Tag Archives: portfolio-strategy

Think Flexible With Emerging-Market Asset Classes

By Morgan Harting A midyear sell-off in emerging-market stocks highlighted the challenges investors face in volatile times. We think a flexible approach that spans the asset classes can help. Equities dropped by about 25% between April and August, and volatility spiked to levels not seen since the mid-2013 “taper tantrum.” The cause: investors fretted about slowing Chinese growth, weaker commodity prices and looming US Federal Reserve rate hikes. It was particularly tough for passive equity investors whose exposure was concentrated in the BRIC countries – Brazil, Russia, India and China. Don’t Pay for Beta in Emerging Markets This experience seemed to reinforce the notion that investors shouldn’t “pay for beta,” particularly in emerging markets. Passive equity strategies in that arena can be as much as 50% more volatile than in developed markets. The added return needed to justify a passive equity allocation requires a lot of conviction – or disregard for higher volatility. The good news is that emerging markets are still pretty inefficient. Active managers can add value by generating higher returns to justify higher risk, or by reducing the risk in passive strategies. We think the flexibility to tap multiple asset classes in one portfolio – including bonds – can be effective. It’s a compelling way to get more active, seeking to dampen volatility and improve risk-adjusted returns. Episodes like the taper tantrum – a global sell-off across asset classes – can disrupt things. But we think those are the exception, not the rule, in cross-asset diversification. In the recent downturn, multi-asset strategies did indeed outperform passive broad-market equity strategies. Multi-Asset: Newer to Emerging Markets Developed-market multi-asset strategies have been around for a while, but the emerging-market versions are relative newcomers. Many investors still prefer asset-class “pure” emerging-market strategies: all equity or all debt. As the thinking goes, it’s better for managers to focus on asset-class expertise than venture into other areas. We think high volatility in passive emerging-market equity changes the argument. Investors should use every tool to reduce risk and preserve returns. Multi-asset emerging-market approaches offer a tool that controls volatility better than just moving to lower-volatility stocks. The average volatility of emerging-market stocks? It’s 22% over the past decade. For bonds, it’s less than 5%, and with much less downside risk. The recent sell-off in emerging markets has made the volatility and downside risk-reduction benefits more evident, as these managers have outperformed meaningfully. The Case for Crossing Asset-Class Boundaries Granted, some active managers are very skilled in individual asset classes. But no matter which emerging-market asset class you’re in, the main return driver is broad emerging-market risk. The proof is in the return patterns. Over the past decade, the correlation between emerging-market stocks and bonds has been 0.7, much higher than the 0.1 between developed-market equity and debt. 1 With so many common return drivers among emerging asset classes, it seems to make more sense to manage emerging-market equity and debt together in a single portfolio than it does with developed markets. After all, the correlation between US and Japanese stocks is just 0.5, 2 but it’s hardly controversial anymore to suggest one manager for a global equity portfolio. Many investors want to take part in emerging-market growth and may see today’s attractive valuations as an enticing entry point. But they also might question whether it’s really worth it after factoring risk into the equation. We think multi-asset approaches offer a way to reduce some of that risk. Morgan C. Harting, CFA, CAIA Portfolio Manager – Multi-Asset Solutions 1,2 For the 10-year period ending September 25, 2015. Emerging-market stocks represented by the MSCI Emerging Markets Index; emerging-market bonds by the J.P. Morgan EMBI Global; US and Japanese stocks by their respective MSCI indices. Disclaimer: MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

How To Use Active Funds In A Diversified Portfolio

Active management has been out of favor for a while-high fees, high tax burdens, and poor long-term performance. But with the slow rise of actively managed ETFs, which have lower costs and more tax efficiency than traditional active mutual funds, the gateway to active management has potentially been reopened. This is certainly a positive move, but cheaper more tax-efficient active funds don’t answer the question of how should one use active exposures in a portfolio. We address this question in this post and propose several reasonable approaches one can take to incorporate active ETFs in to a diversified portfolio: Core-Satellite: The core of the portfolio is cheap index funds, the satellite funds are concentrated active ETFs. High-conviction: The core is active ETFs, combined with strategies and asset classes that tend to work well at different times. Let’s dig into each of the approaches in more detail. Core-Satellite Approach: The Core-Satellite approach is fairly simple – for the “core” of the portfolio (let’s say 80%), invest in passive index funds. For the “satellite” of the portfolio (the other 20%), invest in highly active ETFs. Additional information can be found from the CFA institute and Vanguard . Why would this be good for an advisor or a DIY investor? One issue with going “all-in” on actively managed ETFs is that they tend to have a large deviations around an index (i.e., tracking error). For advisors who have to answer to short-horizon clients that review their accounts daily (or DIY investors who always compare themselves to an index), tracking error can create angry clients very quickly. The core-satellite approach may be optimal in this situation, because, by construction, a large part of the portfolio is allocated to passive index funds, which always keep the portfolio roughly inline with broad benchmarks. This core-satellite approach will lower tracking error of the overall portfolio, but give clients a shot at outperformance over time. How much is dedicated to passive and how much is dedicated to active really depends on the client-advisor relationship and the amount of time the advisor spends educating clients on thinking long-term when it comes to portfolio performance. The details of creating an effective core-satellite approach can get complex, but we outline some basic principles of concepts related to a core-satellite approach here . High-Conviction: The high-conviction approach is the approach we take with our personal wealth and most of our clients. Why we take this approach is described here and here . In this approach, the passive part of the portfolio does not exist because it is effectively captured in a long-only diversified portfolio already. There are many active strategies available, but we believe that Value and Momentum are the best long-term bets when it comes to active management. Of course, the problem with high-conviction active portfolios is they aren’t the entire market, and can gyrate wildly around an index. If an advisor has short-term focused investors and the gyration is positive, you’re a hero, but if short-run performance is negative, you no longer have a career in asset management-yikes! We recommend that advisors building a high-conviction active portfolio combine a variety of top-shelf concepts so they help diversify their client’s exposures and also so they limit their own career risk (unless this isn’t a factor because of unique clients). Sounds great, but if high conviction has a higher expected risk-adjusted return, why diworsify? Consider high conviction value investing, which sounds so simple – buy the cheapest highest quality stocks you can find. The problem with these strategies is they can underperform for long stretches of time! After 6 years of underperformance, are you really going to stick with the strategy? For most advisors (and their clients) and DIY investors, the answer would be NO! So diversifying across high-conviction active ideas is critical! Ideally we could find strategies that work well at different times, and then just allocate a portion to each of the strategies. For example, as shown here and here , Value and Momentum tend to work well at different times. So one might consider investing in BOTH value and momentum, as opposed to focusing on the absolute merit of one over the other. Conclusion: Overall, we outline two reasonable approaches to using high conviction active ETFs: Core-satellite and high-conviction. For those advisors and investors who want to track an index and hope to beat the market by a small amount, the core-satellite approach may be the best route. For advisors and investors who are not as concerned with more informed clients and less short-run career risk, the high-conviction route may be a better approach. Good luck.

