Tag Archives: portfolio-strategy

Tactical Asset Allocation – My Ideas From 30 Years Of Learning

Summary How to create an investment portfolio using Tactical Asset Allocation. Three key measures I use are interest rates, valuation, and growth outlook. When selecting countries or regions, consider demographics, job growth, urbanization, debt levels, geo-political risk and currency effects. Tactical Asset Allocation (TAA) is defined as a dynamic investment strategy that actively adjusts a portfolio’s asset allocation . My goal in this article is to share with you the ideas that I have developed over the past 30 years, and to encourage discussion amongst readers, so as we can all learn from each other’s ideas and experiences. Introduction As a financial adviser, I must first consider a client’s risk profile. Younger clients with less capital invested will typically be prepared to take on more risk, and older clients will usually be comfortable taking on less risk. To keep it simple, I consider the following four asset classes: Cash, Bonds (CDs), Property and Equities. NB: I may also add Infrastructure (when interest rates are low to medium) or other sector funds, on occasion, as a small percentage of the portfolio. In determining my clients’ asset allocation, I consider the following factors: Interest rates Valuation Growth outlook Interest Rates The table below guides me, as does the 10-year Bond rate versus the equities dividend yield. BEST WORST Interest Rates Number 1 Number 2 Number 3 Number 4 Low (0-3%) Property Equities Bonds (CDs) Cash Medium (3-6%) High (6%+) Cash Bonds (CDs) Equities Property NB: The above % interest rates above are based on the reserve bank rate. Typically, the actual lending rates are around 2-3% higher. NB: When interest rates are “Medium” (3-6%), then their effect on the four asset classes is fairly neutral. Interest rates falling is better for bonds (CDs), property and equities. Interest rates rising is better for cash. Valuation My preferred valuation measures for asset allocation are: Price Earnings (P/E) Ratio : I look at a region or country’s P/E, both historical (last year’s earnings) and forward P/E, where available. My rule of thumb is to buy heavily as the P/E heads towards 10 and sell heavily as the P/E heads towards 20. A P/E of 15 is considered neutral. Having said that, I will also factor in interest rates. The Rule of 20 holds that P/E should be 20 minus the current interest rate. E.g., USA’s P/E should currently be 20 – 0.25 = 19.75. This makes allowance for times of extreme interest rates, as does the table below on interest rates. Long-term Charts of a Country’s Equity Index : Here, I simply view a 10- or 20-year chart and see if the index is above or below its trend line. Above being overvalued, below undervalued. Growth Outlook I will assess the following for a region’s or country’s growth outlook; GDP – Current year and forecast for next year. Earnings Per Share (EPS) – Forecast for next year. I will take a look at the following factors: Demographics – Is there a rising middle class, a growing work force or wealth effect? (You can read my article on demographics here , and the one on the rising Asian middle class here .) Job growth (unemployment) – Is the country gaining jobs? Urbanization – Is the country urbanizing? Debt levels – Are household debt levels low? Geopolitical risk and quality of government – Is there low geopolitical risk? Currency valuation – Is the currency undervalued? Trying to factor in all of the above is, of course, no easy task. Nor is it an exact science, but rather, is an art form, in my opinion. Having said that, I will give an example below of how I am currently (as of August 2015) recommending to my Australian clients, based on the above. Moderate-Risk Australian Client – $1m (AUD) Cash – 30% Bonds (Term Deposits, or TDs) – 0% Property – 20% Equities (comprising Asia) – 40% Sector funds – 10% (comprising Global Infrastructure – 5%, Global Resources – 5%) NB: TDs in Australia are the same as CDs in USA. Discussion on the above Tactical Asset Allocation Cash – 30% : Low percentage, as aggressive client and interest rates are very low. The reason to maintain 30% is to have cash available (to protect and invest) in case we see a severe market correction. Cash rates in Australia are still around 2.5% p.a. Bonds – 0% : Zero percentage, as interest rates are falling in Australia. 0% to International bonds, as the rates are already very low in developed markets. Could consider Asian or emerging market bond funds, where the rates are around 5-6% p.a., but there would be currency risk. Property – 10% in Australian-listed property : Low percentage due to earnings growth outlook being weak, with a weak Australian economy and rising unemployment. Low interest rates and fair valuation (P/E 15) suggest some exposure is necessary. Finally, most Australians already have very large $ exposure to an overvalued residential property sector. 