An Asset Allocation Strategy For A Risky Market (Part II Of II)

by: James Hickman

US Equities deserve a portfolio underweight and select International Equities warrant overweight.

Overweight true Alternatives but beware of faux-Alts.

Emerging Market sovereign debt offers best balance sheets, growth and fiscal trajectories.

Allocate 10% to Gold as a systematic risk hedge.

In the first article of this series, the case was made for an asset allocation strategy reflecting basic economic realities of the various asset classes, and the respective factors driving them. This article makes the actual asset allocation recommendation. This recommendation assumes a 10-year investment horizon (noting when a particular allocation will require review and adjustment during that period), seeks to minimize expense ratios and is guided, as relevant, by replacement cost economics, macro-economic factor analysis and absolute valuation analysis. Mutual funds and ETFs mentioned as vehicles for asset class exposure are based on our own analysis, but we have no relationship with any of funds or managers involved, economic or otherwise. Individual investors should consult their professional advisor about suitability of any recommendation herein.

Asset Allocations May 2017

Allocate 10% to Cash for opportunistic rebalancing.

Equities (35%)

US equities allocation of 15% via Vanguard S&P 500 ETF (NYSEARCA:VOO). US equities may rise further, but the risk reward is uncompelling. We have argued for four years that long-term rates will stay below 3% for years, not quarters. The sturdy support of the US stock market - few corrections in excess of 20% when 10-year is below 4% since - suggests downside protection. But investors should allocate capital based on risk/return expectations over the next 7-10 years. In that frame, US equities from current levels, are likely to experience returns significantly below long-term averages, and we believe a drawdown in excess of 50% is likely. For convenience, the factors suggesting high systematic risk from first report are repeated below:

  • a historically over-valued US market
  • nearly a full generation of corporate capital allocator wariness about investing in organic growth and a related plateauing in labor productivity
  • corporate profit margins still 40% above historical norms
  • US federal debt as a percentage of GDP is up from 64% to 108% since 2007
  • an unsustainable and worst-in-world US fiscal deficit trajectory (true of advanced economies broadly)
  • sixteen years and counting of US production growth below 2% without a single 4% print
  • deflationary demographic trends
  • high levels of underlying financial risk from a protracted period of market complacency during the central bank's protracted experiment with zero-bound interest rate policies

The tables below summarize critical macroeconomic and valuation metrics for key countries in each major region. These factors inform both the overall asset allocation and specific country weightings recommended herein. Color codes were added as an optical aid, with red reflecting worrisome and potentially short-worthy factor trends ("Awful"), pink reflecting "Weak," light green reflecting "Good" and dark green "Great" combinations of sovereign balance sheet, production growth, fiscal trajectory, inflation and equity values. Brief notes are also provided for each country.

Macro-economic Trends and Value Metrics by Region/Country

Source: International Monetary Fund and other public sources.

International equities (20%) offer more interesting value opportunities than the US. We remain cautious about China because of chronic misallocation of capital and a poor balance sheet when shadow debt is appropriately included, corruption and lack of transparency. But current market levels, 7.6 PE and 1.0 price-earnings to growth ratio ("PEG") warrant 5% exposure via iShares MSCI China (NYSEARCA:MCHI). See tables below - dark green shading suggests stronger macro and better investment potential, light green positive but less so, orange not attractive, and red borders are short-worthy - see notes for equity versus debt.

We also like South Korea via iShares MSCI Korea Capped (NYSEARCA:EWY), Colombia via Global X MSCI Colombia ETF (NYSEARCA:GXG) and India via iShares MSCI India (BATS:INDA), each with a 5% allocation. Despite strong economic fundamentals and attractive valuations, the Philippines carries significant risk given its volatile and controversial President Duterte and recent imposition of martial law. Turkey presents an attractive trend-and-value profile as well, but also bears substantial geopolitical risk.

Fixed Income (30%)

Allocate 15% to long-term US fixed income using Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV), but be opportunistic. Using US 10-year as a benchmark, if rates near 3%, add exposure up to 20%; if they fall to 1.5%, trim back to 10%. In addition to the enduring, structural deflationary headwinds created by the financial panic, long-term rates simply do not rise in the absence of robust production growth or inflation, both of which remain far below average.

Allocate 15% to emerging market bonds as follows: 5% to SPDR® Bloomberg Barclays Emerging Markets Local Bond ETF (NYSEARCA:EBND), 10% to VanEck Vectors J.P. Morgan EM Local Currency Bond ETF (NYSEARCA:EMLC). Both of our suggested EM debt ETFs are local currency denominated. If you think there is more risk of a dollar retreat, a break-down in the currency carry trade (selling low cost $ to finance purchase of higher-yielding EM assets) will cause significantly more harm to these local currency funds. An alternative, US dollar denominated EM Bond fund is iShares J.P.Morgan USD Emerging Markets Bond (NYSEARCA:EMB).

It's a sign of the new normal that systematic risk is worrisomely high, the third longest recovery in US history is also the weakest, and emerging market sovereign debt is part of the solution. But existing debt levels, fiscal trajectories and production growth are far better in places like Mexico, Chile, Peru, Colombia, New Zealand, the Philippines and South Korea.

