Asset Allocation: It s Not About What You Own But Why You Own It.

Transcription

1 Asset Allocation: It s Not About What You Own But Why You Own It. Prepared by Chris Haverland, CFA Asset Allocation Strategist Reviewed by Sarah Douglass, ASIP Managing Editor, Investment Publications In this white paper 1 Executive summary 2 Introduction 2 Traditional approach what you own 3 Scenario-based approach why you own it 4 Combining the scenario-based approach with asset management 4 Case study 7 Conclusion

2 Executive Summary. Over the past few years we have faced numerous economic, market, and geopolitical uncertainties that have been distracting to investors, sometimes causing them to change their investment strategy in response. Contributing to the natural tendency to react to events is the type of conversation that investors often have with their investment advisors. When investors inquire about their investment portfolio, a typical response revolves around what they own their stock, bonds, cash, and other less liquid assets, such as private equity and real estate assets rather than why they own it. We think it s time to change the conversation. What do you need the money for? We have found that reframing the what do I own discussion to one that focuses on how your portfolio is structured to deal with specific scenarios can be helpful. Such a discussion can make it easier to avoid getting sidetracked by market events. What do we mean by scenarios? Here are a few that we think are worth considering when creating your investment plan: n Catastrophic events. These types of events have the ability to radically change the landscape and create extreme distress in the global capital markets. They seem to happen about once a decade. We just went through one in Having a portfolio that is constructed to minimize the downside risk of such events is important. n Unexpected events and unforeseen opportunities. We could call this the unknowable scenario. It could be unforeseen changes in family circumstances, capital needs due to a long-term illness, or a much happier occasion, such as when you are suddenly presented with an unanticipated investment or business opportunity. Whatever the circumstance, you will need access to sources of readily available liquidity. You don t want to find yourself in a position where you have to sell illiquid assets at a loss or take a large tax hit to meet these liquidity needs, so your investment portfolio needs to take into consideration the potential for such unforeseen needs. n The failure of your sources of income to meet your income needs. Your income is the cash flow that can be used for consumption, philanthropic distribution or any other needs. This is distinct from liquidity, which is the ability to sell assets fairly quickly without a large hit to valuation. Unfortunately, income can fluctuate and you may need to plan for this. n Rising inflation. Inflation is one of the forces that has the most corrosive impact on long-term family wealth. Our long-term capital market assumption for inflation is three percent, which means that, if your investments aren t growing, you could lose half of the value of your money in 25 years. Inflation doesn t happen in a vacuum. Is your portfolio invested in assets that appreciate with inflation? n Market volatility. The more regular ups and downs of the market can result in hasty decisions based on market moves rather than long-term needs. n Maintenance of sufficient assets to support your lifestyle. Asset growth potential is a typical investor goal. You may want to ask yourself whether your investments are positioned to grow faster than inflation. Also, will your portfolio have enough assets to meet your desired future needs? As you discuss your portfolio s asset allocation with your investment manager, ask yourself, What do I need this money for? Change the conversation from one about performance to one about what your assets are expected to do for you under different scenarios. Start to think about different elements of your portfolio as an insurance policy against the unforeseen and the unpredictable, and this will help you be prepared for most eventualities. Asset Allocation: It s Not About What You Own But Why You Own It 1

