Cover Story: Where To Invest '96: The Framework: Asset Allocation
DIVERSIFY IS STILL THE MANAGERS' MANTRA
Some investors got a rude shock in 1995. They thought global diversification would maximize opportunities while reducing their risks. Instead, investors who sank all their savings into a mutual fund indexed to the all-American Standard & Poor's 500-stock index earned 37%, compared with 12.5% for sophisticates who put their money in funds composed of international stocks and bonds.
But many money managers are betting that 1995 will turn out to have been an exception. They argue that Wall Street's gains were brought about partly by an anemic dollar that didn't revive until late summer. Americans' love affair with their own high-technology issues also fueled the rise. Now, the steep runup in U.S. stock prices has many investors chanting their mantra of global diversification more loudly than ever. "I think in 1996 the foreign markets will outperform, just because the U.S. did so well this year," says Sandor Cseh, chief international strategist for Boston Cos.
RISK FROM THE DOLLAR. High valuations in the U.S. aren't the only reason global investors are reaffirming their multi-asset philosophy. While the Federal Reserve is expected in the near future to lower short-term U.S. interest rates by a quarter of a percentage point, greater reductions are anticipated in continental Europe, Canada, and Australia, where slowing economic growth has forced central banks to rethink their tight-money policies. And the Bank of Japan continues to pump money into an economy that has been stagnant for four years. That environment bodes well not just for many non-U.S. stock markets but also for overseas bond prices. "Investors are likely to find the best returns from non-U.S. bonds, especially in the European markets," says Gary Brinson, president of Brinson Partners Inc.
Indeed, some fund managers think the lower interest-rate picture for Europe merits an aggressive concentration in continental bonds (page 48). Take the $488 million Fremont Global Fund, which returned 14% through Sept. 1, 1995. Half of the 27% that manager Robert J. Haddick has designated for his global fixed-income allocation is in European government debt. He believes overseas bonds will match or beat the 29% appreciation that the U.S. bond market saw last year.
But there is one big risk: a possible rise in the dollar that could diminish the value of overseas holdings. To guard against a higher dollar in 1996, "investors need to understand that exposure to non-U.S. equities and bonds alike should be hedged," says Brinson, who manages $50 billion of institutional and mutual-fund investments.
Hedging typically limits the investor's potential gains while setting a floor under possible losses. Still, Haddick estimates that 10-year government bonds from continental markets such as Germany, France, and the Netherlands should beat similar U.S. debt by at least two percentage points in the first half of 1996. On an annualized basis, he expects continental bonds to return 7%-10%, compared with 5%-7% in the U.S.
DISCIPLINED STRATEGY. Some allocators are shifting their resources to capture the greater gains they expect overseas. But they are also maintaining a healthy exposure in the U.S., where many believe stock and bond prices still have room to run. Indeed, the best way to exploit the benefits of falling rates around the world may be to carve up a portfolio into fairly even slices, say, of U.S. or international stocks and bonds. That's the approach of the $895 million USAA Cornerstone Fund. Its prospectus specifies a 22%-28% range for each asset class except gold, which is held between zero and 10%. "We're set up to stay diversified no matter what happens," says Portfolio Manager Harry Miller, who reviews his allocations once a quarter.
The disciplined strategy forces Miller to buy low and sell high, he says, since he must regularly replace high-flying securities that push an allocation beyond the 28% limit with less expensive ones. Cornerstone posted a 13% return for the first nine months of 1995. For the current quarter, Miller has just over 26% in U.S. stocks, where he thinks the aerospace and chemical sectors still offer value. He is paring his weighting in retail names, which he believes will suffer as strapped consumers approach their credit-card debt limits.
Unlike Haddick, Cornerstone's Miller had put his nearly 23% international allocation entirely in equities. Miller is betting on continental bourses--mainly Switzerland, Germany, Britain, and France--which he thinks will bounce as long-term interest rates fall. And he has a relatively heavy bet in Denmark, whose fiscal health wins his praise.
Many of Miller's counterparts share his enthusiasm for European stocks' attractive valuations. At prices that average five times projected cash flow, says Jean-Marie Eveillard, who runs the $2 billion SoGen International Fund, "continental Europe is half as expensive as the U.S." Eveillard believes France, whose stock market was flat in 1995 amid mounting political and fiscal turmoil, represents a clear buying opportunity with the risks already priced in. Brinson also mentions France as a prime candidate for a market recovery.
Besides Europe, asset allocators favor Southeast Asia as a region to comb for bargains. In emerging markets of the Pacific Rim, including Malaysia, Thailand, and Indonesia, Fremont Global's Haddick recommends liquid stocks such as banks and utilities. These stand to gain from lower inflation and falling interest rates, and "are trading at the low to midpoint of their historical valuation ranges." And John F.H. Trott, London-based chief international investment officer for Bessemer Trust Co., is putting the biggest portion of his 20% allocation of non-U.S. stocks in New Zealand and Australia. He believes industrial and banking shares there are better buys than the bigger, more commonly held resource stocks.
"MORE TO GO FOR." Trott, whose fund has reasonable valuation as one of its main stock-picking criteria, nevertheless is dedicating 45% of his portfolio to large-cap U.S. growth stocks. "Despite the rise of last year, we think there's still something more to go for," he says. "We believe we could see 650 on the S&P 500 this year"--about a 5% gain--"and by many years' standards, that's a fine return." He also recommends a sprinkling of small-cap niche stocks, with somewhat fewer technology names than in 1995.
SoGen's Eveillard agrees that the U.S. market has some buys left. He is loading up on paper and metals stocks--as a play on emerging markets. His rationale: Developing countries for years were considered exporters of commodities and importers of manufactured goods, but in fast-growing nations such as China, the opposite is true. Eveillard believes that as the Asian economies continue to build steam, their demand for raw materials will keep commodities prices heading upward for the next two to three years.
That's also why he has a relatively hefty 8% of his portfolio in gold. Explains Eveillard: "There's a supply-demand imbalance of more than 1,000 tons a year in gold," now trading between $385 and $390 an ounce. He thinks the price could go well above $500 if the strong demand for jewelry continues in Southeast Asia as consumers there grow more prosperous. Besides the classic mining stocks, Eveillard owns shares in the Swiss-based Bank for International Settlements. A clearinghouse owned by major central banks, it has half its assets in bullion. Even at a rich $7,500 a share, its stock provides an opportunity to buy gold at a discount, Eveillard says.
One area of disagreement among money managers remains Japan. At Bessemer, Trott has kept his funds completely out of the country in 1995, and for the coming year, he believes that the market is still too expensive--even with the Japanese economy finally emerging from its recession.
By contrast, Cornerstone's Miller thinks that lower interest rates are setting the stage for better growth in 1996. And Eveillard, who bailed out of the Tokyo market before the bubble burst in 1989, has begun slowly rebuilding his position in Japanese stocks, which now make up 6% of his fund's total assets.
Such uncertainties, of course, are just what have always made the case for diversification so compelling. The danger of a year like 1995 is that it tends to raise the expectations of investors. But history tells us that whether they come from emerging markets or developed countries, 30%-plus returns rarely happen two years in a row in one place. That's why global asset allocators are still repeating their mantra for 1996.By Joan Warner in New York