Posts Tagged ‘asset allocation’

Nearly a decade ago, David B. Leoper of Wealthcare Capital Management published a well-read paper on asset allocation. In his paper, he argued that diversification alone, which we underline here at the Mutual Fund Site, is not enough to water down the risk attributes of a portfolio. It seemed to me when I first came across his piece that he was either nuts or the concept of asset allocation, which is one of the fundamentals driving all mutual funds, might be widely misunderstood.

Diversification alone is not enough

One of the most striking arguments that Mr. Leoper makes in his paper is that diversification should not be used as a carte blanche excuse to explore higher risk investments within one’s portfolio. And while we have examined some very worthy small cap funds at length recently, Leoper’s point is extremely valid.

Just because you might have the risk tolerance to jump in bed with the RBC Micro Cap fund, it does not necessarily mean you should. Even if you were to limit that exposure to just 5% or even 2%, making an investment like that needs to be done for the right reasons.

And that, the idea of making investment decisions for the right reasons, is really the message we and every other financial planner, consultant, advisor should aim for. And while it sounds hokey, superficial and possibly even contrived, the reason for really getting to know an investment, whether mutual fund, ETF, or individual security makes perfect sense.

Make investment decisions for the right reasons

Ultimately, each investment within your portfolio will relate differently with other securities. It is like having a classroom full of male computer geeks (yep, I would be there!) and then adding an aggressive female athlete into the mix. All of a sudden, the dynamic changes. Some students might compete for the female’s attention, others might take a more aggressive position when it comes to their projects, etc.. Either way, the classroom would change, maybe dramatically or maybe subtly, but definitely it will change. And with time, that change may have a positive or negative impact; either way, there will also be an impact.

To invest for the right reasons, investors will want to understand how the new, added investment will change the portfolio’s dynamics. This might involve simply aligning the investment with other asset classes and sub-classes or it can involve something as complicated as R-Squared.

More importantly (and a lot simpler), the new investment should make sense with the portfolio’s overall objective. For example, if one wants long term growth, choosing an investment that focuses on speculative technologies might not make much sense. As well, this sub category may not correlate well with other asset classes within the portfolio.

By taking a closer look at one’s portfolio, it can be fairly easily ascertained whether a new investment will make much sense at all. Of course, for investors who are die hard mutual fund investors, the concept of diversification is an easy one to understand and appreciate. But that alone does not give free reign to buy assets that add no value, either tangibly in terms of risk-adjusted returns or intangibly in terms of how well such an investment compliments the balance of the portfolio.

It is about that time again where the Mutual Fund Site stresses the importance of asset allocation. This has very little to do with the recent market turbulence that has seen volatility (as measured by the VIX) jump to the highest levels of the year and more about how asset allocation accounts for more than 90% of one’s long-term performance track record. Regardless of whether mutual funds, exchange traded funds or any other asset management system are part of one’s investment strategy, asset mix is clearly important.

What else influences long term performance in an investment?

Other factors that influence a portfolio’s long term returns are asset selection, market timing and other factors (such as dollar cost averaging, expense ratios and so forth). But as shown here, none of those factors account for more than 5% of returns.

And here is why: the above factors involve investor intervention whereas asset allocation does not. An investor must consciously decide when to buy and sell (market timing), what assets to include (asset selection) yet asset allocation does not involve decision making.

Asset mix can be determined through a series of a questions like the handful of questions we ask on our Asset Allocation Model Builder. All the investor needs to do is stick to the asset mix recommended. Plain and simple; no emotion-driven investment decisions required unless it is for rebalancing or making higher level changes to the asset mix itself.

This is supported by the simple fact that many fund managers are better managers with their portfolios than we are with our own: we have an emotional investment in our savings whereas fund managers do not. Emotions cloud the logic that one needs in order to be a successful investor.

At more than 90% of a portfolio’s long-term returns, it is therefore well worth taking the time to review one’s asset allocation and making the appropriate changes to one’s investment portfolio. This is a no brainer, really.

As a follow up to our former Contrarian Investment Practices post, we want to take a closer peek at exactly where to invest if these contrarian theories have any merit. Of course, we will look at mutual funds specifically.

In a recent article published by Russel Kinnel, the Director of Mutual Fund Research over at Morningstar.com, it became quite apparent that Contrarian Investment practices actually do work. The methodology that Kinnel used involved investing in funds that were seeing cash outflows (the “unloved” funds) rather than those funds that were deemed most popular based on the dollar amounts of inflows (the “loved” funds).

