HOW TO REVIEW YOUR ASSET ALLOCATION. PRESENTED BY: Graham Rich, Publisher, PortfolioConstruction Forum 18 July 2005

Transcription

1 HOW TO REVIEW YOUR ASSET ALLOCATION PRESENTED BY: Graham Rich, Publisher, PortfolioConstruction Forum 18 July 2005

2 INTRODUCING PORTFOLIOCONSTRUCTION FORUM

3 Markets Asset Allocation Portfolios Products Parameters Journal Conference Tools

4 TOOLS Media Roundup Research House Roundup Bob DownUnder DIRECTINVESTING Rapid Ratings Listed Investment Research Handbook Investment Strategy Handbook

5 HOW TO REVIEW YOUR ASSET ALLOCATION

6 IS DIVERSIFICATION DEAD?

7 Diversification SOME THINGS HAVE CHANGED Yes, the markets HAVE fundamentally changed. But the principles of diversification have not.

8 Portfolio Construction ISN T WHAT IT WAS Some things haven t changed - bubbles eventually burst (yes, house prices can fall) - the business cycle lives on (thanks to fear & greed) - diversification is paramount - investors still want high returns - investors still want capital preservation but some important things ARE changing - central banks are less paranoid about inflation - the economic balance of power is shifting away from the US - the impact of an ageing population is becoming more pronounced

9 Some important things ARE changing PORTFOLIO CONSTRUCTION ISN T WHAT IT WAS The world is in transition Disinflation is no longer driving asset returns The US has some big economic challenges ahead Emerging markets are becoming more important The ageing population is starting to have an effect but what are the implications?

10 Some important things ARE changing PORTFOLIO CONSTRUCTION ISN T WHAT IT WAS Overall returns will be lower No disinflationary tailwind (amongst other problems) Large cap equity markets (eg US) will underperform Global equity portfolios will shift away from arbitrary benchmarks toward growth opportunities. Favour Asia, emerging markets Investors will need to look for diversification outside financial assets Need to achieve true economic diversification Growth uncorrelated structured asset classes, commodities, total return funds Income will dominate capital growth in asset returns No free kick from falling inflation Demand for income will rise No free kick from falling inflation So your asset allocation approach must be contemporary and effective

11 Diversification SOME THINGS HAVE CHANGED Yes, the ways of efficiently and effectively achieving diversification - being quality asset allocation and portfolio construction HAVE changed. But the underlying principals have not.

12 ASSET ALLOCATION

13 Asset allocation MY VIEW Asset allocation is NOT just a fancy term dreamed up by advisers to justify their existence. The term describes a portfolio construction absolute every portfolio has an asset allocation, deliberate or not

14 Asset allocation MY VIEW A crucial tool in portfolio construction kit A credible asset allocation process that works in good times and bad.

15 Helicopter view THERE ARE 3 STEPS IN THE REVELATION OF ANY TRUTH In the first, it is ridiculed. In the second, resisted. In the third, it is considered self evident. Arthur Schopenhauer, Philosopher

16 An asset allocation process that works asset allocation process and implementation

17 Portfolio Construction Principles 1. Return forecasts should be forward looking 2. Risk means risks faced by the investor 3. Portfolio s should be constructed to meet the investor s needs 4. Transaction costs and taxes matter 5. There is more than one way to achieve an investor s objectives

18 asset allocation process 1. Forecast returns of asset classes 2. Forecast risks of asset classes 3. Trade-off risk and return to create model asset allocations 4. Match Model Allocations to investors 5. Implementation Investment Strategy Handbook

19 asset allocation process 1. Forecast returns of asset classes 2. Forecast risks of asset classes 3. Trade-off risk and return to create Model Asset Allocations 4. Match Model Allocations to investors 5. Implementation

20 Forecasting returns Methodology Key assumptions Reliability Timeframes Assumptions in detail (later)

21 US Equities: 20 year rolling returns 25% 20% 15% 10% 5% 0% years ending

22 US Equities: 10 year performance 25% 20% 15% 10% 5% 0% Actual from start date shown

23 Using the rear view mirror! US Equities: Extrapolation v 10 yr actuals 25% 20% 15% 10% 5% 0% actual 20 year extrapolation

24 Long run returns are driven by three factors Income + Growth in income + or - Effect of change of PE Ratio

25 Long run returns-an example EPS PE Price Contribution $ $ %pa Income + Income Growth + PE effect 5%pa Total

26 Long run returns-an example EPS PE Price Contribution $ $10.00 $ $ %pa +7%pa Income + Income Growth + PE effect 12%pa Total

27 Long run returns-an example EPS PE Price Contribution $ $10.00 $ $20.00 $ $ %pa +7%pa +7%pa 19%pa Income + Income Growth + PE effect Total

28 Long run returns-an example EPS PE Price Contribution $ $10.00 $ $20.00 $ $ %pa +7%pa -7%pa 5%pa Income + Income Growth + PE effect Total

29 Why the mirror chart looks that way EPS PE Price Contribution $ $10.00 $ $20.00 $ $ %pa +7%pa +7%pa 19%pa Income + Income Growth + PE effect Total

30 Why 10 year forecasts? 40% Australian Equities 1 yr vs 10 yr EPS growth 30% 20% 10% 0% -10% % -30% 10 year EPS growth 1 Year EPS Growth

31 Earnings growth lags GDP GDP Growth v Dividends Growth Country Real Div Growth %pa Real GDP Growth%pa Dilution %pa Australia Canada Ireland South Africa Sweden Switzerland UK US Average

32 14% 12% 10% 8% 6% 4% 2% 0% US GDP v EPS Growth Nom GDP Growth EPS Growth

33 US PE vs Inflation S&P500 PE % 2% 4% 6% 8% 10% 12% 14% US inflation

34 Using the rear view mirror! US Equities: Extrapolation v 10 yr actuals 25% 20% 15% 10% 5% 0% actual 20 year extrapolation