3 Asset Allocation: It s Not About What You Own But Why You Own It. Introduction. Making decisions about what types of assets to include in an investment portfolio is one of the single most important decisions investors make. The types of assets investors hold and the types of accounts in which they are held can have a significant impact on investment success. And yet, the ways in which investment portfolios are constructed don t always reflect the importance of the asset selection process. Selection can be random, based on past performance or value judgments about what types of asset are likely to be most successful in the near-term. Selection also may be more thoughtful, focusing on short-term, medium-term, and long-term financial goals. This latter approach does at least try to address the question, What is the money for? Figure 1: Having the Wrong Strategic Asset Allocation in Place has the Potential to Disrupt Your Financial Plan approach of what you own is that it can be difficult for investors to define what they need the money for. In this report we will discuss the traditional approach and then outline why we think a scenario-based approach makes the why you own it conversation so much easier. Traditional approach what you own. The traditional asset-allocation conversation is about the assets in your portfolio stocks, bonds and cash. Figure 2 shows the spectrum of objectives that investment advisors typically address with clients, from the more conservative income-oriented client to the more aggressive growth-oriented client. A typical part of that conversation is that income investors own more cash and fixed income, while more growthoriented, aggressive investors own more stocks, private equity, and other risky asset classes. Figure 2: Spectrum of Investment Objectives Strategic Asset Allocation 77% Key Drivers of Return Variability Tactical Asset Allocation 6% Security Selection 10% Other 7% Income Balanced Growth Fixed Income Asset Group Real Asset Group Equity Asset Group Complementary Strategies Source: Wells Fargo; The Journal of Wealth Management, Vol. 8, No. 3, Strategic Asset Allocation and Other Determinants of Portfolio Returns, 08/05, data updated 08/09 In this paper we suggest taking the selection process one step further by considering possible scenarios you may encounter and how you may need to use or structure your assets to meet your needs under each scenario. This should help you change the conversation with your investment advisor from the more traditional one about what you own to what we consider a more useful one, why you own it. Building an investment portfolio based, first and foremost, on your needs may seem intuitive, but the reason that many investors stick to the more traditional In our experience, the struggle that many investors face with such an approach is that the world isn t just about stocks and bonds. As a result, there is a temptation to add or remove assets individually rather than reviewing the impact of such an addition or subtraction on the portfolio as a whole and in the context of their financial goals. The evolution of investment strategy has been pretty dynamic over the last 20 to 25 years. Investment advisors now look at total portfolio construction, specifically how assets work together in a portfolio rather than at individual assets. However, the approach of many money managers remains pretty one-dimensional. They primarily consider risk and 2 Asset Allocation: It s Not About What You Own But Why You Own It

4 return. Risk means only one thing, volatility, which is measured mathematically by annualized standard deviation the degree to which the price of an asset varies from its average price. Yet no client has ever approached us and said, Today my portfolio s annualized standard deviation is 17½ percent and if we can get that down to 15 percent, my family will be better off. Similarly, reward is defined simply as total return. But we know for a fact that there are other rewards that investors want from an investment portfolio. They want cash flow, they want liquidity, they want security, they want tax efficiency, they want diversification there are lots of other things that provide reward. What happens in the more traditional investment conversation is that you and your advisor discuss the issues of volatility and when you might need the money. Investment professionals focus on what you own; they don t talk about why you own it and how it s addressing the other risks that you may have on your financial balance sheet. They don t talk about the other rewards that you might want from your investment portfolio, and they may not even address the various time horizons that you may have for your investments due to specific life goals, be they short-term lifestyle needs or longerterm philanthropic or legacy needs. Changing the conversation to why you own specific assets has the potential to provide a much more comprehensive approach to addressing the needs of your balance sheet. Scenario-based approach why you own it. Instead of asking, What s the investment objective? we believe a better approach is to ask, What s the money for? A good starting point for such a conversation is to address what you may need as insurance for any emergencies that may arise. We refer to it as your number--the amount of short-term liquidity that you will need to satisfy both living needs and emotional needs during market turmoil. It s very important that this number not change because of anxiety around capital markets, because it s really lifestyle-dependent as opposed to capital-market dependent. The next question is: What are your investment goals? This can be a difficult question to answer. It might take time to identify all the important goals and these goals can change over time. If your investment advisor asks the what s the investment goal question, often the first answer that pops into your head is whatever you have been particularly preoccupied with lately. For example, if you paid college tuition this morning, you might say that you are worried about paying for your children s education. Allowing sufficient time to discuss these goals can allow the conversation to change to why you own certain asset classes. The next issue to address is time horizon. Your time horizons for specific goals are constantly shifting. For example, a forty-year-old planning for retirement may not think about the fact that at age fifty that retirement goal is a lot closer and maybe his or her portfolio asset allocation needs to change. So understanding these time horizons is extremely important. It s not just a time horizon for one goal, but rather for several goals that need to be discussed. So when you talk about your portfolio with your investment advisor, it should be clear that certain assets are there to address the various goals and time horizons in the portfolio. Given the shifting nature of investment goals and time horizons, the what is the money for? question can still be hard to answer. We have found that an easier way to have this conversation is to tackle investors concerns about their financial situation and the financial markets head on. We have identified six scenarios that typically address such concerns: n Catastrophic events. These types of events have the ability to radically change the landscape and create extreme distress in the global capital markets. They seem to happen about once a decade. We just went through one in Having a portfolio that is constructed to minimize the downside risk of such events is important. n Unexpected events and unforeseen opportunities. We could call this the unknowable scenario. It could be unforeseen changes in family circumstances, capital needs due to a long-term illness, or a much happier occasion, such as when you are suddenly presented with an unanticipated investment or business opportunity. In either circumstance you will need access to sources of readily available liquidity. You don t want to find yourself in a position where you have to sell illiquid assets at a loss or take a large tax hit to meet these liquidity needs, so your investment portfolio needs to take into consideration the potential for such foreseen needs. Asset Allocation: It s Not About What You Own But Why You Own It 3

