Tag Archives: global

The Proper Intellectual Framework For Assembling An Investment Portfolio

Summary Making asset allocation decisions using a backward looking framework based on the global financial portfolio ensures mental rigor. Investors asset allocation decisions should take into account current conditions. Investors will need to adjust expectations and allocations as equity and bond returns will likely be lower than in the past. We’ve written a several articles in the past about what investments and assets classes shouldn’t be in your portfolio such as commodities , currency funds , and bank loan funds . We also wrote a few articles about asset classes that should be in your portfolio such as international bonds . But, we’ve never discussed how to assemble a comprehensive, well diversified portfolio. It’s important to note we are talking about an investment portfolio so we will not be considering cash which would be part of someone’s savings portfolio. In this ongoing series of articles we’ll be discussing each of the asset classes we use to assemble client portfolios. Over the next few weeks we’ll be discussing each asset class in depth and talking about what risk and reward attributes they bring to a portfolio. For this series of articles we’ve divided the asset classes into three conceptual categories: low risk, medium risk, and high risk. The links to previous articles are below. Low Risk Medium Risk High Risk How to Assemble a Comprehensive Investment Portfolio Every Investor’s Starting Point When assembling your portfolio from all the worthwhile asset classes it’s important to keep your starting point in mind. Many investors probably utilize a forward looking mental framework. They think well, I have $100,000 to invest so I’ll allocate $x to asset class A, $y to asset class B, etc. I think a better way to look at things is to take a backward looking point of view. Start with what a portfolio of all global investable financial assets would look like. From the paper in the previous link, which was published in 2011, we can see the breakdown of all financial assets in the world is as follows. We removed some assets like hedgefunds which mostly just hold duplicative positions in equities and bonds which are already included in the global portfolio. We also removed private equity funds because they are not generally available to most investors. It’s also arguable whether or not they would constitute a distinct asset class. After all, they are just funds made up of equity investments. However since those equity investments are not publicly tradable it’s likely that private equity should be considered a separate, albeit expensive to invest in, asset class. In any case, investors should use the adjusted global financial asset portfolio as a starting point and then make changes based on their preferences and goals. For example, the global portfolio is a very bond heavy. An investor with a higher risk tolerance and a desire for higher growth would likely find it much better to overweight equities and underweight government bonds as compared to the global portfolio. Investors who’ve read our articles on commodities and high yield bonds and know that neither asset provides a compelling risk versus reward ratio would know to skip allocations to those assets. An investor with extensive private real estate holdings may elect to skip or reduce their real estate exposure. Don’t Ignore Current Conditions It’s also important to not ignore current conditions when making asset allocation decisions. For example, with short term US interest rates at zero it is highly unlikely that interest rates along the entire curve will fall very far (if at all) thus US bond returns are likely to be muted during the next few years as the Fed slowly begins to raise rates. On the other hand many foreign central banks are still keeping interest rates low or negative. Thus, investors desiring both the safety of government bonds and higher returns may find overweighting currency hedged foreign bonds a good idea. Likewise, a conservative investor planning for retirement who previously may have liked a 50/50 balanced stock and bond portfolio might find that no longer adequate to meet their return goals. As we said bond returns are likely to be below historical averages and with the US stock market either fairly or perhaps slightly overvalued equity returns are likely to be average at best going forward. Therefore, our conservative investor may need to adjust his portfolio, however uncomfortable that may be, to be more aggressive in order to meet his retirement goals. The point of all of this is that deviating from the global financial portfolio is fine. In fact, I’m not sure there would be many investors for whom the global financial portfolio would be appropriate for anyway. What investors need to do, however, is make sure that there are logical reasons for choosing the asset weightings in their portfolio. Summary In summary, an investor should start with the global financial portfolio and then in a logical manner work backward in adjusting the asset allocation of the portfolio to meet their investment goals. I believe this method is most helpful as it forces investors to put more thought into why they are making the asset allocation decisions they are.

