El-Erian's Recommended Allocation vs. Harvard, Yale

I just read Mohamed El-Erian's new book When Markets Collide this past weekend.

Am I the only person to notice that his allocation only adds up to 98%? Weird. (I just added 2% to cash.) I did like this quote from the book which reminded me of my post a couple months ago on optimizing happiness:

There is growing talk about the importance of reducing noise lest it adversely impact quality-of-life indicators.

Anyway, below are the allocations of the Harvard and Yale Endowments vs. El-Erian's recommended allocation. As you can see, it is a fairly similar allocation to the Harvard endowment, with a little more in foreign bonds and no allocation to hedge funds. I lumped infrastructure in with real estate so that it could be compared to the endowments on an apples-to-apples basis.

Following that is a comparison if you back out the private equity and hedge fund allocations. Special situations was lumped into cash. He described them as:

investment opportunities that are attractive but do not fit comfortably into the categories I have covered so far...they usually relate to two types of activities: new longer-term activities that are supported by a secular hypothesis but are yet to gain broad-based acceptance; and shorter-term activities that materialize due to sharp dislocations that involve significant overshoots.

This seems to be somewhat of a subjective recomendation and not all that useful for the retail investor. He mentioned water, agriculture, and carbon credits as three areas for the longer-term secular activities.

The expected return is right in line with the endowment allocation I mentioned in my paper, or roughly a 1:1 return to volatility ratio (about 10% return with 10% volatility and 20% drawdown over time).

Comments

[desi]

Mr Mebane Faber...

Thanks for linking the portfolio allocation to ETF's . This helps an individual investor to easily create his own portfolio. In an Interview with Barron's two weeks back, Mr EL Erian had recommended a similar allocation. Thanks again

[rudi]

I'd find it interesting to know, how these portfolios are being created. As I am involved into asset allocation a lot, I wonder why there is so little allocation into bonds. I think the difficulty is, what expected returns to assume, when optimizing the portfolio by the best sharpe ratio (or some other ratio). As you can see, all portfolios assume >10% commodities to be appropriate. I find results like that, when I imply the empirical returns of commodities for the last years. Minding the efficient market hypothesis, there is no reason to assume more than the inflation rate plus some increased demand due to worlds economic growth, as an expected return. This would be 3-4% in my opinion. This leads me to a portfolio with maximum 5% commodities.

I conclude the harvard portfolio to be defenitely the best, since they are best diversivied, i.e. they have the most asset classes. High yield bonds and inflation-linked bonds should be included in every good portfolio.
In spite of that, the harvard portfolio could be easily outperformed (risk adjusted) by a portfolio like that:

-International Stocks (weighted by marketcap) 20% (ACWI)
-International inflation-linked-bonds 30% (TIP)
-High yield bonds 3% (HYG)
-Bonds with short avg. maturity 18% (SHY)
-International Bonds 12% (BWX)
-Commodities 5% (DBC)
-Real Estate 7% (VNQ)
-Private Equity 5% (PPE?)

Keep in mind, that private equity is correlated with stocks. So there is a lot of emphasis on stocks market in all mentioned portfolios.

The idea of having hedge funds is in my opinion misleading as well, since they are either doing some similar allocation, or they apply some strategy, which includes short selling (not sticking to efficient market hypothesis), what means, you are long and short in the same assets at the same time, just wasting fees.

By the way, there are even more asset classes, that should be added to the portfolio, but I wanted to show a portfolio, which doesnt't include more than the harvard one and is already more developed.

best regards
rudi

[Seaferer20]

I agree with Desi - correlating ETFs with Mr. El Erian's asset allocation model translates his institutional thesis into individual investor tools.

[Seaferer20]

Rudi posted his comment as I was writing mine. It's interesting to note that there doesn't appear to be any domestic stocks in Rudi's although he closes with the caveat that "there are even more asset classes, that should be added to the portfolio". But then what and how much would be subtracted from the above?

[Foust]

"I conclude the harvard portfolio to be defenitely the best, since they are best diversivied, i.e. they have the most asset classes."

There is a difference between being the most diversified (number of asset classes) and best diversified. Also, there must be some sort of distinction in the hedge fund space to fully appreciate the allocations, it is too generic and broad a category. Same with private equity (venture, buyout, etc.) and where do timber and other private real asset classes fall?