10% in Global-listed property : Low interest rates are favourable and valuations fair. Equities – 40% : High percentage due to low interest rates, fair valuations in some regions/countries, strong growth prospects in Asia (demographics mostly good, rising middle class set to triple in size by 2020, according to DBS , with good jobs growth, urbanization, mostly low household and government debt levels, mostly low geo-political risk, and mostly good governments). Global Infrastructure – 5% : Low due to valuations being somewhat elevated. Could go to 10%, based on low global interest rates. Global Resources – 5% : Low, as this sector has been smashed down, and Asian demand for resources will pick up, with 290 million new homes required by 2020 and massive infrastructure projects planned. The valuations may look a bit high, but they are based on very low commodity prices at present. The following P/Es and growth outlook were part of the consideration. Australia: P/E – 15.67, Growth outlook – Poor Asia: P/E – 17.05, Growth outlook – Strong USA: P/E – 19.92, Growth outlook – Average-to-poor Europe: P/E – 19.11, Growth outlook – Average-to-poor Japan: P/E – 16.91, Growth outlook – Average-to-poor The above allocations will certainly lead to many debates, and this is healthy. US investors will naturally have more exposure to their local assets, which will avoid currency risk. They may choose to hold a percentage in US shares, given that the long-term outlook for US companies is strong. I do not disagree with that. My concerns are for non-US investors buying into the US late in the bull run, with a high valuation and a high USD. The main point of this article is to give investors some ideas on how they can go about building their portfolios, with consideration to both risk and return. For me, as discussed, I like to start with interest rates, then consider valuations and growth outlook. I always keep one eye on risk control and the other on optimizing returns, based on the client’s risk tolerance. 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. Additional disclosure: The information in this article should not be relied upon as personal advice.

5 Ways To Handle A Low Return On Capital Environment

Summary Basic market valuation fundamentals suggest that investors should prepare for more muted returns from their equity portfolios. Economy wide transformations led by technological progress also support decreasing returns on capital. Although this low return on capital environment is undoubtedly more challenging, there are 5 strategies that can help investors build and manage a portfolio of stocks more effectively. CNBC pundits, analysts, hedge fund gurus and amateur market watchers love to make predictions about the future. They hum and haw about macro forces. They discuss the possible impacts of a rate increase and they debate the importance of China as the world’s growth engine. They try and pinpoint what the next “game-changing” technologies or companies will be and they try and estimate what the overall market will do. This preoccupation with the future is certainly fascinating to seasoned market participants but what does it all mean for the majority of investors who most likely have a large portion of their savings exposed to the stock market or at the very least is considering where to allocate their savings? At the very least market fundamentals and economy wide transformations suggest that investors should prepare for more muted returns from their equity portfolios. Market Fundamentals Suggest More Modest Returns First and foremost, basic market fundamentals support more modest returns. In terms of valuation, the Shiller CAPE ratio for the S&P 500 (NYSEARCA: SPY ) which is a cyclically adjusted price/earnings ratio – has been stuck at around 27 which is high given the median of 16. This represents its highest level since 2000 and suggests that profits are far higher than normal and should either plateau or sink from these highs, a process that may already be underway . In addition, Morningstar’s price/fair value chart suggests that value is becoming harder and harder to find. In addition, the current 12-month forward P/E ratio for the S&P 500 is 16.7. This P/E ratio is above the 5-year average of 13.9 and the 10-year average of 14.1. These valuation indicators are a cause for concern as low starting valuations have historically been one of the best indicators of market performance. Whether we are in a bubble on the verge of popping is unclear, yet what is obvious is that when prices are elevated versus earnings, future gains will be lower. Economy Wide Transformations Suggest Return On Capital Will Continue To Decrease Nevertheless, there is something more significant going on than just above average stock market valuations. More fundamentally, there are transformational economic forces that are re-shaping our societies and thus our markets. The effects of this technological progress indicate that the return on capital (or cost of capital) will decrease as technological progress increases. Why? Because technology makes innovation cheaper and thus capital more abundant. Think back to the industrial revolution. During this period it was virtually impossible for someone to start a business without substantial capital reserves. This was due to the fact that innovation was cap ex heavy (commodities, infrastructure, wages