Asset Allocation: Time for New Tactics?David Bogoslaw
You'd think that economists and financial professionals have become gardening fans lately, what with all the chatter about green shoots of hope starting to push through the U.S. economy's frozen fields. Granted, first-quarter corporate earnings for the most part are turning out better than anyone thought, but that's not saying much given how low expectations were. And consumer and business confidence seems to have bounced in April from March, while a bigger-than-expected decline in first-quarter gross domestic product serves as a reminder of just how weak the economy remains.
All of this, plus high hopes for the Obama Administration's $787 billion stimulus package—and its aggressive efforts to clean up the banking and automotive industries—has fed a rally in stocks that has had more staying power than many people thought possible. But how much has really changed in the overall economic picture? It's that nagging doubt that continues to test the nerves of equity investors.
At the same time, more and more investors are chomping at the bit to shift bigger chunks of their portfolios into riskier asset classes that can deliver higher returns. The historically wide yield spreads between many corporate bonds, both investment grade and high-yield, and risk-free U.S. Treasuries have attracted many people who can't wait for the stock valuations to return to anything near their former strength.
Enticed by the opportunity for higher yields as well as the defensive characteristics, investors and financial advisors are taking a closer look at a strategy that's been used for nearly 25 years with mixed success: tactical asset allocation. The investment method actively adjusts a portfolio's strategic weighting in assorted asset classes based on short-term market forecasts with the goal of taking advantage of inefficiencies or temporary imbalances among different asset classes.
Back in Fashion
The idea is gaining renewed currency: Van Kampen Funds, Legg Mason Investor Services, and Baring Asset Management have all launched tactical allocation funds in the past three months. And it may reflect lesser expectations for equity returns over the long term, not just during the recession.
And with investors hyper-sensitive to sudden and outsized swings in the market on the latest headline, the tactical approach is especially tantalizing. Above all, it's very practical, using very liquid assets such as exchange-traded stock or bond funds or commodity or currency futures to get into and out of positions with great ease. The concept is simple: a portfolio overweights assets expected to perform better over the near term and underweights those expected to fareless well.
The 13 tactical portfolios that Los Angeles-based Portfolio Management Consultants (PMC) offers to its network of financial advisors are invested in exchange-traded funds and adjust their allocations between stocks and fixed-income products based on quantitative, macroeconomic, and technical indicators.
PMC's sector- and country-rotation portfolios allow advisors to choose between fixed income and any or all of either 10 sectors represented in the S&P 500 index, or any and all of 20 countries outside the U.S., based on where they think the economy is headed. In the sector-rotation model, if an advisor thinks there's more risk than reward in a certain industry such as technology, he'll put that sector's entire 10% portion of the total capital into fixed income. Both rotation portfolios have been 100% allotted to fixed income since the start of the market downturn in October 2007.
"The sector-based models are tilting and getting closer to an equity bias, but the fundamentals don't yet confirm that," says Richard Hughes, co-president of PMC. Information technology, health care, and telecom are three sectors with the best chance of turning positive soonest, he thinks, while Malaysia, China, and Singapore are the countries most likely to recover quickest.
Retail investors who are willing to meet the $2,500 minimum investment requirement can get direct access to Schroders' Multi-Asset Growth Portfolio Fund (SALAX), which invests in stocks and bonds, as well as alternative asset classes such as real estate, commodities, and currencies. It's only during the slowdown phase of the economic cycle that precedes a recession that risky assets underperform cash and bonds, says Ron Albahary, head of strategic investment solutions at Schroder Investment Management North America. During any of the three other phases, including recession, "it's time to start figuring out what kinds of risky assets we should have in the portfolio and how much," he says.
Schroders slashed its equity allocation from 60% to 38% after calling the recession in late 2007 and has kept it in the low 40% range for much of the past 16 months, says Albahary. His team's analysis shows that risky assets such as stocks start to anticipate a recovery nine months before the economy bottoms. If the end of the recession is being called for sometime in the first four months of 2010, risky assets should start a sustainable move higher some time in the third quarter of this year, he says.
Investors are missing out on the opportunities created by high volatility if they stick to the old set-it-and-forget-it allocation philosophy, and there are greater inefficiencies between asset classes to profit from now than at any other time in the past 20 years, Albahary believes. One element in Schroders' strategy is executing pair trades based on finding a significant dislocation from the normal relationship between two different assets. "We want to play both sides of that trade," he says.
