How Worldly Is Your Portfolio?
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Psst. Want a hot stock tip? Your dream, of course, is to get in early on the next eBay (EBAY ) or Google (GOOG ). But if you want a tip that will withstand the test of time, ignore the buzz. For the most part, it doesn't matter much which stocks or mutual funds you buy. What really counts is asset allocation, or how you divide your money among a diverse menu of investments.
Sure, you may think you're diversified. You've got a big chunk of your money -- probably about 60% to 70% -- in U.S. stocks, perhaps a mutual fund tracking the Standard & Poor's 500-stock index. Another 25% to 30% is in bonds, most likely rock-solid U.S. government bonds.
That's so-o-o 20th century. With returns on U.S. stocks in low gear and yields on the 10-year Treasury note about 4%, the flaws of such a plan are obvious. What you need for the 21st century is a more diverse set of investments. Thanks to a proliferation of new products, you can build a sophisticated, well-diversified portfolio on a scale that wasn't possible even five years ago. In the new portfolios:
-- Foreign stocks take on a larger role. In fact, almost half your investment in stocks may be abroad. "It pays to be as broadly diversified as possible," says Jeremy Siegel, a finance professor at the Wharton School. "You need a world portfolio."
-- U.S. stocks become less prominent, perhaps less than 50% of the whole.
-- High-yield, foreign, and emerging-market bonds are used in part to offset low returns from Treasury bonds.
-- Inflation-indexed securities, commodities, and real estate help protect against inflation.
-- Even hedge funds and private equity can be sprinkled in, to enhance returns.
What's wrong with the U.S. stock and bond approach that worked so well for so long? Quite simply, by dividing your money between just two types of investments, you take on more risk than you would by spreading it over a variety of assets that rise and fall at different times. Ideally, a diversified portfolio should include investments that can hold up in different economic climates, including inflation, deflation, and even a global financial crisis. Such a portfolio can't protect you from losses. But it can limit losses so that when good times resume, you'll have a bigger foundation to work with.
Your choice of which assets to invest in is crucial. A 1986 study of pension funds concluded that 93.6% of the difference between the funds' returns could be explained by their asset allocations. In contrast, the stockpicking and market-timing decisions that investors usually spend most of their time on accounted for little. "Asset allocation is the area in which you can exert the most influence over your returns," says David Darst, chief investment strategist for Morgan Stanley's Individual Investor Group (MWD ).
SPRINKLE IN THE RISK
You may cringe at the thought of investing in commodity futures or junk bonds. After all, isn't this risky stuff? All by themselves, yes. But small doses blended into a larger portfolio can actually reduce risk -- provided you pick investments that moderate the ups and downs of what you already own.
This may sound radical, but it's a strategy that has been tested by some of the largest and most sophisticated institutional investors in the country -- college and university endowments. Endowments with more than $1 billion under management have earned an average of 7.9% a year over the five years through their June 30, 2004, fiscal year, the most recent data available. In contrast, a conventional portfolio of 60% blue chips and 40% high-quality U.S. bonds gained an average of just 1.2% a year. "The bear market taught us that diversification really pays off," says John S. Griswold Jr., executive director at the Commonfund Institute in Wilton, Conn., which polls endowments on their mix of investments.
Of course, even a savvy individual with a seven-figure portfolio does not have the wherewithal of a multibillion-dollar institutional investor. Harvard Management Co., which runs the university's $22.6 billion endowment, has a team of experts who scout timberland investments. Harvard and its peers also have access to top hedge funds, often at a fraction of the fees most individuals pay.
But there are more tools to help you build this new portfolio than you might think. They include mutual funds that track commodity prices; real estate investment trusts (one, Plum Creek Timber Co., owns tracts of forest); and most notably, more than 180 exchange-traded funds and 400-odd index funds that invest in everything from the global stock market to real estate investment trusts (REITs), gold, and the emerging markets. Some mutual funds have done a good job of mimicking hedge-fund strategies at a fraction of the cost. And you can get a rough approximation of a private-equity fund by buying stock in public companies that take stakes in private ones. As demand for nontraditional investments grows, more products are sure to follow.
