Up to now, we have treated the global investment world as if equi-
ties were the only investment choice available. We have formulated models and techniques for choosing countries to invest in, for avoiding bear market periods, and for choosing specific equities to
put into your portfolio. While global equities offer excellent long-
run total returns, unparalleled liquidity, and participation in
human progress, they are far from being the only investment class available to global investors. And, as our money management rules dictate, global equities should never be the only asset class in your portfolio.
OUTPERFORMANCE AND ASSET ALLOCATION
After I had learned the basic techniques of the European money
manager who innovated the concepts we use in our global equity relative strength methodology for choosing countries to invest in,
a question I kept asking was "If there were one or two things that you could improve in this model, what would they be?" We dis- cussed this issue at great length. One of the first things we came
up with was that it would add great value if we could develop 287
288 OTHER ASSET CLASSES AND MODELS TO EXPLOIT THEM
some method of choosing individual equities that would outper-
form their selected indexes. In Chapter 7, we have described the
outcome of the research effort spawned by this idea.
After long consideration and we both decided that the low performance of being in cash for prolonged periods was certainly another area for improvement. This brought out the idea of incorporating other asset classes into a portfolio. We then decided that bringing the risk/reward of other asset classes, via similar models to the original model (meaning only when many criteria looked especially positive and with the goal of avoiding negative environments in each selected asset class) would likely add value to the existing system, as well as enhance the return of the portfolio during periods when it had little or no allocation in global equity markets. When I left Europe, in the mid-1980s, I had received the incredible gift of a phenomenal global equity sys- tem, and I also had a good idea of what research I might do to im- prove on it.
After Tom Johnson and I completed our vehicle selection re- search, I began to dig into the asset allocation question. Again, I voraciously read everything I could get my hands on discussing global asset allocation among various asset classes. The first thing I found was a dearth of meaningful research on real global asset classes. There is a ton of information on stock/bond asset alloca- tion choices. Figure 8.1 shows the basic thrust of the data. The bot- tom line is that adding some mix of bonds to a of stocks tends to cut risk, although it also brings down return, with the generally best risk/reward mix being a somewhat even split be- tween stocks and some duration of bonds.
There were two really slam-dunk clear conclusions I could draw from asset allocation research. The we covered earlier in this book: Adding global to a stock portfolio adds long-term returns while decreasing long-term risk. The second way that an investor can increase long-term returns while decreasing long-term risk in a statically allocated portfolio is by adding a group of top-rated managed futures or resource-oriented funds, as summarized in Figure 8.2.
While this particular study is far too short-term to be ex- tremely illuminating, other studies done going back much further
beyond 1980 generally that adding managed futures or re- source funds to either a pure equity or equity and bond portfolio tends to
Source: Associates, based on model portfolios during Used with per- mission. 1998 Ibbotson Associates, Inc. All rights reserved. (Certain portions of this work were derived from copyrighted works of Roger G. Ibbotson and Rex Sinquefield.)
dampen drawdown and volatility while slightly enhancing long-term re- turns. If managed futures can add value during one of the best 15- year runs in stock market and bond market history, they certainly ought to be able to add value when stocks and bonds aren't in a
screaming record-breaking bull market. We have done extensive
research on this subject, and in general find that an allocation of
somewhere between 10 percent and 25 percent in top-rated diversi- fied manager managed futures funds add optimal long-run value to statically allocated portfolios. In fact, this is a substantially clearer additive factor to profitability than is globalizing equity
AND ASSET ALLOCATION 289
290 OTHER ASSET CLASSES AND MODELS TO EXPLOIT THEM
Figure 8.2 IMPACT OF INCREMENTAL ADDITIONS OF MANAGED FUTURES TO THE TRADITIONAL PORTFOLIO
Source: Used with permission. Copyright © Managed Account Reports Inc. Ail rights reserved.
or even adding bonds. We will be discussing it in de- tail in our section on this asset class.
While globalization and the addition of managed futures or re- sources seemed to be clear conclusions from most asset allocation research, much of the research on asset allocation to date is what I term, "overly academic." First, it is often written by someone with little real-life experience investing in global markets. This has tended to prolong purely unrealistic assumptions such as using standard deviation or volatility as a of risk, when in fact these are ridiculous from a true investment standpoint. Upside volatility and sharp moves in a favorable direction are de- sirable investment traits, and do not accurately any negative potential risk, for example.
Second, authors of academic research on asset allocation tend to believe in some combination of the efficient market hypothesis and/or totally long-run investment decisions. From this, we get assumptions like the of adding value via stock selection, country selection, and asset-class selection, as well as static asset allocation models that continue to hold bonds in a
AND ASSET ALLOCATION 291 wildly inflationary environment despite their potential losses, or stocks during a period of skyrocketing interest rates and weaken- ing economic growth. There are times when it is clearly a poor en- vironment to hold a particular yet most research assumes no change in allocation during these periods. Probably because of the assumption of static allocation, there is little re- search or understanding of the dynamics behind positive and neg- ative return environments in the different asset classes.
