Not too many year ago - back in the day when counting eyeballs was more important than counting cash flow - there was an index of high-tech internet stocks that was constructed by the stock picking ability of a dart-throwing monkey named Richard Thurgood. The index, called the MonkeyDex, was around for a while until, like Rodger Clemens's pitching arm, Mr. Thurgood was unable to throw an acceptable dart.
Fast forward 12 years, and today many investors still chose their investments like Thurgood, throwing money at what is presumed to offer an adequate return for an assumptive risk to invested capital, without much consideration of the impact on the overall portfolio asset allocation. Over time, a conglomeration of stocks can become overweight in specific sectors and some asset categories could lack exposure altogether. A better approach could be to evaluate your portfolio against a measurable asset allocation. The one I like to use is a Broad Asset Classification that pigeonholes most investments into one of 8 major and 14 minor groups. These are:
- US Equities - Large-Caps
- US Equities - Mid-Caps
- US Equities - Small-Caps
- Foreign Equities - Developed
- Foreign Equities - Emerging
- Real Estate
- Hedge Funds
- US Bonds - Fixed Coupon
- US Bonds - Treasury Protected Securities
- Foreign Bonds - Developed
- Foreign Bonds - Emerging
Within this matrix, an investor can derive a clearer picture of the diversification of assets. Individual investment strategies, such as dividend growth or value fundamentals, can be incorporated into this broad based model. For example, a dividend growth investor could select the majority of equities with this focus, such as finding the best dividend achiever within the real estate sector.
The categories are pretty self-explanatory. Commodities & Resources, Real Estate, and Hedge Funds are considered by some to be "alternative" investments. However, they can also be main stream with the inclusion of oil, coal, timber, natural gas, and metals. Real estate could include timberlands and the wide variety of REIT configurations. Hedge fund exposure is a bit easier for individual investors with the advent of publicly-traded hedge fund firms and their debt. Many public hedge fund firms are structured as LLCs and, like a MLP, have unique tax considerations. While some have greatly disappointed their initial IPO investors, owning a piece of the fund manager rather than the products they are pushing may have interesting opportunities.
An individual's investment risk should drive the composition and weighting of each asset group. For example, a more conservative, older investor may choose to have a higher exposure to fixed income than a younger, less conservative investor. However, the flexibility to design specific strategies within the grouping creates the ability for the conservative investor who is concerned with interest rate risk to focus on short maturities and low durations while a higher risk-taker could look for longer maturing, high yield corporate bonds.
Some investment allocations may be best covered using ETFs or low-cost mutual funds. For example, the category Foreign Bonds - Emerging Markets may be difficult for individual investors to follow intelligently. Relying on specific expertise in niche allocations is a vast improvement over having no exposure at all. Utilizing Wisdom Tree's Emerging Market Debt in Local Currency (NYSEARCA:ELD), for example, gives exposure to both emerging market debt and a falling US Dollar as the debt is priced in local currency with minor hedges against the dollar.
Even for a "couch potato" investor, it is very possible to choose low cost ETFs and index funds to gain overall asset exposure. For example, using popular index ETFs, broad based S&P 500 ETF (NYSEARCA:SPY) or Vanguard S&P 500 ETF (NYSEARCA:VOO), S&P Mid-Cap 400 ETF (NYSEARCA:MDY) or Vanguard Mid-Cap Growth ETF (NYSEARCA:VOT), and S&P Small Cap 600 ETF (NYSEARCA:SLY) or Vanguard Small-Cap Value ETF (NYSEARCA:VBR) would fulfill the US Equities component. To add a bit more speculative flavor, the S&P Oil and Gas Exploration and Production ETF (NYSEARCA:XOP) alongside the iPath Dow Jones-AIG Commodity Index Total Return ETN (NYSEARCA:DJP) would gain Resources & Commodity exposure.
Scan the ETF universe for international exposure, such as S&P Emerging Market Infrastructure ETF (NASDAQ:EMIF) or Vanguard Total International Stock ETF (UXVS). Add in some iShares Dow Jones U.S. Real Estate Index Fund ETF (NYSEARCA:IYR), a little ELD and PIMCO Australian Bond ETF (NYSEARCA:AUD) for international bond exposure, along with short-term PIMCO 1-5 Year TIPS ETF (NYSEARCA:STPZ) and a dash of date-specific Guggenheim 2015 Corporate Bond ETF (NYSEARCA:BSCF).