Stay Out Of Shipping Stocks; Bankruptcies Loom

Despite the Baltic Dry Index popping briefly, shipping rates are falling once again. Dry shipping is a tough sector to be in, fraught with dilution. If rates stay this low and the global economy slows, we will see M&A and bankruptcies. “We expect a marginal improvement in earnings from the third quarter but this will be too small to have any noticeable effect on industry income. We anticipate a recovery from 2017 driven by rising demand from developing Asian economies,” – Rahul Sharan, Drewry’s lead analyst for dry bulk By Parke Shall The Baltic Dry Index continues to drop with Chinese markets correcting, the global economy in question, and federal interest rate rises on the horizon. U.S. markets have led global markets in shaky trading over the last couple of weeks and many, including us, are speculating that this could be the beginning of a global slowdown in growth. The Baltic Dry Index has never seen a global recession with rates as low as they are now, and with nowhere lower to go and with oil on the rise, we think the stage could be set for some bankruptcies and dilutive offerings in the sector. It’s for this reason we suggest avoiding dry shipping altogether. Here’s the BDI over the last month, after it’s quick pop up over 1,000. (click to enlarge) It was just weeks ago when the Baltic dry Index had popped over 1,000; we came out and said not to get used to it, and that rates will continue lower again as many global economies continue to churn a little bit slower. You could see this with China’s PMI out about two or three days ago, which came in between 47 and 49. Those that follow drybulk carriers and drybulk shipping know the BDI very well. Elsewhere in the financial world, it is a semi-unknown indicator. To those that follow drybulk shipping and commodities transport (especially import/export commodities from Asia and Africa) know that the BDI is one of the key indicators as to the world’s economic view on shipping via the oceans. The index is based out of London. The simple reasoning? When there’s more demand for cross-ocean shipping of goods, rates go up. Therefore, when the price rises, productivity globally is thought to be increasing. The same goes for when rates drop, which usually signals too many carriers without enough goods to ship. Export/import shipping declines, generally seen as a signal that the global economy could once again be slowing. Our thesis now is that the BDI doesn’t have much lower it can go and the economy is shaping up to slow, not grow. With contracting demand for oil and coal and oil prices on the rise, we could be setting the stage for disaster. Look at these recent sentiments from Hellenic Shipping News , The dry bulk shipping market will remain in recession due to contracting demand for iron ore and coal, and any recovery is not expected until 2017, according to the Dry Bulk Forecaster report published by global shipping consultancy Drewry. Falling demand and oversupply has severely impacted commodity values, with iron ore and coal prices in virtual free fall. The dry bulk shipping sector has been a casualty of these developments with resultant impacts on vessel earnings. However, there is some optimism for small vessel employment, as the onset of El Nino weather conditions will increase demand in the long-haul grain trade. The depressed state of the dry bulk sector has led to doubts about the future of many shipowners and their ability to withstand prevailing market conditions. Drewry believes that the future of a number of yards and owners are at risk and further details of this analysis are available in the report. (click to enlarge) Again, we don’t feel that oil is going to head back to or under its lows again and with oil being a major expense for many dry bulk carriers, we’re wary of the effect this will have on the already dilapidated industry. It’s very difficult to recommend dry shipping stocks after the last few years that they’ve had, the questions about dilution for all of them, and the way that the global shipping market sits. We think there is a real risk of the global economy slowing down here and not only taking some you know oil and energy stocks out of their misery, but also some dry shipping carriers either being forced to merge at horrible terms, dilute heavily or go under altogether. We think investors should stay out of shipping stocks, as there’s only more bad news ahead. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Smart Neutral Portfolios