Private bankers have long included such investments in the portfolios of their super-wealthy clients, and now financial planners are starting to do the same for the merely affluent. About 80% of the clients of Evensky & Katz, a Coral Gables (Fla.) financial planner, are using a fund of hedge funds for up to 5% of their portfolios. What makes it accessible is a $25,000 minimum investment. The Bank of New York's Lockwood Advisors plans to launch a separate account on July 1, for investors with more than $250,000, that will include commodities, REITs, and hedge funds, plus stocks and bonds. "We're modeling the account in a similar fashion to the way the institutions do it," says Lockwood President Len Reinhart.
Just loading up on commodity futures or gold or timber doesn't ensure that you'll achieve better returns or lower risk. The key to reducing risk -- without stashing it all in a safe but low-return investment, such as money-market funds -- is to pick investments that don't typically move in sync. That way, when one fares poorly, another is likely to do well -- as was the case when U.S. stocks cratered from 2000 to 2002 but bonds and real estate rose. Because a well-diversified portfolio produces less volatile returns than one made up of investments that rise and fall together, it's by definition less risky. As a result, it's likely to hold up better during periods of poor overall performance.
CALM THE SWINGS
Reducing your portfolio's volatility can also lead to higher returns. Consider two $10 million portfolios -- both of which earn 8% annual average returns. The annual returns of one swing from a 26% gain to a 10% loss, before falling 1% and rebounding 17%. The second is less volatile, with returns of 13%, 3%, 6%, and 10%. After four years, the less volatile one is worth 3.3% more, according to JPMorgan Private Bank. Why? The greater the downswings, the smaller the base upon which future earnings compound. "The lower you can keep volatility over time, the higher your wealth will be," says Tony Werley, head of portfolio construction at JPMorgan Private Bank. "The objective of diversification is to squeeze out every bit of risk that can be removed from a portfolio, which will result in a higher compound return."
Not everyone needs to reduce risk. Using the same methods, you can design a portfolio that should give you a higher return with the same amount of risk. That's accomplished by putting even more money into riskier assets with the potential for higher long-term returns, such as small-cap stocks or even private equity.
Drafting an asset-allocation plan is an inexact science. You may want to tap professionals who use sophisticated computer models. But you can also accomplish a lot on your own, says William Bernstein, author of The Intelligent Asset Allocator (McGraw-Hill; $29.95) and co-principal of Efficient Frontier Advisors, an Eastford (Conn.) financial planner. Bernstein starts with four basic types of investments: large-cap U.S. stocks, small-cap U.S. stocks, U.S. bonds, and foreign stocks. These, he says, can give "you about 70% of the diversification of an optimal portfolio," or the sort a large institution might build. For an even better mix, Bernstein adds emerging-market stocks, small-cap foreign stocks, and REITs. "Use common sense," he says. "You can invest in emerging markets. But don't put 50% of your money in them, because they can go down fast."
To take diversification to yet another level, you can add a wider range of investments, which can include commodities, inflation-indexed securities, and hedge funds. Morgan Stanley's (MWD ) portfolio guru Darst recommends that clients with $1 million to $20 million put 18% to 24% in alternative investments.
Here's a rundown of some of the building blocks of this new portfolio:
STOCKS. With more than 85% of their stock investments riding on domestic companies, U.S. investors are virtually ignoring half of the world's stock market capitalization. How much should you have in foreign stocks? According to Wharton's Siegel, if you have at least two years to invest, 40% of your stock allocation should be in foreign companies, with up to 45% for those with 20 years or longer. Morgan's Darst recommends 30% to 36% of your equities be allocated to foreign stocks.
BONDS. With high-quality bonds, you don't worry about getting paid. But they're most sensitive to changes in interest rates. In contrast, high-yield corporate bonds are more sensitive to the credit quality of their issuers. Adding the lower-quality bonds offsets some of the interest-rate risk and generates extra income. A portfolio with 10% in high yield, 10% in emerging markets, and 10% in foreign bonds is less volatile than one that's 100% investment-grade, says Ibbotson Associates of Chicago.