One of the most frustrating assumptions in many asset alloca- tion studies is that the of asset classes is so tightly con- strained that it is not a serious discussion of the truly different investment options an investor faces in the real world. Typically, the world of investing offers, by these authors' assumptions, only stocks and bonds, or perhaps, stocks, international stocks,
and international bonds, if the author is new-world open- minded. Only rather recently have managed futures, real assets, and real estate started to be included in the potential mix. This still leaves some terrific investments on the table.
This is not to say that there is no value added from many cur- rent studies on asset allocation. Having a good idea what long- term asset allocation tends to provide the optimum risk/reward over the very long term is a valuable starting point from which to begin adjusting to the current and likely investment environment ahead, but it is not the end-all be-all of asset allocation discus- sions. And, the conclusions drawn are not overly helpful unless a full range of actual investments are chosen among and studied. It is, however, important for investors to understand the one rela- tively universal axiom that has developed out of asset allocation literature to date: mixing disparate risky investments lowers portfolio risks while raising returns.
Perhaps as important as this conclusion is the understanding of why this is so. Two examples of potential investments can il- lustrate this concept: one is a banking corporation bond that tends to follow interest rates closely; the other is a diversified group of oil wells that are producing but also offer exploration potential. The largest part of the return of our 100 property oil well produc- tion/exploration comes from the exploration potential. Thus what makes our bank corporation bond go up or down (interest rates) has little or nothing to do with our oil investment. If both investments have an allowable mix of long-term returns, then
292 OTHER ASSET CLASSES AND MODELS TO EXPLOIT THEM
they are likely to add synergy to a portfolio because of deriving their profits from almost totally unrelated things. Thus there is little reason to suspect that bond prices will go down at the same time that our oil investment Since they are both going but due to different factors, mixing them together is likely to smooth long-term performance toward the average of their long- term annual returns.
The best things to mix together in a portfolio thus have an ac- ceptable average annual return together and either derive their long-run returns from totally different and somewhat unrelated activities, or they derive their from opposite forces. As seen in past commodity price rises, such as oil, tend in gen-
eral to move in opposition to bond prices. This means that to some extent our two proposed investments are likely to be uncor-
related. Bonds are likely to go down in a rapidly rising oil price
environment, and conversely, oil prices are likely to come down in
a weakening economy, a benefit for bond holders. The more un-
correlated and disparate the investments mixed in a portfolio, the
more likely they are to smooth long-term performance, thereby reducing risk.
In a reserve monetary system under a normal tionary environment, stock prices get hurt by monetary tighten- ing. When the economy begins to overheat and begins to show up on those limited government indicators of inflation
equities start to expect tightening and they usually decline
as interest rates move up to cut off the excessive demand pres-
sures. This is the beginning of a typical negative environment for equities. Now if we could an asset that typically from the same environment that causes queasiness in equities and
manages to produce gains on a long-term basis, but especially in
the environment described, then we would have an almost per- fect smoothing effect on an equity portfolio creating a mix.
Commodity futures funds are probably the closest thing to this description. The reason is that commodity prices tend to rise overheating while bonds and equities become nervous. In addition, higher priced commodities mean more price volatil- ity, making profitability more likely for top managers. And an overheating economy means first excessive demand and then a slowing economy that leads to a boom/bust in economically sensitive commodity prices. Since top futures managers are able
to from both the upturn and and simply need
BUILDING A PORTFOLIO 29?
volatility and trends as the main ingredients in their profitabil- ity, this is a promising potential environment for such funds, at exactly the same time that it is a negative environment for stocks and bonds. This is why mixing futures funds with equities is particularly advantageous. It smooths both overall portfolio ups and downs (risk and drawdowns) while enhancing long-term average returns by adding profits in negative years as well as in positive ones. Most top-rated futures funds also produce higher long-run profits than global equities.
So an excellent diversification is an investment that profits long-term but shows enhanced returns at the exact time that something else in your portfolio has trouble. And a worthwhile diversification builds profits in a way that is totally unrelated to the reason something else in your portfolio generates profits. A fair diversification is something often providing different timing of investment gains and losses, but occasionally moving in tan- dem with most things in your portfolio.
BUILDING A PORTFOLIO
Armed with this simple understanding of diversification and its effect on long-run returns and risk, we can examine some tradi- tional asset allocation choices to dissect their effects on a portfolio. Would you say global equities are an excellent, good, or fair diversification when matched with U.S. equities? Somewhere around fair-plus is probably accurate. It is true that many markets such as India, China, Korea, and Colombia have very low historical correlations to U.S. equities. It is also true, however, that in most recessions global equities, even those least correlated with the United take a hit just as the United States does. There was virtually no equity market on the globe that did not take some hit from October for example. World equities, in fact, often take bigger hits than the U.S. blue chips do in such instances. This was true in 1929-1932, 1937, 1973-1974, 1981, 1987, and even the relatively minor 1989-1990. Only Taiwan and Korea escaped 1994, which wasn't even a recession. So while global equities provide some smoothing, in a global recession they are highly correlated with the United States and provide little or no insulation. And, after all, the reason you want diversification is mainly to protect you in negative environments.