etc.). Fast-forward to today and things have changed dramatically. It has never been cheaper to start a business and thus we have large (by market cap not by employee count) companies like Facebook (NASDAQ: FB ) buying companies with 55 employees like WhatsApp for $19 billion dollars. This is a world in which the barriers to entry are dropping across all industries. Such “new age” businesses generate enormous wealth for shareholders and entrepreneurs, yet result in comparatively few new jobs. Instead, what is generated is a rapidly increasing supply of capital. Corporations are piling record amounts of cash and thus we have a lower demand for capital which causes an increasingly higher supply. The higher the supply of capital, the lower the returns on capital. Yet the transformational change does not stop here. Not only does technology make capital more abundant, it also makes capital markets and the allocation of abundant capital more efficient. This is evidenced by the rapid adoption of algorithmic trading and information technology which makes the flow of information more efficient. In this environment arbitrage opportunities become more difficult to find as information asymmetries become more unusual. There isn’t a day that goes by without a high profile hedge fund manager bemoaning the lack of opportunities for return. Thus, the cycle continues: abundant capital chasing fewer return opportunities leading to even lower returns. Nevertheless, all is not lost. Although this low return on capital environment is undoubtedly more challenging, these 5 strategies can help investors build and manage a portfolio of stocks more effectively. 1) Reset Intuitions and Assumptions Since the market bottomed in March 2009 the S&P 500 has returned around 20% on an annualized basis. This amounts to a tripling in value rising by a staggering $12.8 trillion. So given the forces outlined above which suggests lower future returns what can be expected? Traditionally, for a diversified portfolio of stocks the typical expected annual return has hovered around 6-7% . Is this lower number even reasonable? Some leading investment analysts are suggesting that a more reasonable number would be around an average of 2% annual return, after inflation and fees. Thus, projecting an annual return of around 5% would be a more useful guide. 2) Reduce Investment Costs In light of projected lower future returns, controlling a portfolio’s various costs will yield major benefits over time. For example, paying a 1% expense ratio on a balanced portfolio that earns 10 percent on an annualized basis takes a 10% cut out of the return. Lower that 10% portfolio return to 5% and a 1% expense gets much more significant. As such, purge any mutual funds replacing them with low cost ETFs and be sure to use a low cost broker. 3) Reconsider Asset Allocation Beware of over exposure to bonds. Starting yields on Treasury bonds have explained much of their performance over the subsequent decade and with yields as low as they are, overexposure to bonds will almost guarantee low returns. On the other hand investors who maintain higher allocations to equities will be better positioned to eke out the best returns possible over time. 3) Invest In Quality And Focus On Dividends Effectively dealing with a lower return environment starts with putting together a portfolio of high-quality stocks. Although high-flying growth stocks may be alluring, the risk of a terrible year of returns far outweighs the possible benefits of a fleeting moment of outperformance. Instead focus on ” wonderful businesses ” with high moats that are profitable and that will survive whatever an uncertain economy may throw at them. In addition, focus on dividends and their re-investment. Dividends have historically accounted for the vast majority of all stock returns for the last century. Some have even postulated that dividend growth is the most important factor for creating long-term wealth. Thus, companies with strong returns, consistent earnings and consistently growing payout ratios should see better than expected returns over the long term. 4) Consider Increasing Exposure to Non-U.S. stocks Despite reports of a “relatively stagnant” global economy, research suggests that there are many global markets that are projected to grow at high rates. Although foreign stock outperformance is no sure thing , there are certainly pockets of relative geographic market undervaluation worth considering. In Europe , the UK, Germany and Spain present compelling opportunities. Elsewhere, Singapore, Thailand, Australia and Russia remain significantly undervalued by Prof. Shiller’s CAPE measure. 5) Avoid Chasing Returns And Stay Focused On The Long-Term Common during bull markets yet even more common when markets are going sideways is the impulse to buy stocks that are skyrocketing while your portfolio remains grounded. Yet if you chase the best-performing stocks or sectors you risk leaving your plan behind and jumping in when these assets are reaching their peak. Try and relax, pay attention to valuation and stick to your long-term dividend growth plan. 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.