Summary Asset allocation decisions are the most important ones that investors make. Here are some recommendations. Modern Portfolio Theory asserts that the global market portfolio is optimal for the average investor, but its underlying assumptions are too restrictive. Also, defining the global market portfolio is no easy trick. An article by Doeswijik, Lam, and Swinkels (2012) provides very helpful research. Target date funds from Vanguard, Fidelity, and Schwab provide an indication of conventional thinking regarding asset allocation for U.S. investors. In a blend of these approaches, “smart neutral portfolios” are presented for conservative, moderate, and aggressive investors. The Need for Neutral Portfolios Most investors realize that asset allocation decisions are the most important ones that they will make. Studies have shown that the vast majority (90% or more) of the long-term return of any overall portfolio is determined by its asset mix. The risk and return implications of even relatively modest differences in asset mix can be dramatic, particularly when compounded over time. Investors, especially those savvy enough to realize the dire consequences of being wrong on asset mix, are afraid of making a mistake. They are eager for guidance that will help them make sound asset allocation decisions. This paper, which builds upon an earlier paper concerning asset mix , is designed to fill that need. Neutral portfolios provide a recommended asset mix in the absence of an informational edge relative to other investors. They are recommendations for the neutral or normal asset mix for a typical investor. (I focus on U.S. investors.) The circumstances of each investor will influence the neutral portfolio appropriate for their situation. Typically, level of investor risk aversion and expected investment horizon are the most important circumstances that affect neutral portfolios. Investors with the lowest levels of risk aversion (highest risk acceptance) and/or the longest investment horizons will have the most aggressive portfolios. Those with high risk aversion and/or short horizons will prefer the more conservative portfolios. Below I present three neutral portfolios, for conservative, moderate, and aggressive investors. These can be further customized as needed. The Global Capital Market Portfolio Under a fairly restrictive set of assumptions, Modern Portfolio Theory (MPT) recommends that all investors own a representative slice of the global market portfolio. The global market portfolio includes all capital assets weighted according to their total market value (capitalization). Capital assets clearly include stocks, bonds, and commercial real estate, but could also include commodities, currencies, private equity, and even human capital in the form of education. However, usually the global market portfolio is assumed to include only investable capital assets, such as publicly traded stocks, bonds, and real estate securities. Many investors find great comfort in the fact that, so defined, MPT provides a universal, exact, and intellectually defensible neutral portfolio. It is the portfolio that can be owned by all global investors. It is assumed to be the most efficient portfolio, meaning that it has the highest expected return compared to expected risk. Although limiting the global market portfolio to publicly traded stocks, bonds, and real estate securities is common, arguably it leaves out a large segment of assets that could be very important, including non-traded real estate and privately owned companies. Measuring the size of these less common components of the global capital market, and calculating their returns, is problematic. The returns of publicly traded real estate (e.g., REITs) and publicly traded companies that invest in private equity can be used to proxy for non-traded real estate and private company returns, but the approximation will be rough at best. The best recent work attempting to measure the market values of a very wide variety of global capital assets is found in a 2012 paper by Doeswijik, Lam, and Swinkels (DLS) entitled Strategic Asset Allocation: The Global Multi-Asset Market Portfolio 1959-2011 . In the table below, I cite their figures as a starting point and then make several adjustments. I mentioned above that MPT has some fairly restrictive assumptions. These are not necessarily realistic. For example: MPT Assumption: Well informed investors will not prefer capital assets in their home country over other global assets. Reality: Investors are generally saving to fund future expenditures in their home country denominated in their home currency, so a bias in favor of the home market is entirely sensible. MPT Assumption: Global capital markets are frictionless, with no tax, legal, structural, informational, or cultural barriers to the free flow of capital. Reality: Important barriers exist in many countries, and these often reinforce the home market bias. MPT Assumption: All investors are motivated only by economics (risk and return). Reality: Some important investors are motivated mainly by politics, including governments and central banks. Many institutional investors operate with various regulatory or tax structures that affect their investments. All investors are influenced to some extent by various psychological biases. MPT Assumption: All capital assets are priced efficiently and reflect all knowable return and risk expectations. Reality: The volatility in the pricing of capital assets far exceeds any rational changes in return and risk expectations, indicating a high level of time-series inefficiency. (Price changes are far too large