294 OTHER ASSET CLASSES AND MODELS TO EXPLOIT THEM
What about U.S. bonds? Well that depends on two
the duration of the bonds and the period in which you get your data to study. For instance if you go back to the post-Civil War era to get your you're likely to see bonds in a better light than if you start your study in 1981, or even following World
War II. As mentioned in a gold standard, bonds often
move inversely to stocks. Since both produce positive long-run
gains, bonds made a much better diversification with stocks prior to the 1920s than they did when the era of en- vironments was created with the launch of the Federal Reserve Board in the World War I era.
In addition, the lag between bond price movement and stock price movement has become smaller and smaller since the Fed was formed, as the markets slowly caught on to the relationship and as the economy grew more and more addicted to credit. Tech- nical innovations and proliferation of news via new media tech-
nology helps speed reactions to events as well. Prior to the
great bonds were really a good to good-minus combina-
tion with stocks. But after the great period, long bonds in particular have actually become a fair to poor diversification with U.S. stocks. Especially since the 1981 beginning of the disin-
era, bonds and stocks have moved very closely in lockstep.
Adding long bonds to a portfolio since 1981 has done little ex- cept cut total returns when combined with U.S. equities. However, if psychology changes again from disinflationary to deflationary, or deflationary fearing, we could again see bonds rally while
stocks decline to more realistic earnings expectations. And cer-
tainly in Japan, where exists, bonds and stocks are much
more inversely correlated. Remember, too, that long bonds are not
the only type of bonds. There are junk bonds, zero-coupon bonds,
short duration bonds, foreign bonds, distressed bonds, convertible
bonds, (Government National Mortgage
adjustable rate bonds, and so on. We will explore these in more de- tail in the following section.
EXPLORING ASSET CLASSES
You should now better understand what makes something a good
diversification to add to allocation, and what can change that
ASSET CLASSES 295
analysis. Now that we understand what makes combinations of in- vestments work together we can examine a broad array of asset classes to determine how we can apply similar techniques to them thus avoiding negative periods and highlighting periods in which they offer a particularly good risk/reward. The following asset classes are discussed: (1) bonds, (2) gold and silver, (3) real Estate, and trust deeds, (4) arbitrage funds, (5) global hedge funds, and (6) resource and commodity futures funds.
Bonds
First, let's look at different classes of bonds. In a fractional reserve
system long-term bonds are simply a speculation on interest rates, pure and simple. If you buy long-term bonds, you are saying you
expect rates will go down. Zero-coupons are either a leveraged way of speculating that interest rates will go down, or for short-term zero's, a way of locking in what you expect will be a high in rates. Buying foreign long bonds is a speculation on that coun- try's interest rates, and on its currency. Buying foreign bond fu- tures is a way of speculating that the interest rates will go down without as much currency exposure (because really, only your margin is exposed to the exchange rate change dur- ing holding). Buying one-year (short duration) foreign bonds is a way to lock in a currency price and interest-rate combination that you expect both of which will move in a favorable direction. One-year U.S. bonds, short-duration blue-chip preferreds, and
adjustable rate bonds are an anchor will give you
an extremely reliable positive return, but will also keep you from making double-digit profits if you own too much of them. Junk bonds are a bet that the economy will not weaken significantly. Distressed bonds are a bet that the managers can find turnarounds in bankruptcies and extremely distressed companies and that in- terest rates won't rise substantially or economic growth decline significantly. GNMAs are a way to lock in rates you expect to slowly decline. If rates decline too fast, most mortgages will refi-
nance and cut the yield on GNMAs. Convertible bonds and con- vertible preferreds offer a way to build high yields with the
potential kicker of capital gains down the road from an underlying security. They are thus a good way of building a long-term position in a depressed equity, market, or industry when a market, industry,
296 OTHER ASSET CLASSES AND MODELS TO EXPLOIT THEM EXPLORING ASSET CLASSES 297
or equity is very undervalued, but not yet on the technical and fun- damental path toward marked improvement.
The key points here are (1) there is almost always a bond in- vestment making money in any kind of imaginable environment; and (2) if you can reliably determine which way interest rates and the economy are heading, you can adjust your bond investments to profit from the environment, as shown in Table
Synthesizing this table, the aggressive bond investor will move through Stages 1-4 of the Liquidity Cycle by (1) buying long zero-coupon bonds as the economy weakens and goes into reces- sion or soft landing; (2) moving out of zero-coupon bonds and into
long bonds or convertibles on the first hints of decent economic growth; (3) moving into junk bonds or emerging market debt as the recovery becomes clearly established; (4) moving into ad- justable rate junk, adjustable rate short bonds, and distressed bonds as the economy begins to show signs of overheating.
Investors should note that Stages 1 and 3 in particular often