What Kinnel discovered was that investing in the unloved funds yield returns that were better than not only the “loved” funds returned, but the S&P 500 as well. In some cases, those “unloved” returns were substantially higher — 8.1% for 3 years versus the “loved” returns of 6.24% and the S&P returns of 6.96%.

The same trend holds for a five-year period as well, with the “unloved” mutual funds outperforming (8.08%) both the loved funds (4.25%) and the S&P 500 (5.76%).

The Question becomes one about finding out what the “unloved” are.

Finding out what the unloved funds are poses something more of a challenge. Kind as he is, Kinnel pointed out in his article that the “unloved” funds or categories were the large-cap growth, large-cap value as well as world stock. Easy enough to find the top performers in these categories; simply visit Morningstar.com and use their free fund screener.

But what about those times when finding these unloved categories is more difficult than finding them in an article so kindly published by someone like Kinnel? Well, let’s take a look at Kinnel’s statistics once again. In terms of best performing mutual funds, the following trend emerges quite easily:

• Unloved categories will outperform the Loved categories
• The S&P 500 will outperform the Loved categories, but not the Unloved categories.
• The Loved categories will not outperform either the Loved categories or the S&P 500.

So, if you cannot figure out what the “unloved” funds are (or even what the “loved” funds are for that matter, meaning you can’t figure out what to sell), there is one option. Consider that the S&P 500 outperforms exactly what your friends buying and likely what the advisors are recommending… why not buy Index Funds?

Index Funds might not beat out the top Unloved categories as a whole, but will definitely outperform what your advisor is recommending (or even what your friends are buying). This is particularly convenient if contrarian investing is something that investors are unable to fully agree with (e.g. cannot stomach being possibly wrong with their contrarian choices as they fluctuate and fail to return a positive number for a couple of years). While this is not the absolute best way to achieve the best returns, it definitely is where to invest if you do not want the hassle and potential expense associated with learning about mutual fund inflows and outflows.

Introducing our Asset Allocation Model Builder

Have you ever wondered what your asset allocation model would be if you could work it out on your own? That is without your planner or advisor looking over your shoulder or asking the questions while you sit across from him or her?

Well, now you can. This Asset Allocation Model Builder allows you to work on your Investor Profile independently of your planner or advisor. In fact, if you do not work with a planner, the Asset Allocation Model Builder will let you know what kind of asset mix you should incorporate into your own investment portfolio.

And the best part is that it will not cost you a dime.

What The Asset Allocation Model Builder Does

The following six (6) questions ask you about your beliefs about investing. They are not intended to be tricky or deceptive so that we might “sell” you an aggressive, speculative fund that pays a pretty trailer fee (remember, we do not sell anything at the Mutual Fund Site).

When you complete this form and submit it, the team at the Mutual Fund Site will evaluate your responses and provide you with an independent, minimum 2-page standardized report as to what your Asset Allocation Model should look like.

What Will You Do With My Name, E-Mail and Information?

We use your name and e-mail simply to personalize and respond to your Asset Allocation Model Builder submission. We will never write to you again, meaning you will never receive S-P-A-M e-mails from us. Period. (BTW, in order to be compliant with anti-SPAM regulations, webmasters must use third-party e-mail response systems like AWeber and a host of others).

Your information (the responses to the following 6 questions) is used simply to analyze your tolerance for risk, time horizon and investment objectives. From these questions plus some of the secondary questions that relate to how much risk you should prudently take (based on income and net worth, for example), we can gauge just how much weightings you should place in each asset class.

Aside from using this information to provide a professional recommendation, we have no other use for it. In other words, we are not using it to conduct any kind of demographic or market research (we can use Quantcast for free and save ourselves a ton of work).

How Long Does It Take To Get My Recommendation?

Due to volumes, we currently need 2 business days to e-mail responses to those who submit the survey.

Even though we are not here to sell you anything and we still urge you to speak with a professional planner who is licensed in your State before embarking on an investment program (you should use our Asset Allocation Model Recommendation as a great starting point), we believe in providing you with quality recommendations or nothing at all.

We have chosen quality.

So please help yourself to our Asset Allocation Model Builder and expect a response from us within 2 business days.

While mutual funds by themselves offer tremendous diversification potential within sectors, industries, market capitalization and so on, unless you invest in balanced funds, proper asset allocation is usually only achieved by holding different types of asset classes. Understandably, giving up the potential for aggressive gains in growth funds (which are usually suggested through historical return data) in favor of more stable returns in bond funds is not an easy thing  for most investors to do. However, while those historic gains might seem attractive at first sight, proper asset allocation is paramount if one wishes to achieve long-term growth and income.