Playing Both Ends
One such trade involves the Japanese yen and the South Korean won, whose current exchange rate is way off the historic norm. The portfolio is shorting the yen and has a long position in the won, anticipating a return to the historic exchange rate within six to 24 months. Similarly, it is overweight U.S. stocks and underweight European stocks, excluding the U.K., based on the view that U.S. stocks are currently a better value than Europe's. The portfolio is using the S&P 500 index futures for its U.S. position.
The economic signals are certainly mixed and don't offer as clear a direction as investors would like. The U.S. economy shrank by 6.1% in the first three months of the year, much more than the expected 4.6% decline. Real consumption growth, however, was slightly stronger than expected, rebounding 2.2% after dropping 4.3% in the fourth quarter and 3.8% in the third quarter of 2008.
Albahary wants to see stronger signs that an economic recovery is near, starting with confirmation that the monetary stimulus is actually inducing more lending by banks. He also wants more proof that housing prices are stabilizing and more certainty about corporate earnings for the next year.
While consumer confidence jumped in April, the swine flu outbreak could push it lower again within the next 30 days, says Hughes at PMC. "We're coming up on the summer season of travel, and the flu [if it spreads more widely] could dampen travel and tourism, and a whole bunch of industries would be affected, especially in certain parts of the world.
Not Out of the Woods
The rebound in consumer confidence comes against a backdrop of rising unemployment, and an acceleration in job losses could darken the consumers' mood yet again.
Unlike some tactical models, the one that Franklin Financial Planning has developed puts great emphasis on the strength and direction of market sentiment. Since consumer sentiment can be a lagging indicator, Roman Franklin, president of the Deland (Fla.) firm, uses it in conjunction with a measure of hedge fund sentiment—a proxy for institutional investors' views—and volatility to reach a much broader consensus of investor expectations.
Until a few weeks ago, the VIX equity volatility index had been the most heavily weighted of the three indicators in Franklin's model, based on how prominent it's become in investors' thinking due to all the media attention it now gets. "When we pulled below 40 five or six weeks ago, that was a very positive sign. The VIX index has tried to get above 40 [since then], but hasn't been able to," he says. "[That] shows a shift from negative to positive [sentiment]," given that 40 had been the support level for the volatility reading during the most serious market decline last fall.
Based on his model, Franklin reduced his clients' exposure to stocks to no more than 15% of their portfolios in the fall of 2007, which limited their losses to 4% last year, he says. His equities allocation is now 35% to 40% and he's waiting to see the VIX reach 30 to tell him it's safe to boost that allocation toward the 60% to 70% range that's been traditional during good times.
The Reset Reality
One of the more intriguing aspects of the tactical approach is its ability to address what some strategists believe will be the new market reality once the economy rebounds: Stock returns aren't likely to be as high as they once were, and fixed income will help make up the difference.
PMC's Sector Rotation Total Return Strategy is a case in point. By using leveraged ETFs to get exposure to any or all the 10 equity sectors, it puts just half, or 5%, of the capital allotted for each sector into the ETFs, getting double the return for every move up or down. The other 5% for each sector is redeployed into fixed income for additional yield. At first glance, this looks like a sacrifice of some upside in exchange for downside protection during a bear market, but Hughes says that's not the goal.
While the strategy is flexible enough to invest the full 10% of each sector's capital allocation in stocks for twice the payout once the bull market returns, that's not PMC's plan. The objective, says Hughes, is to have identical exposure to stocks as in the regular version of the sector-rotation model but with potential for higher total portfolio yield through the fixed-income component.
The relative safety of bond ETFs over stock ETFs is clear during a recession, but some strategists believe the proliferation of fixed-income vehicles over the past two years doesn't reflect a temporary defensive stance among investors biding their time until the bull market resumes. After the jolt of 30% to 40% portfolio losses last year, investors are reassessing risk and seeking assets with a true negative correlation to stocks. That's likely to continue for the next three to five years, says Anthony Rochte, senior managing director at State Street Global Advisors (STT) in Boston.
For Hughes at PMC, the enormous investment inflows into fixed-income vehicles reflects a desire among investors to take advantage of unprecedented spreads that may offer once-in-a-lifetime yield opportunities—and recognition that consumer spending will be less of a driver of corporate earnings.
It's hard to see how equity valuations will be able to return to pre-recession levels, says Hughes, "in a society that is de-leveraging and spending less than it once did."