Balanced Investing For Balanced Living

In the market’s never-ending story, we never know how its most recent action will play out. One thing we do know is that when the market is more volatile than usual, investors who lack a personalized, long-term plan to guide their way are far more likely to make the wrong moves by the time the cycle is complete. In our opinion, every investor’s long-term plan should include embracing a buy, hold and rebalance approach to investing. This is one of the simplest and most effective ways to diversify, and it may help you prosper in various financial markets over the long term. To achieve this goal, a portfolio is initially allocated based on each investor’s needs across different asset classes, such as stocks, bonds and real estate. The portfolio mix is then maintained by periodically rebalancing. Winning investments are pared back, and underperforming investments are increased during a rebalancing. A rebalancing can occur on a specific date, such as a birthday or anniversary, or it can be done using a percentage of asset method. See my book All About Asset Allocation for a detailed discussion of rebalancing techniques. Figure 1 is an illustration of rebalancing using a 50% stock and 50% bond allocation. When stocks gain versus bonds, their percentage or allocation becomes too large. Shares of the stock investment are sold, and the proceeds are reallocated to bonds. This serves as a risk control mechanism for the portfolio. Another effective way to rebalance is to employ new dollars when they are available. For example, if you were to receive a modest lump sum of cash , you could use it to “feed” the portion of your portfolio that requires additional assets. If you were underweighted in bonds, for example, you could apply the new dollars there. This helps you rebalance, while minimizing the transaction costs involved. Figure 1: Rebalancing a 50% stock and 50% bond portfolio (click to enlarge) (Chart by R. Ferri) Some financial pundits criticize a balanced approach. They say a buy, hold and rebalance strategy is simple-minded and a relic of the past. Often, their solution is to be tactical, meaning they suggest that investors aggressively move in and out of the markets in an attempt to avoid the worst returns and capture the best ones. As it turns out, the data suggests that more than half the experts fail to time the markets correctly ; their portfolios are expected to fall short of the simple strategy they mock so much. Consider Figure 2, which illustrates the returns of a portfolio initially allocated to 50 percent in stocks and 50 percent in bonds from January 1, 2007 through August 31, 2015. The period begins just prior to the worst bear market in recent memory, and includes a surge in stock prices that occurred in the years thereafter. The proxy for stocks was the CRSP Total Stock Market Index, and the proxy for bonds was the Barclays Capital US Aggregate Bond Index. Both indexes hold broad representations in their respective markets. The 50/50 portfolio was rebalanced monthly; annual rebalancing works just as well. Figure 2: Comparing a 50/50 Bond/Stock Portfolio to Each Index (click to enlarge) (Source: CRSP and Barclays Capital data from DFA Returns Program, chart by R. Ferri) At least on paper, every stock investor lost portfolio value during the crushing bear market that began in October 2007. Prices were down nearly 60 percent from peak to trough. A 50 percent stock and 50 percent bond portfolio was down about 20 percent from the peak. Even a portfolio holding only 20 percent in stocks didn’t escape the bear, and was down about 5 percent by the time the market hit bottom in March 2009. Still, Figure 2 shows that the 50/50 diversified, rebalanced portfolio fared quite well during the bear market and the recovery that followed. The return hasn’t matched a 100 percent stock portfolio over the entire period, but the volatility was considerably lower – and volatility matters! Investors who assume the party will never end and take on too much equity risk when the markets are surging upward over extended periods run the risk of capitulating in the next bear market. They often lack a disciplined plan to see their way through, and may never fully recover the realized losses they incur after selling. Lower volatility created by a disciplined allocation to stocks and bonds helps keep you invested during all market conditions. Ideally, our crystal ball could tell us to get out of stocks before the crisis, but realistically, no one knows what the market is going to do in the future. We invest in stocks because in the long term, the returns are expected to be substantially better than those from bonds. We need this growth just to stay ahead of inflation and taxes. Patience is a virtue, though. Bear markets occur without warning; bull markets often follow on their heels with equal unpredictability. And so on, and so forth. Only those with discipline throughout can expect to build wealth according to a rational course, rather than depending on random and very fickle fortune to be their “guide.” Balanced investing is part of balanced living. A buy, hold and rebalance strategy using broad market index funds is one of the simplest and most effective ways to diversify and prosper over the long term. It helps keep us sane and our portfolios more reliably on track during good times and bad. Disclosure: Author’s positions can be viewed here .