All investors need to do is look back to 2009 to see just how powerful proper asset allocation can be. For example, the S&P 500 returned roughly 20% throughout all of 2009 (over 60% since its impossible-to-predict low in March 2009). Investing in a 30-year Treasury by comparison would have returned roughly 65% a staggering amount of return for that same period.

While 2009 was undoubtedly one of those “off” years, the data from 2008 tells a similar story about the importance of proper asset allocation through asset class diversification. Arguably a devastating year for equities, 2008 was also a painful (a much more painful in fact) period for long-term Treasury bonds. For that year, equities gave up a touch more than 35% while 30-year Treasury gave up marginally more. While both were evidently “losers” in terms of total return, equities actually outperformed the 30-year Treasuries.

And one year earlier, 2007, also teaches a valuable lesson. While equities ended the year up nearly 5%, 30-year Treasuries were down nearly that same amount.

By incorporating an asset allocation model that touches all asset classes (we are simply looking at the S&P 500 and 30-year Treasuries here), investors will not only sacrifice some of the “wild” gains by being 100% invested in equities, but they will mute those losses in one classes by offsetting them with investments in another.

To illustrate this, consider that same period from 2007 through to 2009. While the year-by-year playbook shows favorably for equities, in fact the 2009 gains in 30-year Treasuries would help produce positive (or less negative) returns for an investor who purchased an S&P 500 Index Fund as well as a long-term bond fund. With a long-term bond fund that imitates the returns on 30-year Treasuries returning nearly nothing over that same period, the other fund, which follows the S&P 500, would still be down roughly 20%. In other words, an asset allocation model that splits the assets 50/50 between an index fund and a long-term bond fund would have only lost a little more than 10% (instead of the full 20%).

One of the most e-mailed op-ed columns in the NY Times was published on February 1, 2010… a few days after the Mutual Fund Site released its write-up on the Dryden Financial Services Fund, a mutual fund that has a strong reputation for its investment management prowess and stunned investors with staggering returns in 2009.

Why is this important and why should you care?

Let’s take a look at the column in question. In it, Nobe Prize winner, Paul Krugman describes how the Canadian banking system, which was coincidentally modeled after the first American secretary of Treasury, Alexander Hamilton, is remarkably the soundest system in the world (versus the US system at 40th). More specifically, Krugman points out that the banking reform currently pushing its way through the system will substantially Canadian-ize the domestic banking system.

In addition to the obvious statements by Paul Volcker (who advocated in early 2009 that his vision for the banking system “looks more like the Canadian system…”) and those by President Obama (let’s not get started), it seems that the US banking system may some day soon resemble Canadian system.

This is key, and also brings us to the importance of the publication dates for these two pieces. Less than a week prior to Krugman’s op-ed column, the Mutual Fund Site gave “top marks” to the Dryden Financial Services fund. And guess what makes up their core holdings. That’s right, Canadian banking stocks.

More than 11% of their meager $162 million under management is invested in Canadian banks. In fact, three of their top 25 holdings are Canadian banks, all of which have among the lowest P/E ratios in the fund’s top 25. What makes this interesting is that the Dryden Financial Services mutual fund has outperformed, by a long-shot, the S&P 500 as well as its peers in the last year, proving that their investment management strategy and, most importantly, their attention to detail has really paid off. Some of this might have to do with the Canadian banks’ ability to maintain dividends and, in many cases, increase those dividends. If bought at the right time, some of those yields would have exceeded 8%. Still, even with an 8% dividend yield, another 60% in return had to come from somewhere…

Does Krugman’s popular piece provide support for investing in a mutual fund like Dryden’s? Not necessarily, although it certainly provides some credibility to why we, at the Mutual Fund Site, gave Top Marks to the Dryden mutual fund. More importantly, given the amount of attention the New York Times piece has attracted, it seems that, if governments start modeling their financial services firms after the Canadian system, and it seems they will, Dryden could see some good, long-term growth provided their investment management team and strategy remains intact.

Questions about where to invest money invariably come down to finding the right asset allocation model for the investor. The process of asset allocation normally becomes a tad simpler when the investor is looking at mutual funds as a way to not only secure solid returns (good and bad) but proper investment management.

Defining the right asset allocation model is not a two-minute process. As the cornerstone of your investment management strategy, it should never be taken lightly given the variations from one model to another.

Ultimately, any portfolio that incorporates equities into its program will fall under three different types of asset allocation models; conservative, moderate and aggressive, with conservative being the least risky and aggressive being the most aggressive.

