Smoothing Out the Bumps May 2012

Transcription

1 Smoothing Out the Bumps May 2012 MSSB s Doug Schindewolf, Invesco s Scott Wolle, and Finance Professor Richard Marston of Wharton discuss the importance of a well-diversified portfolio Portfolio diversification is perhaps the most basic component in building stable long-term investment returns. Achieving diversification and balancing risk, however, are complex undertakings that vary by investor. Diversification is an ongoing objective for MSSB s Global Investment Committee, and given the recession in Europe and slower U.S. growth, the topic is all the more timely. In a special report published in March, the GIC detailed the way in which a mix of assets can help to smooth out the bumps that occur during difficult investment environments. History shows that the relative performance among different asset classes often spans a very wide range, explains Douglas Schindewolf, director of asset allocation at Morgan Stanley Smith Barney. The best-performing asset classes in one period are among the worst the following period. In a call hosted by MSSB Deputy Chief Investment Officer Charlie Reinhard, Schindewolf recently discussed the topic of portfolio diversification with Richard Marston, a professor of finance at the Wharton School at the University of Pennsylvania and author of Portfolio Design: A Modern Approach to Asset Allocation (Wiley Finance), and Scott Wolle, chief investment officer of Invesco Global Asset Allocation. The following is an edited version of their conversation.* Charlie Reinhard: The GIC may change its tactical allocations as economic, valuation or market conditions dictate, but our model portfolios are always diversified by asset class and geography. Can you share with us the reason? Doug Schindewolf: A well-diversified portfolio can [help to] smooth out the bumps that inevitably occur during a market cycle. Correlation is the primary factor to consider when constructing a well-diversified portfolio. Correlation is an estimate of the degree to which asset classes move in the same direction. Effective diversification depends on combining asset classes that have low or, ideally negative, correlation. This concept is important to us when we construct the long-term strategic blends in the Global Investment Committee s asset allocation models. We retain the conceptual importance of diversification when we set our shorter-term tactical allocations and limit how much tactical allocations deviate from the strategic allocations. And we only go to a zero tactical allocation in exceptional cases. History shows that the relative performance among different asset classes often spans a very wide range. The bestperforming asset classes in one period are among the worst the following period. Anticipating these performance swings is quite difficult. One way of coping with that challenge is to maintain a diversified portfolio.

2 Reinhard: Dick, you wrote that in order for diversification to be successful, investors need to be familiar with all the major asset classes that go into modern portfolios. Walk us through them and explain how much each adds to portfolio diversification. Richard Marston: Let s start with the assets in the GIC s models assets that provide extensive diversification for investors. In the bond category are Treasury and corporate investmentgrade bonds but also high-yield bonds, which offer added return [potential] during economic recoveries. Finally, Treasury inflation-protected securities [help] provide [protection] in the event of higher inflation. In the category of stocks, there are the traditional U.S. and foreign developed-country equities, emerging-market stocks and allocations to real estate through real estate investment trusts (REITs). This diversification makes a difference in the long run. Emerging-market stocks have outperformed U.S. stocks by 3% a year over the past 20 years or so, and REITs have outperformed U.S. stocks by 3% per year as well over the past 20 years [according to my research]. So broadening the portfolio has made a great difference to clients of the firm. Reinhard: Scott, your allocation approach is a little different. You determine asset class weights so that each contributes a similar amount of risk to the overall portfolio. Why? Scott Wolle: It really starts with our primary objective, which, simply stated, is to win by not losing. The math of compound returns makes it clear that minimizing losses should be a key consideration in managing any portfolio. And we try to do this by thinking about economic outcomes and matching asset classes with those outcomes. But just having exposure to an asset class isn t enough. There has to be a sufficiently large exposure so that the asset can [help mitigate risk to the overall portfolio]. For example, in mid-2011, many portfolios had an allocation to bonds yet still lost value because they lacked sufficient risk, or weight, in their bond holdings to offset losses by equities and other risky assets. That s why we focus on risk as the primary building block in portfolio management. In our view, there are three major economic outcomes: non-inflationary growth, inflationary growth and recession. We target these outcomes with three asset classes: equities for non-inflationary growth, commodities for inflationary growth and bonds for recession. When we balance the amount of risk in each of those different areas, we re able to hedge some of the worst effects of those more difficult environments, such as recession and inflation, while still being able to participate when equity markets rise. Reinhard: Doug, in our report we noted that certain correlations have significantly increased during the past two decades. Does this affect the way in which investors should approach diversification? Schindewolf: The two higher correlations we highlighted in the report were between U.S. stocks and other developedmarket stocks and between developed-market stocks and emerging-market stocks. Both sets of correlations have been trending upward in the area of about 0.9. Remember, a reading of 1.0 represents a perfect, positive correlation. So these high correlations mean investors can t count on achieving the benefits of diversification simply by adding non-u.s. stocks to their portfolios, as once was the case. Suitable investors should consider other asset classes that demonstrate lower correlation to traditional stocks and bonds. This means incorporating alternative investments into portfolios. All of the Global Investment Committee s asset allocation models incorporate alternative investments. Level 1 models include liquid alternatives such as commodities, REITs and inflation-linked bonds. Level 2 models include those liquid alternatives as well as managed futures and hedge funds. Finally, Level 3 models include these plus private equity and private real estate. Reinhard: Dick, are there different rules of thumb to follow, depending upon the total value of a portfolio? For instance, should a high-net-worth individual avoid any asset classes that might be considered de rigueur for an endowment or pension fund? Marston: Since 1999, I ve run a program at Wharton for very wealthy investors who typically have at least $50 million in assets. So I ve given a lot of thought to what s appropriate for different levels of wealth to what a highnet-worth investor should be investing in. 2

