Fund; A fund of five commodities funds with an Asian focus, the fund’s investment objective is to achieve high returns through the use of “fundamental-based relative value trading”, the process of identifying and capturing likely changes in the price relationship between related or similar assets in the same or different markets.   

6. Income Funds;

LM First Mortgage Income Fund. Invests in first registered mortgage securities in Australia, cash and “at call” securities to outperform cash.  To date distribution rates have been paid as published and investors’ capital has been preserved. Three and six month maturities are also available at correspondingly lower yields. Also available Currency Hedged Fixed Term Option in USD, GBP, EUR, CAD, HKD, SGD, JPY, NZD, THB, CHF, SEK, TRY. The currency hedging is with UBS. As there is a hedge, the investment is illiquid during its term, which may be one, three, six or twelve months. Rates on application, typically +1-2% higher than equivalent bank yields.

LM Managed Performance Fund. Same principles as the Mortgage Income Fund but with commercial loans, i.e. loans to businesses as well as on property, hence with slightly more risk and correspondingly higher returns. Also available in a range of currencies over fixed terms. Rates currently 11%.

7. Housing; best avoided for the next while our best guess is look for opportunities as they arise over the next several 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.   

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.

Since 1975, the ratio between the one-ounce price of gold and the S&P 500 has averaged just over 1.3. Even at today’s $900 gold price, the ratio remains beneath its historical average and exponentially below the levels of the last major gold bull-run in 1980, when rampant inflation and a declining dollar plagued the U.S. economy. Sound familiar?

The opportunity in this chart is clear; gold is grossly undervalued compared to the stock market, and the potential upside is enormous.

How to contact us:

Banner Japan K.K.

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Telephone: 03 5724 5100

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