5 n The failure of your sources of income to meet your income needs. Your income is the cash flow that can be used for consumption, philanthropic distribution or any other needs. This is distinct from liquidity, which is the ability to sell assets fairly quickly without a large hit to valuation. Unfortunately, income can fluctuate and you may need to plan for this. n Rising inflation. Inflation is one of the most corrosive forces that detract from long-term family wealth. Our long term capital market assumption for inflation is three percent, which means that if your investments aren t growing, you could lose half of the value of your money in 25 years. Inflation doesn t happen in a vacuum. Is your portfolio invested in assets that appreciate with inflation? n Market volatility. The more regular ups and downs of the market can result in hasty decisions based on market moves rather than long-term needs. n Maintaining sufficient assets to support your lifestyle. Growth potential is the typical investor goal. You may want to ask yourself whether your investments are positioned to grow faster than inflation. Also, will your portfolio have enough assets to meet your desired future needs? Figure 3: Hypothetical Example of Assets Allocated Based on Different Scenarios Catastrophe 10% Liquidity 15% Inflation 15% Balanced Portfolio Volatility 10% Growth 25% Income 25% Combining the scenario-based approach with asset management. Constructing a portfolio taking into account these different scenarios requires investments in multiple asset classes. One single asset class is unlikely to address one scenario. Rather, it takes multiple asset classes to address each scenario, and each asset class is used to address more than one scenario, resulting in a well-diversified portfolio. Figure 4: Examples of Potential Asset Class Diversification under Each Scenario Catastrophe Cash, Commodities, Hedge Funds, Managed Futures. Volatility International Bonds (DM), Hedge Funds, Managed Futures. Inflation International Bonds (DM), Domestic Equity, International Equity (DM/EM), REITs, Commodities. Income U.S. High-Yield Bonds, International Bonds (DM/EM), U.S. Large/Mid Cap Equity, International Equity (DM), Real Estate/REITs. Liquidity Cash, International Bonds (DM), U.S. Large Cap Equity, International Equity (DM). Growth U.S. High-Yield Bonds, EM Debt, Domestic Equity, International Equity (DM/EM), Real Estate/REITs, Private Equity. Understanding how each asset class fits within the different buckets of the scenario-based asset allocation is important. The following case study should help to clarify what we mean. Case study. In the case study we are going to use the hypothetical example of the Johnsons, a successful couple in their mid-fifties who have amassed $10 million in assets. They are planning to retire early and live off their assets for a long period of time. As a result, they want to address the following scenarios: n Protect their assets from unforeseen catastrophic events n Have adequate liquidity for short-term needs plus the unanticipated desires that they may discover in early retirement n Maintain enough income to be able to afford the lifestyle that they have been accustomed to, which includes protecting their assets so that inflation doesn t eat up about three percent of their purchasing power a year 4 Asset Allocation: It s Not About What You Own But Why You Own It

