Asset Allocation and New Wave Portfolio Theory
Paul Justice moderated a panel discussion with Sandip Bhagat and Erik Ristuben on strategic asset allocation and New Wave Modern Portfolio Theory. Bhagat is Vanguard's head of equities, overseeing both passive and active strategies. Ristuben is the chief investment officer for client investment strategies for Russell Investments. The topic of the panel was to what extent new investment opportunities and techniques should be brought to bear on the staid field of tactical asset allocation. Many investors came away from the financial crisis dissatisfied with the buy-and-hold strategy that they were counting on to guide them through the ups and downs of the market.
Both Bhagat and Ristuben agreed that while the buy-and-hold philosophy is not dead, it does need resuscitation. Additionally, the alternative to buy-and-hold is not necessarily a fool-proof approach. Bhagat pointed out that if the market-timer missed just a handful of days over the course of a 20-year period his or her upside would be cut in half. Ristuben agreed that sitting on the sidelines waiting for the right time to invest can be frustrating.
Both panelists reminded the audience that buy-and-hold is only part of the buy, hold, and rebalance philosophy that they endorse. Additionally, new products and innovation in markets require that we reassess the tools available to us. For example, 30 years ago, a typical advisor might recommend a 60/40 portfolio of investment-grade bonds and S&P 500 stocks. Today, the more prudent approach considers international markets, both developed and emerging, as well as alternative investments such as currencies, commodities, and real estate. Even a small allocation to these alternatives would have had the profound effect of reducing portfolio volatility during the crisis.
For plan sponsors who are concerned with asset and liability matching, investors prefer certainty and wish to avoid any shortfall, but Ristuben reminded the audience that certainty is expensive and many plan sponsors can not afford the level of certainty that they desire. While not overly optimistic about prospects for the equity markets, they observed that the market was perhaps too pessimistic at this point and it would be a mistake to extrapolate the flat returns in stocks from the past 10 years over the next 10 years. Asset allocators need to look at long-term valuation trends, not day by day or even quarter by quarter.
-- Michael Rawson
Currency Asset Class: Diversification For Challenging Times presented by Axel Merk
Axel Merk is the CIO of Merk Investments and portfolio manager of Merk Hard Currency, Merk Asian Currency, and Merk Absolute Return Currency funds. Merk presented currency investing as a long-term diversification tool.
Many investors don't understand why there is a return to be extracted through currencies. The currency markets are inherently inefficient because, unlike in stocks and bonds, there are nonprofit maximizing participants, such as corporate hedging departments, central banks, and tourists.
Currencies can improve the risk-adjusted return of a portfolio because of their low correlations to other asset classes. When buying or selling a currency, one pairs one currency against another (AUD versus NZD, for example), and that relative relationship is unlikely to exist in a traditional portfolio of stocks and bonds, providing the low correlation. One could alternatively gain exposure to currencies by trading baskets of equities of one country versus another, but more risk is introduced. For example, buying Chinese equities is significantly more volatile than buying the yuan. Also, because many international companies are selling to the U.S. consumer, their stocks tend to highly correlate to each other as well as to domestic companies.
Instead of stocks, one could buy international bonds to achieve international currency exposure, but investors in this case are taking on duration risk, typically at the long-end of the yield curve. Long-dated government bonds have historically seen much more risk than a normal distribution would suggest, even without sovereign credit risk, which is now a concern to investors.
Some investors believe that currencies--for example, the USD--are highly correlated to stock markets and growth in an economy. Merk believes that this can be true over short periods of time but not over the long term. In addition, Merk believes that currency appreciation is only related to growth in countries that run current account deficits. Japan, in contrast, finances spending internally, and therefore the yen has appreciated despite a slow economy.
Besides sporting low correlations to traditional assets, currencies are less volatile than equities and even fixed income. Many investors believe that currencies are more volatile than they actually are, because, traditionally, currency strategies are highly leveraged, and because small moves in currencies are highly publicized. But Merk doesn't use leverage in his strategies, and small movements in currencies do not have a large impact on the overall currency market, which is very large and extremely liquid.
In terms of investing, one can approach currencies directionally (long the USD versus single or multiple foreign currencies) or non-directionally. Nondirectional strategies include long or short the USD or foreign currencies, carry trade (long high-yielding and short low-yielding currencies), momentum (long appreciating or short depreciating currencies), and valuation strategies (long undervalued and short overvalued currencies). Both directional and nondirectional strategies can provide positive returns with low correlations.
Merk's current investment themes revolve around his belief that the U.S. economy is weaker relative to the European economy, as the U.S. continues to print money and to subsidize consumers rather than allowing consumers to deleverage. Furthermore, much of the new money supply is not reaching the appropriate participants and is instead inflating assets such as commodities. Europe, on the other hand, has taken significant measures to reduce deficits and, instead of subsidizing consumers, provides unlimited liquidity to banks to lend. Specifically, Merk is positive on Spain, as it consolidated its banking system prior to the stress tests, and its large banks are heavily exposed to more stable international markets such as Brazil. Merk believes that Greece will succeed in shrinking its deficit significantly, to 3% or 4%, and may then default, but the economy will feel a much smaller shock than it would now. Merk believes the yen can continue to appreciate but only in the absence of government intervention.
-- Nadia Papagiannis