REAL ESTATE. Real estate has been a winner for five years now. The best diversifier is directly owned property -- an apartment or office building. But investing in REITs is much easier and cheaper. Their trading patterns also tend to differ widely from those of stocks and bonds. Since rents and property values often rise with inflation, real estate helps offset potential losses on stocks and bonds. A big portion of REIT returns comes from dividends, which lower volatility.
COMMODITIES. Academic research indicates that over the past 45 years, commodity futures have tended to move in the opposite direction of stocks and bonds. While unexpected inflation punishes both stocks and bonds, commodities fare well, says Gary Gorton, Wharton School finance professor and co-author of a study on futures. Gorton's research also indicates that while individual commodities can be very volatile, a diversified basket is no more volatile than the S&P.
Getting into commodities is tricky. A good choice is one of a handful of mutual funds that use derivatives to invest in indexes of commodity futures, including grain, crude oil, and precious metals. Some funds, including Oppenheimer Real Asset (QRAAX ) fund, track an index that now has 75% in energy; others, including the PIMCO Commodity Real Return Strategy (PCRDX ) fund, follow an index that caps exposure to each commodity sector at 33% of assets.
HEDGE FUNDS. Hedge funds and managed futures funds -- a type of hedge fund that invests in stock, bond, currency, and commodity futures and options -- have performed well when stocks are under pressure. But with the total fees on many such funds topping 3% a year, plus 20% of the profits, you could end up paying more than you'll earn in returns. A better bet: mutual funds that borrow from the hedge-fund playbook at average expense ratios of 1.82%. Among those with good track records, even during the bear market: the Hussman Strategic Growth Fund (HSGFX ) and the Legg Mason Opportunity Trust (LMNOX ).
PRIVATE EQUITY. Returns on private equity have averaged 13.8% a year over the past 20 years, compared with 11.7% for the S&P. You can't get into a private-equity fund without committing millions. But you can buy stock in a little-known type of closed-end fund, called a business development company (BDC), which is required by law to invest at least 70% of assets in private firms.
Most BDCs make loans to private firms at rates of about 13% and buy equity stakes, too. Because BDCs are required to distribute virtually all their income, the interest payments on their loans underwrite fat dividends. Two of the biggest such companies, Allied Capital (ALD ) and American Capital (ACAS ), now yield 8.3% and 9%, respectively. Since its inception in 1960, Allied is up 17.9% a year, on average, while American has risen 21% a year since going public in 1997.
Even this approach has its risks. The share prices of the smallest BDCs can be extremely volatile. In addition, most BDCs trade at premiums to their net asset values, so you'll pay more per share than their assets are worth on paper. If the economy softens or interest rates rise, borrowers may default. A BDC sponsored by private-equity powerhouse Apollo charges 2% of assets plus about 20% of the profits. Others deduct expenses -- also around 2% of assets -- from income before passing gains to investors. If you invest more than a token amount, spread the money among several BDCs.
INFLATION-INDEXED SECURITIES. Many advisers recommend putting some assets into inflation-proof bonds. Treasury inflation-protected securities (TIPS) have been around for eight years -- long enough to see that their prices behave differently than stocks and most bonds. TIPS protect against the unexpected inflation that erodes stock and bond returns.
Whichever you choose, be mindful of costs. In an era in which returns are expected to be modest, index funds and exchange-traded funds have the key advantage of low expenses. They can fill in a large part of stock and bond allocations.
Don't try to revamp things overnight. Consider the tax consequences. Instead of selling winners and paying taxes, you may be better off holding on and putting new money to work in the investments you need to bring in. Put assets that produce income taxed at high rates in tax-deferred accounts. If you're buying REITs, emerging-market bonds, TIPS, or other investments that have rallied lately, build up to your target positions over time.
Always keep an eye on your portfolio. If some assets grow well beyond your target allocation, you may need to rebalance -- take some profits from winners and channel the money into the laggards. Rebalancing is a practice that forces you to sell high and buy low. Now that's a plan that works in any century.
By Anne Tergesen