6 n Manage volatility appropriately so that volatility doesn t distract from their long-term investment goals and derail their plan In addition, since they are only in their fifties they will have to plan for longevity and will need solid growth to address their lifestyle needs for about 40 years. We can use this information as a starting point to construct an appropriate investment portfolio for the Johnsons. We start by identifying the percentage of assets that should be allocated to address each scenario based upon this family s needs, circumstances, and requirements. Within each of the scenarios, we create an asset allocation that is appropriately diversified, taking into consideration the specific risks associated with that scenario. Lastly, we combine it all together into a portfolio to make sure that we don t have inadvertent implementation risk in the total portfolio. Now let s walk through the Johnson family s portfolio. Looking at the portfolio as a whole, 50 percent of the family s portfolio is balanced between growth and income. Income will support lifestyle needs, growth will address the longevity need, inflation and liquidity have equal exposures in this portfolio, there is appropriate liquidity for unexpected opportunities, and there is inflation protection. Then there are equal allocations between catastrophe and volatility to make sure that unexpected global events in capital markets, economics, and politics don t derail this family s long-term investment plan. Figure 5: Johnson Family Hypothetical Scenario-Based Asset Allocation Catastrophe $1 million Liquidity $1.5 million Inflation $1.5 million Volatility $1 million Growth $2.5 million Income $2.5 million Catastrophe. For catastrophe, we don t want the portfolio allocation to be in cash alone, but want to include investments that are economically viable during times of stability and in times of unexpected global disruption in the global capital markets. Our foundation is a fairly predictable allocation of cash and bonds for liquidity and principal value that will hold up during periods of distress, but also a commodity allocation, as commodities tend to respond favorably in catastrophic events. We also suggest that investors consider including an allocation to hedge funds where appropriate to help manage some of the risks associated with a catastrophic event. Figure 6: Hypothetical Suggested Catastrophe Scenario Asset Allocation Hedge Funds 40% Cash 20% U.S. Investment- Grade Bonds 20% Commodities 20% Liquidity. Having liquidity means holding assets that can be converted to cash quickly. It doesn t require a cash allocation, which is very economically unproductive over long periods of time. Rather, it requires assets that can be converted fairly quickly to other assets when the need presents itself. That means asset classes that don t tend to have short-term volatility during periods of stress or vulnerability to liquidity squeezes, so we don t include assets like small-cap stocks and emerging markets that tend to be volatile during times of stress. Instead, we include high-quality bonds and large-cap equities that can be bought and sold with ease. Figure 7: Hypothetical Suggested Liquidity Scenario Asset Allocation At this point we ve created a scenario-based allocation. Now we will dive deeper into each scenario and create an asset allocation to address the specific risks associated with each one. Int l Developed Mkt Equities 13% U.S. Mid-Cap Equities 7% U.S. Large-Cap Equities 27% Cash 7% U.S. Investment- Grade Bonds 33% Int l Developed Mkt Bonds 13% Asset Allocation: It s Not About What You Own But Why You Own It 5