Taking a closer look at each model, we will see the following:

Conservative Asset Allocation
25% Cash, 60% Income and 20% Equities.

With the exception of cash, the bulk of the investor’s attention (or the adviser’s) will be spent analyzing the quality of bond funds or other types of income-producing investments to incoporation in the model. With equities at just 20%, breaking the total portfolio into specialized growth funds would be futile. In most cases, the 20% Equities would be properly diversified by number of shares and type of shares and possibly even geography.

The Income component however will need to draw on several specific funds in order to be properly invested. This can include a small amount (say up to 10%) in high yield investments with the balance being spread around different bond funds (government bonds, muni bonds, etc., etc..). The point is that the income-heavy Conservative portfolio really puts a lot of attention on the Income aspect.

Moderate Asset Allocation
10% Cash, 30% Income, 60% Equities.

The greatest area of focus in a Moderate portfolio is shared by the Equities and Income areas. Some specialization will occur in the Equities portfolio (perhaps 10% to 20% in highly specialized funds, such as Real Estate, Energy, Healthcare and so forth) while the balance can easily be spread among domestic growth funds, value funds or a blend of both (up to 20%) with the balance being further diversified by geography.

Of course, the bond funds held in such a portfolio will also demand investor attention. A smaller amount of specialization is needed here (say 5%), but investors would be wise to consider high yield investments for this small percentage with the remaining 25% being gobbled up with high quality bond funds including a good spread between government and corporate bond funds.

Aggressive Asset Allocation
5% Cash, 15% Income, 80% Equities.

The Aggressive portfolio becomes an Equities-focussed portfolio. The investor will typically incorporate highly concentrated equity funds for up to 50% of the total portfolio in areas like Real Estate, Healthcare, Energy, Resources, Small-Cap, Venture and so forth. This represents a tremendous risk to the overall performance of the portfolio in terms of overall strategy. As such, the strategic asset allocation may shift on a micro level (shifting from 50% in specialty funds during boom periods to a more defensive 20%, and vice versa).

The Cash and Income components of such a portfolio then become secondary and normally represent the liquidity portion of the portfolio. Many investors are simply looking for safe parking spots for such money in order to take advantage of opportunities in equities and to earn income on funds they know they will not want to reinvest for some time.

These three asset allocation models evidently take a look at three types of investors insofar as equities holdings are concerned. Of course, these portfolios can become even more conservative once equities are removed. These models show the difference between the most conservative portfolio and the most aggressive and illustrate just how important the asset allocation process really is, even when (or especially when) dealing with mutual fund investments.

Okay, you have just three years and a hundred thousand dollars burning a hole in your pocket. Three measly years and you need to know where to invest that money so that, in three years when you need that investment, you know that you have not risked that money for the sake of return. Where do you invest it? What type of mutual funds, including ETF’s meet this requirement?

Three years as a time horizon is a tricky one. It is neither short-term nor long-term. Some may call it medium-term, but when you have just three asset classes from which to choose – cash, income, equities – how to do you find that best 3-year time horizon. Because let’s face it; based on the interest rate environment, many bond funds now have a 5-year time requirement. And high yield investments, due largely to their speculative nature really should be longer-term, even if they come with the probability today that they will benefit from rates in the next 12-36 months.

Based on the interest rate environment, many bond funds now have a 5-year time requirement…

And equity funds, well, even the most conservative come with a minimum time investment of 5 years. Anything short of that is just far too risky for the investor. Of course, luck can always prevail and provide the right return after just 3 years, but there is no guarantee of that. Suppose you invested in 2005… three years later would put you into 2008, arguably one of the worst years for the markets. You would have been (censored), kicking yourself.

Okay, and let’s say you invested in bonds at the same time. Short of a government bond fund that saw rates plummet while the US borrowed heavily and saw some rates so close to zero that brokers quoted them that way, you would have also been (censored), kicking yourself for ever thinking that bond funds were the safest and greatest thing since, well, sliced bread.

In 2005, the best 3-year investment would have been a 3-year term deposit… with a financial institution that did not go under. But remember, even people who invested in Citibank were nervous in 2007/2008, lining up to get access to their money. Remember that panic?

But that was the past, right? Today, things are different. Citi is still around, rates are at their lowest and some of the best performing mutual funds in 2009 were indeed bond and equity funds. It makes high yield investments look really lucrative right, especially after this very site announced that its top pick for 2010 was a high yield investment fund. But even the most aggressive financial planner would recommend a 5-year time horizon on a fund like that!

So what are your options when it comes to a 3-year maximum time horizon?