3 Let s start out at one extreme, with private equity and venture capital. If I were rich, I would be investing in both private equity and venture capital. On average, in the long run, they earn significantly higher returns than ordinary stocks. [Though that return potential may come with greater risk of losing principal and less liquidity.] That said, it s very important to find the best managers to invest with. The rankings performance gap between the firstand third-quartile managers is enormous. Still, an investor with $5 million or even $20 million in assets generally finds it very hard to access this market. Most investors will only commit about 10% or 20% of their portfolios to private equity. At those wealth levels, I don t think you can get proper diversification across types of private equity. Hedge funds are accessible to a larger group of clients. Investors with $5 million, for example, can invest in hedge funds, at least through a fund of funds. Unlike many experts, I m a fan of fund-of-funds, despite the extra layer of fees. I like them because they allow high-net-worth investors to diversify across hedge fund managers. Of course, if investors are really wealthy, they can invest directly in hedge funds and avoid the extra layer of fees. With real estate, you can invest through REITs, and it doesn t matter what your level of wealth is. You can have $1 million or less and still invest in a broad portfolio of office buildings, shopping malls and distribution centers. I view that as a real opportunity, and I think REITs are something that [suitable] retail investors should have in their portfolios. Reinhard: Scott, how do you seek to mitigate the impact of negative shocks while still allowing participation during more favorable environments? Wolle: We try to mitigate shocks at three different levels: first, through strategic allocation, then through tactical allocation and finally in the way we invest in the asset classes, a method that could be likened to an intelligent beta approach. Having layer after layer of ways to mitigate the shocks that has been a crucial part of our portfolio from strategic allocation to tactical allocation to the specific way we build our exposure within each of the asset classes. Reinhard: The Baby Boom generation is beginning to retire from the workforce. Arguably, the timing couldn t be worse. How should current and near-retirees approach diversification from an income-withdrawing perspective? Marston: I m writing a chapter on this topic in my new book. So it s very much on my mind. Let me start by saying there are precious few ways to find income in today s investment environment. Let s start with bonds. The only way to find a reasonable coupon on taxable or taxexempt bonds is to reach farther out on the term structure. Last week, the five-year corporate bond was paying 2.3% coupons, whereas the 20-year was paying 5.3% [according to my research]. We know that long-term bonds are vulnerable if interest rates start to rise and that rates have to start rising at some point in the near future. We may not know when, but it is coming. So it is risky for a retired person or someone nearing retirement to put all their eggs in a longer-term fixed-income portfolio. I m a big fan of municipal bonds, particularly for those investors in higher tax brackets. But once again, attractive yields are found only by going way out on the term structure. As for stocks, the dividend yield on the average stock is pitiful. I would advocate tilting toward value in your retirement portfolio if you re looking for yield. The average dividend yield on large-cap value stocks is better than that of growth stocks but, again, don t expect much. REITs offer higher dividends than stocks. Over the past 10 years, for example, the REIT dividend yield has averaged 4.9% compared with the dividend yield on the S&P of only 2%.[according to my research] However, it is not prudent to put too much of your retirement portfolio in REITs. The point is that retirees will find it hard to generate sufficient income for retirement. That s why experts say they should be drawing their spending out of total return rather than current income. The conventional wisdom is that we spend something of the order of 4% annually of our accumulated wealth in retirement. But to do so, we will have to draw from something other than current income. The only other way to do that would be to distort the portfolio deliberately just to generate income. But in doing so, we would inevitably incur greater risk. Wolle: The way to think about retirement income is from a total-return perspective, rather than from trying to distort the portfolio structure just to get yield. 3