35 Forecasting works 30% US equity forecasts v actual 10 yr returns 20% 10% 0% actual forecast

36 Forecasting v The mirror All Ords Forecast v actual 25% 20% 15% 10% 5% 0% Actual Forecast history

37 Forecasting v The mirror Listed Property: Forecast v actual 25% 10 Year returns 20% 15% 10% 5% 0% Actual Forecast history

38 Long term forecasts are a massive improvement Logical Academically rigorous Understandable Communicable Defendable

39 asset allocation process 1. Forecast returns of asset classes 2. Forecast risks of asset classes 3. Trade-off risk and return to create Model Asset allocations 4. Match Model Allocations to investors 5. Implementation

40 What is risk? Tracking error? Standard deviation of returns? Short term volatility? Not meeting your objectives?

41 If risk is not meeting needs Main problem is insufficient, real, long term returns Anxiety along the way also an issue Volatility Volatility of income Familiarity with the assets Liquidity easily managed

42 10 Year Forecasts as at October 2000 Asset Dividend EPS PE Central Yield Growth Effect Forecast Australian Equities 4.5% 5.0% -1% 8.5% US Equities 1.0% 6.0% -1% 6.0% LPTs 8.5% 1.0% 0% 9.5% Bonds 6.0% 0% 0% 6.0%

43 Pessimistic 10 year forecasts as at October 2000 Asset Dividend Yield EPS Growth PE Effect Pessimistic case Australian Equities 4.5% 2.0% -4.0% 2.5% US Equities 1.0% 2.0% -7.0% -4.0% LPTs 8.5% -2.0% -1.5% 5.0% Bonds 6.0% 0% 0% 6.0%

44 Scenarios drive risk assessment Primary scenario Probability Secondary scenarios Solid growth, low inflation 36% Muddle through Boom Rolling recession Depression Australia loses the plot High inflation 28% 10% 6% 2% 5% 6% Major conflict 7%

45 Risk is not meeting goals Multi faceted Concentrate on long term uncertainty Forecasting process helps develop range of possible outcomes

46 asset allocation process 1. Forecast returns of asset classes 2. Forecast risks of asset classes 3. Trade-off risk and return to create Model Asset Allocations 4. Match Model Allocations to investors 5. Implementation

47 The fabled efficient frontier 16% 14% 12% 10% 8% 6% 4% 2% 0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

48 The fabled efficient frontier 16% 14% 12% 50% A 50% B 10% 8% 6% 4% 2% 0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

49 Different portfolios, almost identical outcomes 16% 14% 12% 50% A 50% B 10% 8% 50% C 50% D 6% 4% 2% 0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

50 Slightly different assumptions change the efficient portfolio 16% 14% 12% 50% A 50% B 10% 8% 50% C 50% D 6% 4% 2% 0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

51 Everything in the band is more or less equivalent 16% 14% 12% 10% 8% 6% 4% 2% 0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

52 Looking for robust portfolios

53 Where would you rather be?

54 Trading off risk and return to produce Model Allocations Aim is to be as robust as possible Model Allocations are the best of a good bunch Without consideration of clients starting position and preferences Excellent track record

55 asset allocation process 1. Forecast returns of asset classes 2. Forecast risks of asset classes 3. Trade-off risk and return to create model asset allocations 4. Match Model Allocations to investors 5. Implementation

56 Matching Model Allocations to investors What Lifestyle outcomes do they want? What Minimum outcomes must they have? How much Pain can they handle along the way? Investment Strategy Profiler

57 How much pain? Defensive Conservative Balanced Growth Aggressive YOUR PREFERRED INVESTMENT JOURNEY Q1. I expect my investment portfolio to: a) give low returns largely independent of the sharemarket. b) give modest returns with some minor fluctuations. c) give solid returns with some significant swings along the way. d) perform well, but not as well as the sharemarket. e) keep pace with the sharemarket. Q2. I would expect my investment portfolio to show positive long-term returns, but can accept a downturn: a) every 15 to 20 yrs b) every 10 to 15 yrs c) every 5 to 10 yrs d) every 4 to 6 yrs e) every 3 to 4 yrs Q3.How big a downturn do you think you could accept in the overall value of your portfolio in any one year? a) a 5% downturn b) a 10% downturn c) a 15% downturn d) a 20% downturn e) a 25% downturn

58 Matching investors and Model Allocations Cash flow wants and needs Acceptable levels of uncertainty Acceptable levels of volatility All criteria must be satisfied Use the Profiler

59 asset allocation process 1. Forecast returns of asset classes 2. Forecast risks of asset classes 3. Trade-off risk and return to create model asset allocations 4. Match Model Allocations to investors 5. Implementation >>>>>>

60 There s more than one way to skin a cat 16% 14% 12% 10% 8% 6% 4% 2% 0% 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

61 Disclaimer. This presentation has been prepared on the basis that it is only for the exclusive use of the person for whom it was provided. Although information is derived from sources considered and believed to be reliable and accurate,, it s employees, consultants, advisers and officers are not liable for any opinion expressed or for any error or omission that may have occurred in this presentation. Any forecasts included are reasonably believed to be reliable based on current information but due to our inability to predict future events with certainty, they cannot be guaranteed. This presentation is of a general nature only and has been prepared without taking into account any persons particular investment objectives, financial situation or particular needs.

62 New paradigms THERE ARE THREE STEPS IN THE REVELATION OF ANY TRUTH in the first, it is ridiculed in the second, resisted in the third, it is considered self-evident Arthur Schopenhauer, philosopher

63 Markets Asset Allocation Portfolios Products Parameters Journal Conference Tools