Many investors have little or no exposure to Real Estate outside their primary residence. IYR incorporates many of the larger companies in the real estate sector with 92% of its 84-position portfolio companies either large- or mid-caps. According to Morningstar, IYR forward dividend yield of 4.48% is higher than its Category Average of 2.38%, while IYR valuation seems a bit lower than its peers at a Morningstar Price/Prospective Earnings ratio of 29 vs a Category Average of 40 and Price to Cash Flow of 15.2 vs 17.5, respectively. However, IYR lower long-term earnings growth rate of 5.5% vs 7.0% for the Category Average could be the reason for Morningstar's Three Star ranking. For some investors, especially those looking for equity income, the substantially higher forward yield of IYR could offset the potential of slower dividend growth that would seem appropriate with lower earnings growth.
The ETFs listed above may or may not be the "best in class" and individual due diligence is required. However, the point remains: With as few as 7 to 13 carefully chosen funds and ETFs, it is possible replicate the core of this diversified asset allocation model.
Overall investment returns would, of course, depend on the specific investments selected and the percentage allocated to each asset group. However, a broad based allocation model comparison should assist in better portfolio management if diversification is one of the basic strategies.
An advantage to this asset grouping is the placement of a high valuation on holding some cash. While currently low yielding, maintaining an investment cash balance provides important portfolio benefits, such as an ability to take advantage of overall market declines by having reserve capital ready to deploy and a reduction in overall portfolio volatility. Image having the capability to buy equities in the spring of 2009 based on a 5% cash balance of a portfolio valued in the fall of 2007?
The conundrum of this type of portfolio analysis is to determine what is "right" for the investor's risk profile and investment goals.
An equal-weighted broad asset classification portfolio would equate to 7.1% weighting in each minor class. An equal weighted minor class allocation would create a major class allocation of 21.3% US Equities; 14.2% each in Foreign Equities, Commodity & Resources, US Bonds, and Foreign Bonds; and 7.1% each in Real Estate, Hedge Funds, and Cash.
Once a year, Barron's publishes the asset allocation of the "top" 40 private wealth management firms. Using an average of the individual asset allocation of these top 40 firms, as of March 2012, would create the following portfolio allocation (with a high/low range):
- US Equities - 30.7% (Merrill Lynch 51%/GenSpring 10%)
- Foreign Equities - Developed - 8.4% (AllianceBernstien 21%/ 3 Firms 0%)
- Foreign Equities - Emerging - 5.6% (Barclay's 10%/GenSpring 2%)
- Commodities & Resources - 3.4% (HBSC 20%/9 firms 0%)
- Real Estate - 2.8% (Wells Fargo 8%/10 firms 0%)
- Hedge Funds - 11.7% (SunTrust, GenSpring 30%/9 firms 0%)
- US Bonds - 29.4%, of which 23.4% is "high quality" (Harris Private Bank 47%/US Bank 14%)
- Foreign Bonds - Developed - 1.8% (Citi Private Bank 12%/20 firms 0%)
- Foreign Bonds - Emerging - 2.1% (GenSpring 7%/14 firms 0%)
- Cash - 3.9% (LPL 20%/12 firms 0%)
This portfolio allocation can also be grouped as 28.4% Fixed Income, 35.5% Equities, 17.7% Alternatives, and 3.9% Cash.
A recent Barron's article dated Sept 3 listed Mr. Joe Montgomery of Wells Fargo Advisors allocation as: US Stocks 10.8%, Int'l Stocks 10.9%, Emerging Market Stocks 4.8%, US Bonds 15.0%, Foreign Bonds Developed 19.0%, Foreign Bonds Emerging 8.9%, Bonds Floating Rate 3.0%, Alternatives 25.6%, Cash 2.0%. Montgomery's allocation can also be grouped as 45.9% Fixed Income, 25.5% Equities, 25.6% Alternatives, 2.0% Cash.
It is very much worth an investor's time and effort to create, and update, a spreadsheet outlining their current investment asset allocation. It is important to review not only individual investments, but to include those assets held in employer-sponsored 401(k) and IRA plans as well.
While not all investors will or should have the same asset allocation, knowing how a portfolio is constructed should give insight into better money management. It is far better to have voids in a portfolio strategy by design with a defined reason for exclusion than by default.
Are the holes in your current portfolio asset allocation by design or default?
The importance of this asset allocation exercise is to better match an investor's risk profile and investment goals with the investments within their portfolio. Adding this layer of evaluation on top of a standard industrial sector analysis should provide a clearer understanding of where an investor's total capital is being allocated.
Before throwing your next dart onto the investment-opportunity dartboard, take a few moments to analyze its impact on the overall basic asset class balance.
Disclaimer: This article is prepared by Mr. Parepoynt as an outside business activity. As such, his employer does not review or approve materials presented herein. The opinions and any recommendations expressed in this commentary are those of the author and do not reflect the opinions or recommendations of his employer. None of the information or opinions expressed in this article constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this commentary constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Mr. Parepoynt or his employer may hold or control long or short positions in the securities or instruments mentioned.