4 But when we think about the glide path investors should have as they move into retirement, it harkens back to basic concepts of finance: finding the optimal portfolio and then either scaling up or scaling back risk, depending on the risk tolerance of the investor. Schindewolf: In our recent special report on diversification, we examined various withdrawal-rate assumptions. We used a moderate-risk portfolio, or model, from each of our three portfolio levels. Not surprisingly, we found that the Level 3 model, the one with the highest allocation to alternative investments and therefore the one expected to do the best job of smoothing out the cyclical bumps, produced the highest probability of success. For this exercise, we defined success as not fully depleting the portfolio over a 30-year time horizon. This reemphasizes the importance of being diversified as you approach retirement, and of staying diversified as you re moving through retirement. Reinhard: Any parting thoughts? Schindewolf: We have had very challenging financialmarket conditions during the past decade. And not surprisingly, this has caused many investors to question the value of portfolio diversification. It s important, I think, to have realistic expectations about this. Portfolio diversification does not provide immunization from severe bear markets. But it can mitigate the damage they inflict. It is one of the things we illustrated in our special report. And this reinforces the wisdom of maintaining a diversified approach when you re constructing a long-term investment portfolio. 4

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Because the return of Treasury Inflation Protected Securities (TIPS) are linked to inflation, TIPS may significantly underperform vs. fixed return treasuries in times of low inflation. Investing in commodities entails significant risks.. Commodity prices may be affected by a variety of factors at any time, including but not limited to, (i) changes in supply and demand relationships, (ii) governmental programs and policies, (iii) national and international political and economic events, war and terrorist events, (iv) changes in interest and exchange rates, (v) trading activities in commodities and related contracts, (vi) pestilence, technological change and weather, and (vii) the price volatility of a commodity. In addition, the commodities markets are subject to temporary distortions or other disruptions due to various factors, including lack of liquidity, participation of speculators and government intervention. Private Funds (which include hedge funds are private equity funds) often engage in speculative investment techniques and are only suitable for long-term, qualified investors. Investors could lose all or a substantial amount of their investment. They are generally illiquid, not tax efficient, and have higher fees than many traditional investments. Hedge funds may involve a high degree of risk, often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees which may offset any trading profits, and in many cases the underlying investments are not transparent and are known only to the investment manager. REITs investing risks are similar to those associated with direct investments in real estate; lack of liquidity, limited diversification, and sensitivity to economic factors such as interest rate changes and market recessions. Managed futures investments are speculative, involve a high degree of risk, use significant leverage, are generally illiquid, have substantial charges, subject investors to conflicts of interest, and are suitable only for the risk capital portion of an investor s portfolio. Before investing in any partnership and in order to make an informed decision, investors should read the applicable prospectus and/or offering documents carefully for additional information, including charges, expenses and risks. Investors should read the prospectus and/or offering documents carefully for additional information, including charges, expenses and risks. Managed futures investments do not replace equities or bonds but rather may act as a complement in a well diversified portfolio PS /2012