The End Of The 30-Year Bull Market For Bonds: Mitigating Portfolio Risk In A Rising Rate Environment

In a rising rate environment an investor should maintain a fixed income allocation, but with caveats. According to history, equities are a good investment option during certain rate hike cycles. Investing in private investments and flexible bond and alternative strategies is a good way to reduce portfolio volatility. The current investment climate presents some unique challenges for investors given the uncertain geopolitical environment, eurozone concerns surrounding Greece, and conflicting monetary policies between the U.S. and much of the rest of the world. Speaking of the latter, investors have been anticipating a rising interest rate environment within the U.S. in accordance with signals from the Fed to likely begin in late 2015. The commencement of quantitative easing (QE) in the eurozone in January and a loose monetary policy in Japan have driven down rates outside of the U.S., making U.S. yields generally more attractive than the rest of the developed world. Please look at chart 1 for interest rate differentials between the U.S. and other sovereign markets. Such a divergence makes little intuitive sense from a credit risk perspective and creates a conundrum for investors. Does an investor buy U.S. yields that are relatively higher yet likely to move even higher, or invest in Europe where the credit might be risky, but appreciation more likely due to QE? Further, how should investors view equities in the context of rising interest rates? Chart 1 (click to enlarge) Source: Bloomberg First, let’s examine the fixed income conundrum. Yes, it is likely that bond investors will experience price declines when the Fed begins the next rate hike cycle. Despite this risk, we argue that conservative investors should maintain some exposure to U.S. dollar denominated high-quality fixed income investments since these vehicles tend to weather market volatility well when investors are fearful; remember negative T-bill yields during the 2008 financial crisis! The aforementioned yield differentials should make the decision to move money to U.S. Treasuries much easier in such a scenario, but ideally investors should hold these positions via separate accounts, individual holdings, or through high-quality, short- to intermediate-term bond funds and ETFs. While it is true that separately managed accounts will decline in value like other bonds, investors will experience only paper losses unless sold, and short dated bonds will redeem at par and reinvest at the higher rates. In terms of bond funds and ETFs, using high quality, short-intermediate dated paper should help to control rate risk and to mitigate potential liquidity problems in the event of forced selling to meet redemptions. Turning to equities, it might be instructive to view stock market performance during previous rate hike cycles. First let’s look at correlations between weekly stock returns and interest rate movements, which are shown in chart 2. Going back to 1963, when 10-Year Treasury yields were above 5% and rising, there was generally a negative relationship between yield movements and stock prices. When yields were below 5%, however, an increase in rates was generally associated with rising stocks prices, reflecting a positive economic environment with generally modest inflation, which should be good for overall corporate profitability. Chart 2 (click to enlarge) Comparing today’s environment with previous cycles, we turn to chart 3, which shows the historical impacts of rate increases. While each cycle displays unique characteristics and circumstances, we would argue that the June 2004-July 2006 period was most reflective of today’s environment. We were at artificially low rates after emerging from a crisis, and while inflation in 2004 was higher than it is today, it was still modest by historical standards. Looking at the green line, while the S&P 500 exhibited some volatility along the way, the trend was generally positive during this 2004-2006 period. A key difference between today and 2004-2006, however, is in corporate earnings volatility. While P/E ratios were similar in both periods (in the 18 range), after a six-year bull market the current and future earnings outlook remains much more uncertain and volatile than was the case in 2004-2006. Chart 3 (click to enlarge) Considering the current environment and the comparison to previous rising rate cycles, how should investors adjust their portfolios to enhance returns and mitigate volatility? While there has been a significant shift toward maintaining maximum liquidity after the 2008 financial crisis, we believe investors should consider initiating or increasing exposure to private and/or alternative investments to diversify away from the volatility of public markets (both equity and fixed income) to reduce correlation among asset classes. For those investors choosing to maintain maximum liquidity, consider investing in flexible fixed income or ’40 Act alternative mutual funds focused on absolute return, not market benchmarks. Additionally, despite the likely scenario of rising rates in the U.S., maintain at least some exposure to high-quality U.S. fixed income based on global interest rate differentials and as a portfolio safe haven. Finally, be willing to hold some cash as it will act as both a buffer, as well as a means for replenishing the marginal liquidity given up in the private markets. 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. I have no business relationship with any company whose stock is mentioned in this article.