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

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

INTRODUCING PORTFOLIOCONSTRUCTION FORUM

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HOW TO REVIEW YOUR ASSET ALLOCATION

IS DIVERSIFICATION DEAD?

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

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

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?

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

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.

ASSET ALLOCATION

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

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

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

An asset allocation process that works asset allocation process and implementation

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

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

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

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

US Equities: 20 year rolling returns 25% 20% 15% 10% 5% 0% 1931 1941 1951 1961 1971 1981 1991 20 years ending

US Equities: 10 year performance 25% 20% 15% 10% 5% 0% 1931 1941 1951 1961 1971 1981 1991 Actual from start date shown

Using the rear view mirror! US Equities: Extrapolation v 10 yr actuals 25% 20% 15% 10% 5% 0% 1931 1941 1951 1961 1971 1981 1991 actual 20 year extrapolation

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

Long run returns-an example EPS PE Price Contribution $1.00 10 $10.00 5%pa Income + Income Growth + PE effect 5%pa Total

Long run returns-an example EPS PE Price Contribution $1.00 10 $10.00 $2.00 10 $20.00 5%pa +7%pa Income + Income Growth + PE effect 12%pa Total

Long run returns-an example EPS PE Price Contribution $1.00 10 $10.00 $2.00 10 $20.00 $2.00 20 $40.00 5%pa +7%pa +7%pa 19%pa Income + Income Growth + PE effect Total

Long run returns-an example EPS PE Price Contribution $1.00 10 $10.00 $2.00 10 $20.00 $2.00 5 $10.00 5%pa +7%pa -7%pa 5%pa Income + Income Growth + PE effect Total

Why the mirror chart looks that way EPS PE Price Contribution $1.00 10 $10.00 $2.00 10 $20.00 $2.00 20 $40.00 5%pa +7%pa +7%pa 19%pa Income + Income Growth + PE effect Total

Why 10 year forecasts? 40% Australian Equities 1 yr vs 10 yr EPS growth 30% 20% 10% 0% -10% 1971 1976 1981 1986 1991 1996 2001-20% -30% 10 year EPS growth 1 Year EPS Growth

Earnings growth lags GDP GDP Growth v Dividends Growth 1900-2000 Country Real Div Growth %pa Real GDP Growth%pa Dilution %pa Australia 0.9 3.3-2.4 Canada 0.3 4.0-3.7 Ireland -0.8 2.3-3.1 South Africa 1.5 3.4-1.9 Sweden 2.3 2.5-0.2 Switzerland 0.1 2.5-2.4 UK 0.4 1.9-1.5 US 0.6 3.3-2.7 Average 0.7 3.0-2.3

14% 12% 10% 8% 6% 4% 2% 0% US GDP v EPS Growth 1957 1967 1977 1987 1997 Nom GDP Growth EPS Growth

US PE vs Inflation 1961-2003 50 40 S&P500 PE 30 20 10 0 0% 2% 4% 6% 8% 10% 12% 14% US inflation

Using the rear view mirror! US Equities: Extrapolation v 10 yr actuals 25% 20% 15% 10% 5% 0% 1931 1941 1951 1961 1971 1981 1991 actual 20 year extrapolation

Forecasting works 30% US equity forecasts v actual 10 yr returns 20% 10% 0% 1931 1941 1951 1961 1971 1981 1991 actual forecast

Forecasting v The mirror All Ords Forecast v actual 25% 20% 15% 10% 5% 0% 1971 1976 1981 1986 1991 Actual Forecast history

Forecasting v The mirror Listed Property: Forecast v actual 25% 10 Year returns 20% 15% 10% 5% 0% 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 Actual Forecast history

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

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

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

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

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%

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%

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% 360 280 100 Major conflict 7% 70 60 20 50 60

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

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%

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%

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%

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%

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%

Looking for robust portfolios

Where would you rather be?

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

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

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

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

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%

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.

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

Markets Asset Allocation Portfolios Products Parameters Journal Conference Tools

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