[Xyrus]

This is kind of amusing. That's pretty much my allocation strategy...right down to the ETFs. :)

~X~

[rudi]

I completely agree with you, Foust. I admit, the sentence you quoted was not the best I wrote ;)
Of course most asset classes does not mean the best allocation. To be more concrete, I like the high yield bonds in the harvard portfolio, and the higher percentage of inflation-linked bonds. Also, they have less stocks then El-Erian.
All portfolios in my opinion underweight bonds drastically!

Seafarer: The domestic stocks are in ACWI (international stocks). As far as I remember they hold 40% US stocks.
To your question: I would add stocks, which are quite unrelated to S&P500 for example. This could be "defense", like LMT. Other ideas are holdings, e.g. BRK.B and shipping, e.g. OSG. Secondly, I would add carry trades to the portfolio. Check out DBV. Since DBV is too expensive, I would make the carry trades manually via forex trading. Thirdly, I would have a look at covered calls, like BEO. If you have some more ideas, please let me know, I am alway looking for some >6% return investments, which are a stand-alone asset class, to diversify with. Back to the question: I would then substract from ACWI mostly and from real estate.

By the way, I am not just guessing these numbers, I retrieve them from statistical portfolio optimization. I can for sure tell you, that >30% stocks is way too much. 10-15% is healthy.

best regards
rudi

[Indexor]

Mebane: Excellent article, as always. I always look for your posts as we share very similar phiosophies on managing assets.

As Xyrus mentioned, that is my allocation strategy as well, including the specific ETFs, although I am weighted a bit diferently.

Thank you.

[Tindesk24]

I do not think that high yield bonds, international bonds or even corporate bonds are true asset classes. US Treasury Bonds are not callable and provide a certain outcome. Other than funding known liabilities what is the purpose of owning a bond? And if there is a purpose to owning a bond why would you buy anything but a UST? My point is that investors do not know the risk of buying fixed income - the recent mortgage bond debacle and its victims should be proof of that. The standard response that bonds lower volitility does not make sense; since volitility is only bad if investors anticipate needing the money. If that were the case they would be better off matching up bonds to those liabilities and letting their bets ride on equities were they are fairly compensated for the risk.

[Hankster]

In reviewing your asset allocation, it appears that you have 63% of your portfolio in bonds? Seems high to me. Would you mind sharing with me why? Thanks.


On Jun 10 08:19 AM rudi wrote:

> I'd find it interesting to know, how these portfolios are being created.
> As I am involved into asset allocation a lot, I wonder why there
> is so little allocation into bonds. I think the difficulty is, what
> expected returns to assume, when optimizing the portfolio by the
> best sharpe ratio (or some other ratio). As you can see, all portfolios
> assume >10% commodities to be appropriate. I find results like that,
> when I imply the empirical returns of commodities for the last years.
> Minding the efficient market hypothesis, there is no reason to assume
> more than the inflation rate plus some increased demand due to worlds
> economic growth, as an expected return. This would be 3-4% in my
> opinion. This leads me to a portfolio with maximum 5% commodities.
>
>
> I conclude the harvard portfolio to be defenitely the best, since
> they are best diversivied, i.e. they have the most asset classes.
> High yield bonds and inflation-linked bonds should be included in
> every good portfolio.
> In spite of that, the harvard portfolio could be easily outperformed
> (risk adjusted) by a portfolio like that:
>
> -International Stocks (weighted by marketcap) 20% (ACWI)
> -International inflation-linked-bonds 30% (TIP)
> -High yield bonds 3% (HYG)
> -Bonds with short avg. maturity 18% (SHY)
> -International Bonds 12% (BWX)
> -Commodities 5% (DBC)
> -Real Estate 7% (VNQ)
> -Private Equity 5% (PPE?)
>
> Keep in mind, that private equity is correlated with stocks. So there
> is a lot of emphasis on stocks market in all mentioned portfolios.
>
>
> The idea of having hedge funds is in my opinion misleading as well,
> since they are either doing some similar allocation, or they apply
> some strategy, which includes short selling (not sticking to efficient
> market hypothesis), what means, you are long and short in the same
> assets at the same time, just wasting fees.
>
> By the way, there are even more asset classes, that should be added
> to the portfolio, but I wanted to show a portfolio, which doesnt't
> include more than the harvard one and is already more developed.
>
>
> best regards
> rudi