relative to changes in fundamentals.) Furthermore, objective studies have shown certain “anomalies,” or excess risk-adjusted returns, associated with characteristics such as value and momentum. The DLS global portfolio data is an excellent start, but in my opinion, several adjustments are needed as described below. (click to enlarge) The first adjustment I make to the DLS data (from the original article) is to break out U.S. stocks, bonds, and real estate from non-U.S. stocks, bonds, and real estate. This facilitates tilting towards U.S. assets for U.S. investors. In column 1 above I estimate the breakout based upon recent data, which indicates that U.S. stocks and real estate are about 50% and U.S. bonds about 65% of the global totals. The second adjustment has to do with the DLS estimate of the value of global real estate. Their figure of $3.7 trillion (column 1) is untenably low compared to the figures provided by multiple other sources. Recent citations for the value of global commercial real estate (which excludes owner-occupied residential real estate) range from $13.6 trillion ( DTZ quoted in the Financial Times , 2015 ) to $26.6 trillion ( Prudential Real Estate, 2012 ) to $31.2 trillion ( Bank for International Settlements, 2011 ). In column 3 I use the lower end of the range, which increases the estimated value of global real estate from 4.4% of the global market portfolio to 14.6%. The third adjustment I make is to zero out the value of all government bonds in column 5. My rationale is that the size of the government bond market is artificially inflated by the fact that both issuers (governments) and some buyers (central banks) are motivated more by politics than by economics. Also, unlike corporate bonds, government bonds largely fund current consumption rather than true capital investment. Perhaps going to zero is an over-correction, but certainly some major adjustment is warranted. Using the DLS value for total government bonds in the original article (not shown above), I subtracted 65% from U.S. bonds and 35% from developed market bonds, leaving emerging market bonds and inflation-linked bonds unchanged. Column 6 in the table above will be the starting point for forming a set of smart neutral portfolios (that reflect “smart” adjustments to global market value weights). However, further adjustments need to be made to reflect 1) an appropriate level of home country bias for U.S. investors and 2) appropriate levels of portfolio risk for various levels of risk aversion on the part of investors. Unlike the MPT-based market capitalization weighted global market portfolio, there is no universally-recognized economic theory to guide the calibration of either home market bias or portfolio risk levels. However, target date funds from the three largest providers of such funds, Vanguard, Fidelity, and Schwab, provide logical reference points. Target Date Funds Most investors find it most comfortable to hold an asset mix that is similar to what they believe other investors hold. Behavioral finance has shown that many investors seek “the comfort of the herd.” Their instincts tell them that staying in the center of the herd is the safest option. Particularly for those who are looking after the assets of others and therefore do not share in the economics of their allocation decisions, minimizing “maverick risk” (the risk of being different and wrong) is usually the chosen path because that is the best way to appear prudent and burnish one’s investment career prospects. As Keynes observed, “worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Individual investors often seek asset allocation guidance from authority figures that are perceived as experts, often in the form of asset allocation funds offered by recognized investment management companies. That is, they seek a “default option” when it comes to asset allocation. This is one reason for the enormous popularity of target date funds, lifestyle funds, and multi-asset funds in 401(k) plans. These funds are designed to guide the investor towards an appropriate default choice based upon easy, objective criteria such as expected retirement date and/or risk tolerance. For the most part, these funds focus on liquid publicly traded asset classes and are no doubt heavily influenced by what will make investors comfortable. Consequently, they reflect conventional wisdom and consensus thinking with respect to asset allocation. (click to enlarge) The table above presents three types of target date funds for three different investment horizons. “Income” funds would be for those who are currently in retirement, and who presumably therefore prefer a conservative portfolio. “Target 2020” funds would be for those expected to retire in 2020, with a moderate amount of portfolio risk. “Target 2040” funds are for younger workers who are assumed to have more aggressive risk preferences. While there are differences among the three fund providers, there is a high degree of consensus. As the target date lengthens, stock allocations increase and bond allocations decrease markedly. This