7 Income. We advocate diversifying income streams in a portfolio. In today s environment income doesn t just come from bonds; many asset classes can provide income streams. The allocation in Figure 8 exploits the full range of opportunities, starting with traditional investment-grade bonds, but then adding high-yield bonds, non-dollardenominated bonds, and high-dividend equities. In our view, such diversification can provide a well-diversified income stream that isn t totally vulnerable to rising interest rates. Figure 8: Hypothetical Suggested Income Scenario Asset Allocation Real Estate 12% Int l Developed Mkt Equities 8% U.S. Mid-Cap Equities 4% U.S. Large-Cap Equities 12% Int l Emerging Mkt Bonds 16% U.S. Investment-Grade Bonds 28% U.S. High-Yield Bonds 16% Int l Developed Mkt Bonds 4% Volatility. Addressing volatility in a portfolio is not about sitting in cash or market timing, but having asset classes that help dampen and control volatility. What you see in this allocation is a bifurcation: two different basic groups. One group is the traditional asset classes of bonds that help dampen the volatility of other more volatile asset classes. The other is hedge funds that trade on volatility and, in fact, benefit from volatility. So one group is helping to reduce the overall volatility of the portfolio and the other group is actually exploiting the opportunities provided by volatility and providing an economic benefit. We believe that this barbell strategy is a sound way to address volatility. Figure 10: Hypothetical Suggested Volatility Scenario Asset Allocation Hedge Funds 60% U.S. Investment-Grade Bonds 30% Int l Developed Mkt Bonds 10% Inflation. When inflation happens in an economic system, something is inflating so let s buy the assets that are inflating. We don t want too much of an allocation to asset classes that aren t able to adjust in an inflationary environment. The foundation here is commodities and real estate, which are traditional inflation hedges. Then we add equities, and we look for companies that have pricing power and are thus able to turn inflation into earnings. In the bond portfolio we keep duration relatively short so that as inflationary pressures build in the economy and interest rates typically rise, the bond portfolio can adjust fairly quickly. In our opinion this is a nice, globally diversified allocation of asset classes that are able to adjust fairly quickly as inflationary expectations are changing. Figure 9: Hypothetical Suggested Inflation Scenario Asset Allocation Growth. The typical growth allocation that many investors consider is one that offers global diversification across asset classes. It exploits all the various opportunities of liquid markets, illiquid markets, equity markets, and real estate markets. It s a very well-designed portfolio that does require diligence on implementation to avoid concentration risk and also rebalancing so that we don t get inadvertent risk exposures as the capital markets respond to different periods of fear and greed. Figure 11: Hypothetical Suggested Growth Scenario Asset Allocation Private Equity 8% Real Estate 12% U.S. High-Yield Bonds 4% Int l Emerging Mkt Bonds 4% Commodities 20% Global Real Estate 7% U.S. Investment-Grade Bonds 13% Int l Developed Mkt Bonds 7% U.S. Large-Cap Equities 13% Int l Emerging Mkt Equities 16% Int l Developed Mkt Equities 12% U.S. Large-Cap Equities 24% U.S. Mid-Cap Equities 12% U.S. Small-Cap Equities 8% Int l Emerging Mkt Equities 13% Int l Developed Mkt Equities 13% U.S. Mid-Cap Equities 7% U.S. Small-Cap Equities 7% 6 Asset Allocation: It s Not About What You Own But Why You Own It

8 Figure 12: Johnson Family Hypothetical Scenario Matrix Catastrophe Liquidity Income Inflation Volatility Growth Total Cash 2% 1% 3% Fixed Income Equities Real Assets Complementary Strategies U.S. Investment-Grade Bonds 2% 5% 7% 2% 3% 19% U.S. High Yield Bonds 4% 1% 5% International Developed Market Bonds 2% 1% 1% 1% 5% International Emerging Market Bonds 4% 1% 5% U.S. Large Cap 4% 3% 2% 6% 15% U.S. Mid Cap 1% 1% 1% 3% 6% U.S. Small Cap 1% 2% 3% International Developed Market 2% 2% 2% 3% 9% International Emerging Market 2% 4% 6% Global REITs 1% 1% 1% 3% Private Real Estate 2% 2% 4% Commodities 2% 3% 5% Hedge Funds Relative Value 2% 2% 4% Hedge Funds Macro 1% 1% 2% Hedge Funds Event Driven 1% 3% 4% U.S. Private Equity 2% 2% Total 10% 15% 25% 15% 10% 25% 100% Putting these all together, we see a matrix of the different scenarios, asset classes, and associated allocations. In the far right column we ve added them all up to the overall allocation of our balanced portfolio. Figure 13: Hypothetical Johnson Family Portfolio Based on a Scenario-Based Asset Allocation Approach Conclusion. In changing the conversation from what we own to why we own it, we believe that investors are better able to understand how each asset class addresses their various concerns and why it is in their portfolio. The example of the Johnson family clearly shows how this can work in practice. Cash 3% Private Equity 2% Hedge Funds 10% Commodities 5% Real Estate 7% Int l Emerging Mkt Equities 6% Int l Developed Mkt Equities 9% U.S. Small-Cap Equities 3% U.S. Mid-Cap Equities 6% U.S. Investment-Grade Bonds 19% U.S. High-Yield Bonds 5% Int l Developed Mkt Bonds 5% Int l Emerging Mkt Bonds 5% U.S. Large-Cap Equities 15% In discussing why you own a specific asset class, should market circumstances change, you are more likely to find yourself better prepared. As a result, you may find it easier to weather the storm without making decisions that can put your investment goals in other words your current and future lifestyle at risk. Asset Allocation: It s Not About What You Own But Why You Own It 7

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