Cash Equivalent

You could look at a cash equivalent fund, but kiss any kind of return goodbye.

You could also look at a term deposit but consider than rates are likely to increase, so if you lock up your money, you will lose purchasing power.

Bond Funds

While bond funds will present marginally more risk, your short-term bond funds will allow fairly decent turnover within the fund, mitigating the risk of holding longer term funds. While rates of return will not come close to those expected in some of the riskier funds, the idea here is to get back what you invest.

Diversify

Perhaps your best bet with your $100,000 and 3-years, would be to diversify your holdings. This might look like 30% short-term bond funds, 30% cash equivalent or Treasuries, 25% Cash, and 15% term deposit. The strategy might involve using the cash and cash equivalent funds to gradually increase your short-term bond holdings or term deposit holdings based on the performance over the next 2 years so that at the end of 2 years, your portfolio might have 65% short-term bonds and 35% term deposits that mature in the year that you need the funds.

A riskier investor might be able to absorb the potential volatility and impact that a lower-risk equity fund can offer, but most financial planners will not even touch that one… leaving you to make your trades with a discount broker.

At any rate, realize that with 3 years your investment options will be limited. And while growth and returns will be low, your objective should be to virtually guarantee return of capital. Even the most educated fund manager would subscribe to such a strategy, ensuring that investment risk is only so high as the expected rate of return.

There is no denying the important role that balanced mutual funds play in one’s investment career. Whether you are a hands-on investor or someone who would prefer to have no involvement whatsoever when it comes to investment management, the right balanced mutual funds can easily find a home in your portfolio. In fact, many investors will hold funds that are managed by their favorite fund manager, and what better place to test a fund manager’s true skill than in a balanced fund.

What better place to test a fund manager’s true skill than in a balanced fund.

As discussed at length elsewhere on this site, the idea of balanced funds is to achieve above-average returns (as measured by some standard, either an index, a combination of indices, or some other standard like LIBOR-plus x%) either through tactical asset allocation or strategic asset allocation strategies. In a tactical asset allocation fund, the fund manager will shift between income assets and equity assets depending on how the manager “sees” the markets heading. In a strategic asset allocation fund, the fund manager ensures that the assets of the fund remain within their prescribed limits (e.g. 25% income class, 75% equity class) and will make adjustments once the assets deviate from this strategy.

Okay, with that out of the way, let’s take a closer look at the importance of balanced mutual funds in everyone’s portfolio, but especially for the hands-off investors.

For the investor who has properly positioned his or her portfolio the way he or she wants it and actually maintains some form of involvement in the investment account, holding a top-performing or top-ranked mutual fund can provide a great deal of insight into the investor’s own abilities. If the investor is astute enough, he or she will find a balanced fund that closely reflects his or her own portfolio or, better yet, his or her target time date. For example, if you know your investments are for retirement and that you are going to retire in the year, say, 2030, then finding a Target-dated balanced mutual fund that mirrors your risk tolerance and investment objective can be quite easy to do. Holding such a fund and comparing your existing portfolio’s performance against the performance of the mutual fund can be humbling and educational. In instances where performance returns vary greatly, you can see exactly where you fell short.

For the hands-off investor, the balanced mutual fund offers a great opportunity to take advantage of the best skills and asset management that money can buy. Best part is that you do not have to pay, directly, for this elevated level of expertise and skill… well, you sort of pay, but it is proportionate to the amount of money you invest. So, if you invest $10,000 and it grows to $20,000, you give up as much as 2.0% (or marginally higher, but you get the idea) annually. That means you will have to give up $400 for that year. The more you portfolio grows, the more you pay.

But let’s take a closer look at this. Let’s say you decide to invest in one of Franklin Templeton’s Target dated portfolios, we’ll go with Target A for fun. In this case, you would pay roughly $100 in fees (which comes out of your asset value, not out of your pocket) and in return you would have a Franklin Templeton VP with more than 20 years of experience at the company (3 years with this particular fund) managing your money. Imagine that. Better yet, consider that this particular fund has extremely low risk given the returns it proves you annually…

Now consider this, especially if you are a hands-off investor:

If someone told you that you could have the VP of one of the largest fund companies in the world managing your money before you read this, what would you have done? Laughed? Thought that person was nuts?

Now you know. The VP of Franklin Templeton will not only manage your money, no matter how much (or little) you have to invest, but he will only charge you 0.5% (or up to 2% elsewhere). And if the VP of Franklin Templeton can’t get it right when it comes to balanced mutual funds (or any other funds for that matter) what does that tell you?

Think about that…

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