is not at all surprising. Perhaps more surprising is the strong consensus regarding home market bias. In all cases, U.S. stocks are preferred to international stocks by more than 2 to 1. The home market bias is even stronger for U.S. bonds, which are preferred over international bonds by more than 4 to 1. Fidelity is somewhat of an outlier with extremely low international bond allocations, preferring an allocation to commodities instead. The fund companies are also differentiated with respect to their attitude towards short-term funds. Smart Neutral Portfolios The purpose of this paper is to put forth a set of neutral portfolios for the long-term (although they will require rebalancing and updating from time to time). They are “smart” neutral portfolios only in the sense that they go beyond the simple capitalization-weighted global market portfolio by making a few adjustments that I believe are sensible, as described above. A final set of smart neutral portfolios, conservative/short horizon – column (3), moderate/medium horizon – column (5), and aggressive/long horizon – column (7) are shown in the table below. (click to enlarge) In selecting the weights for the three smart neutral portfolios, I attempted to balance between the adjusted DLS global portfolio weights shown in column (1) and the averages for the corresponding target date funds. In general, I believe that the smart neutral portfolios are similar in spirit to the corresponding target date funds, but are somewhat better diversified, and as such, should provide a slightly more attractive return/risk tradeoff over the long-term. Clearly, the allocation percentages assigned to each asset class are round numbers. There is no decimal point accuracy implied. Investors should deviate from these weights according to their own preferences and circumstances. Over time, actual portfolio weights will drift away from their initial weights because of divergent performance among the asset classes. Investors may want to rebalance back toward initial weights based upon a time schedule and/or the degree of deviation between initial and actual weights. It may be advisable to review the weights at each year-end, particularly in taxable accounts, which may give rise to the opportunity to harvest losses for tax purposes. (That is, selling a fund to realize a loss and reinvesting in another similar fund.) The table below illustrates how the smart neutral portfolios could be implemented using Vanguard ETFs for the core stock, bond, and real estate allocations. Vanguard tends to have the lowest expense ratios of any ETF provider, as well as among the lowest bid-ask spreads, making theirs the among the least expensive ETFs to both own and to trade. (I have no relationship with Vanguard and receive no compensation from them. I am merely a fan. Substitute funds can be found from other fund companies. Similarly, I have no relationship with and do not receive compensation from the providers of the non-core funds I have selected below.) (click to enlarge) Individual investors with both IRAs and taxable portfolios will want to put the highest turnover and highest yielding ETFs into their IRAs in order to reduce taxes. Some investors may prefer to use “smart beta” funds for the core stock, bond, and real estate allocations listed above. The term smart beta is used to describe passively managed funds that are constructed using algorithms other than market capitalization weighting. Often these smart beta funds are tilted towards one or more fundamental factors, such as yield, volatility, momentum, or various measures of value such as earnings, book value, assets, or cash flow. Critics of smart beta point out that any weighting methodology other than market capitalization amounts to an active bet relative to market cap, and that the higher turnover and higher fund expense ratios of smart beta funds may negate any benefit for investors. I am a proponent of carefully selected smart beta funds, particularly those associated with various forms of momentum and value. However, I try to tilt towards particular factors and away from market cap weighting only when I believe that the reward/risk ratio is particularly favorable. I use a rather complicated process to make these decisions, and I charge my clients a fee. For purposes of this paper, however, I have opted to stick with capitalization-weighted core funds more appropriate for the do-it-yourself investor. Disclosure: I am/we are long VNQ, USCI, JNK, QAI, PSP. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: My long and short positions change frequently, so I make no assurances about my future positions, long or short. The information contained in this article has been prepared with reasonable care using sources that are assumed to be reliable, but I make no representation or warranty regarding accuracy. This article is provided for informational purposes only and is not intended to constitute legal, tax, securities, or investment advice. You should discuss your individual legal, tax, and investment situation with professional advisors.