Gold (10% to physical gold bullion)

Gold is an asset class unlike other commodities in that prices for the latter cycle around the replacement cost of the commodity itself, whereas gold has demonstrated for thousands of years that it is regarded as a store of value, a hedge against inflation. We continue to believe US inflation will remain a non-issue for the next several years. But gold is also a hedge against exogenous risk, showing no correlation to traditional asset classes and during periods of crisis or black swans, an actual inverse correlation. During the period that the S&P 500 experienced a 60%+ maximum drawdown between 1970 and 1983, gold increased 360% in real terms. During the tech bubble crash between 2000 and 2003, the S&P 500 dropped 50%, and gold rose 30%. During the financial crisis, when the S&P 500 dropped nearly 50% again from peak, gold rose 70% in real terms. Given the high levels of systematic risk we observe across financial markets, we believe gold warrants a significant allocation, despite its high levels versus history. We recommend gold bullion out of concern for counter-party risk in the event of another financial crisis.

Alternatives (15%)

Allocate 15% to alternative asset classes. Investors with access to private fund vehicles managed by proven investors in repeatable strategies, including cash flowing distressed real estate, ultra-lower middle market private equity, venture capital outside of the coastal bubbles and carefully vetted hedge funds should consider a higher allocation than 15%. For those without that kind of access, we suggest 5% to Dreyfus Dynamic Total Return Fund (MUTF:AVGRX); 5% to IVA Worldwide Fund (MUTF:IVWIX); 5% to Wells Fargo Absolute Return - GMO as subadvisor (MUTF:WARAX). This asset class warrants a more detailed discussion given its short, and so far, controversial history.

Liquid alternatives became the rage following the financial crisis, during which certain strategies, usually in the structure of illiquid limited partnerships, delivered low and sometimes inverse correlations to a collapsing market in which more traditional asset class correlations spiked. The rush to package "liquid alternatives" strategies in a mutual fund structure was breathtaking, and portended a likely correction. As a proxy for total AUM in liquid alternatives, Morningstar reported "Managed ETFs" it tracked amounted to $27 billion in Q3 2010, and reached $103 billion by Q1 2014. We tracked several dozen open end mutual funds in the liquid alternatives space since 2012, and of the 27 on our list that remain active (10 were shut down), assets under management have dropped by over 35% in the last 3 years, from $134 billion to $86 billion. The average cumulative return across those 27 funds in the three years has been -4%, while the S&P 500 Index has been up 26%. Managed ETF funds tracked by Morningstar dropped from the $103 billion high to a low of $76 billion in early 2016, but are on the rise again into 2017.

Some of the more spectacular drops in liquid alts fund AUM in the last three years include Marketfield Fund (MUTF:MFLDX), down $20 billion in AUM to $500 million; Absolute Strategies Fund (MUTF:ASFIX), which has gone from around $5 billion in AUM to $500 million (decline has been over more than three years); F-Squared, which went from sub-advising on around $25 billion in AUM into bankruptcy (based on damaging investigation); Good Harbor (MUTF:GHUIX), which went from over $1.5 billion to less than $100 million; and Ivy Asset Strategies, which went from over $28 billion to less than $4.5 billion. We are neither recommending nor criticizing any of these products. Instead, we cite them to illustrate that theoretically sound strategies can significantly underperform for protracted periods.

Investors should be mindful that strategies built for non-correlation and risk mitigation drag on returns during buoyant markets and the expected payout occurs during "black swan" maximum-drawdown periods. Any liquid alt showing high market upside capture and correlation is either cheating or relying on a risk on/risk off algorithm that ignores fundamental valuation. Assets have exited the asset class as returns disappointed in the zero-bound interest rate policy market run, and the accompanying, historically low downside volatility.

For investors contemplating the plunge into a less liquid hedge fund, be selective. The HFRI Equity Hedge Index, a proxy for hedge fund performance, shows hedge funds have been lagging passive exposure to the S&P 500 on a 5-year and 10-year basis (the former has underperformed the latter by 5.2% per annum and 0.6% over last 5 and 10 years, respectively, but still has an outperformance edge over the last 15 years of 2.2%). Increasingly crowded trades have driven broad underperformance, as hedge fund assets increased 9X from 2000 to 2010, from $119 billion to $1.7 trillion, and are currently over $3 trillion, according to Barclays (NYSE:BCS). Assets under management have not actually declined with hedge fund underperformance of putatively safer and certainly less expensive passive investment vehicles, but the 20% annual growth rate has meaningfully slowed to "just" 10% in the last five years.

The growth rate in assets in the private equity and venture capital spaces have been similarly robust, and an argument can be made for coastal bubbles in the latter.

The alts funds we recommend come with a warning that returns may continue lagging if broader public equities markets keep rising and correlations remain high, under the persistent low-interest rate scenario we expect. But we continue to fear a Minsky moment in which high systematic risk manifests in actual, substantial asset price declines, triggered by a relatively small catalyst. The low downside volatility represents risk apathy and masks growing financial instability. Any negative surprise could trigger the correction, despite the support of low rates. There were 40%+ annual drops in equities markets during each of the sub-3% long-term rate periods following the Japanese 1989 and US 1929 financial panics, and the 1873 railroad crisis in the US was followed by -0.8% compounded returns despite sub-3% yields.


Lessons dearly learned in the last two ~50% stock market declines, during which correlations between and among historically independent asset classes spiked toward 1.0, fade in the euphoria of protracted upward market movement and historically low downside volatility. The signature error giving market timing its bad historical name is staying with the herd when asset values reach historically extreme highs and lows - when a legitimate narrative has an illegitimate and unsustainable impact on prices. Positioning one's portfolio today to reflect the high-and-rising systematic risk of US equities is sensible, provided the investor does not panic and jump back in if another 10% upside is missed.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.