Asset Allocation vs Stock-Picking March 2011

Transcription

1 Asset Allocation vs Stock-Picking March 2011

2 Agenda 1. How important is asset allocation to total returns? 2. Should asset class weights be fixed or dynamic? 3. How should asset allocation be determined? 4. How does bottom-up stock-picking fit into all of this?

3 How Important is Asset Allocation? Market Timing Share 1.8% Selection 4.6% Other Factors 2.1% Asset Allocation Policy 91.5% 91.5% of the variation in performance results from asset allocation Source: Financial Analysts Journal

4 Modern Portfolio Theory Source: Fidelity

5 Problem 1: Volatility as a Measure of Risk 1. Volatility looks at temporary and permanent fluctuations 2. Volatility treats upwards and downward movements equally 3. When volatility is low, risk is not low it s high 4. When volatility is high, opportunities are created

6 Volatility as a Measure of Risk: South Africa JSE All Share Index vs SA Volatility Index (SAVI) High risk or opportunity? Low risk or trouble ahead? Source: Bloomberg JSE All Share Index SAVI

7 Problem 2: Diversification Is Asymmetrical Modern Portfolio Theory relies on diversification to reduce overall risk by combining assets that are not correlated However, the effects of diversification are not symmetrical When markets are going down, correlations change from negative to positive The more extreme the market event, the higher tendency for correlations to converge to 1

8 Problem 3: Valuation Indifference 25 JSE All Share Index PE Ratio: EXPENSIVE ENTRY POINTS CHEAP ENTRY POINTS Source: Inet Adjusted JSE All Share Index PE Ration Std Dev below Mean Std Dev Above

9 Valuations Matter Part I: Looking One Year Out Comparison of 1 Year Forward Returns for JSE All Share Index : Max, EXPENSIVE ENTRY POINTS % Returns Mean, 32.6 Mean, 11.5 Max, Min, CHEAP ENTRY POINTS PE ratio below 1 std dev Min, PE ratio above 1 std dev Source: Inet, RE:CM Analyst

10 Early Losses Can Be Crippling for Returns 180,000 The Cost of Loss 160, ,000 Value of R100,000 Investment 120, ,000 80,000 60,000 40,000 30% loss in first year 10 years to catch up! 20,000 - Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 30% loss in first year, 10% gain in every year thereafter 5% return every year Source: Intelligent Investor

11 Valuations Matter Part II: Looking 5 Years Out Comparison of 5 Year Forward Returns (annualised) : CHEAP ENTRY POINTS EXPENSIVE ENTRY POINTS 40 Max, % Returns (Annualised) Min, 14.3 Mean, 22.0 Max, Mean, Min, PE ratio below 1 std dev PE ratio above 1 std dev Source: Inet, RE:CM Analyst

12 Valuations Matter Part III: 5 Years Out in Real Terms Comparison of 5 Year Forward Real Returns (annualised): CHEAP ENTRY POINTS EXPENSIVE ENTRY POINTS Max, % Returns 15 Mean, 8.3 Max, Min, -1.0 Mean, -0.2 Min, PE ratio below 1 std dev PE ratio above 1 std dev Source: Inet, RE:CM Analyst

13 Valuations Work Across Asset Classes Source: GMO

14 Problem 4: It Relies on Historical Inputs Annualised Returns Using Historical Performance Depend on Time Period (%) Lehman Period Aggregate S&P 500 MSCI EAFE MSCI EM-Free Five Years Ten Years If portfolio managers cannot have faith in the inputs, how is it possible for them to have faith in the outputs? Source: Datastream

15 Dynamic Asset Allocation From the Top-Down Source: Inet Forecast Economic Growth Forecast Interest Rates Forecast Sectors that will do well Forecast Earnings for Stocks in Sector 70% Probability X 70% Probability X 70% Probability X 70% Probability = 24% chance of getting it right!

16 GDP Forecasts Track Each Other Closely 7 GDP Forecasts from US Public and Private Sectors CBO Forecast Blue Chip Forecast White House Source: CBO Economic Forecasting Record

17 But Are Not Very Good Predictors of GDP 7 Actual GDP versus Forecasts Actual CBO Forecast Blue Chip Forecast White House Source: CBO Economic Forecasting Record

18 SA Earnings Forecasts Are Not Much Better 60% SA Earnings Forecasts vs Actual 50% 40% 30% 20% 10% 0% -10% -20% -30% Feb-93 Feb-94 Feb-95 Feb-96 Feb-97 Feb-98 Feb-99 Feb-00 Feb-01 Feb-02 Feb-03 Feb-04 Feb-05 Feb-06 Feb-07 Feb-08 Feb-09 Feb-10 SA MSCI, Consensus 12m Fwd Growth SA MSCI, Realised Source: UBS

19 The List of Evidence Against Forecasting Goes On Consensus economists have failed to predict any of the last four recessions even while in them! Analysts forecasting company s earnings 2 years prior to the actual event are wrong by 94%. 12 months prior? 45% In 2008, analysts in the US forecasted 24% increase in prices, yet stocks fell by almost 40%. Between 2000 and 2008, analysts didn t even manage to get the direction of change in prices right in 4 out of the 9 years. Source: GMO

20 100% Forecast Success Rate Luck or Skill? Source: BBC

21 Top 5 Excuses for Incorrect Forecasts 1. The If only defense 2. The ceteris paribus defense 3. The I was almost right defense 4. The It just hasn t happened yet defense 5. The Single prediction defense Source: Tetlock 2003

22 The New Normal: Flatter with Fatter Tails THEN NOW Greater uncertainty means forecasting will be even more difficult Source: PIMCO

23 Bottom-up Approach to Asset Allocation 1. Focus on protecting capital first, then growing it 2. Assess each investment idea on a case-by-case basis 3. Start with the equity market the best generator of real returns 4. Buy undervalued assets and sell overvalued assets 5. Defer to cash in the absence of sufficient ideas deferred alpha

24 Bottom-up Case Study: Sun International Quality Company Barriers to entry are high Sustainable competitive advantage Has earned excess returns, grown intrinsic value over time Cheap Market price more than 30% less than intrinsic value Replacement cost is double market capitalisation Popularity Under(over)valued when operating margins low(high) Cycle Household credit growth at low Sun International Total Return Relative to All Share Household Credit Growth Sun International Total Return Relative to All Share Index Operating Profit Margin vs Popularity Average Household Credit Growth Operating Profit Margin Popularity: Price / Earnings Relative to FTSE/JSE All Share Index 0.0

25 Bottom-up Asset Allocation: Does it work? RE:CM Global Fund Equity Allocation versus MSCI World Index % Equity Allocation Total Return of Index Equity MSCI Index Source: Datastream, RE:CM Analyst

26 Bottom-up Asset Allocation: Does it work? 340 RE:CM Global Flexible Fund vs All Asset Allocation Unit Trust Index Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 All Asset Allocation Index RE CM Global Flexible Fund Source: Datastream, RE:CM Analyst

27 Summary 1. Asset allocation matters a great deal to returns 2. Valuations matter even more 3. Real returns should be maximised, risk of capital loss minimised 4. A bottom-up, value-driven asset allocation process does both well

28 Optical Illusion Source:

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