The Investment Scientist

Archive for the ‘Asset Classes & Allocation’ Category

icarra chart

MZ Capital 70/30 model vs S&P 500

(Performance stats last updated on 8/16/2011) I have maintained 4 model portfolios since the beginning of 2007 to show that successful investing can be extremely simple: one only needs to do 1)prudent allocation, 2)disciplined rebalancing. One does not need Harry Dent’s prescience nor Jim Cramer’s encyclopedic knowledge to be successful in investing.

This report shows the construct and performance of the 70/30 model portfolio, the most aggressive of the four. The chart on the right shows the portfolio value of $100 invested on the first day of 2007, relative to the S&P 500.

Asset Classes and Fund Selection

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If you invested $1 in the small cap value index at the beginning of 1927, you would have had $52,892 by the end of 2010. This is according to the recently published Dimensional Fund Advisors’ annual Matrix Book. Included in the book are historical risk and returns of various indices based on capitalization and book-to-market valuation.

Table 1 presents a summary of historical returns. The best returns are marked in green; the worst, marked in red. As one can see, the small cap value index is the best for all the periods considered. And it is the best by a huge margin.

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Recently I asked my assistant John to pull up Harvard Endowment’s 13F filing for Q4 of 2010 and compare it to that for Q4 of 2009 (shown in table below).

Apparently, Harvard Endowment’s year-end position in 2010 had changed significantly from that of 2009. The way I see it, there are three significant changes:

1. At the end of 2009, Harvard Endowment was extremely bullish on emerging markets; the top 10 positions were emerging market positions. That number was reduced to 5 at the end of 2010. On top of that, the size of each emerging market position has been reduced. Take China for example; the value of shares of FXI was reduced from 365k to 203k.

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Inflation is the silent killer of wealth. It does not have the “bark” of a full-blown financial crisis, but it certainly has the “bite.” Just imagine if the inflation rate is 4% over the next 10 years; within a decade you would lose nearly 40% of your wealth if you didn’t do anything about it.

Inflation over the next decade is highly probably because of two simple macro realities:

  1. America – from the federal government to the states down to individual households – is heavily in debt. The easiest way to get out of debt is to print money. There is a tremendous political incentive to do so.
  2. China, which has been the low-price setter for the past two decades, has seen labor costs galloping at a 20% to 30% annual clip lately (thanks to the one-child policy). Before long, that will translate into higher prices at your local Walmart.

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This past Christmas, I had the distinct pleasure of calling several of my clients in retirement and telling them their portfolios are back to their pre-crisis level and their financial freedom is safe and sound.

Their portfolios are variations of the so-called 60/40 portfolio – about 60% in equity-like investments and 40% in bond-like ones.

icarra chart

Many other 60/40 portfolios have been decimated by this crisis. Even with recent gains, they are still far from recovering all their losses. How did I manage to pull even for my clients? There are a few key lessons I’d like to share.

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Look beyond comfort zoneIf you are like most investors, your equity portfolio will have a few auspiciously named stock funds and a few company stocks you feel comfortable with. You think you are well-diversified, but you really are only investing in the universe of the S&P 500 – the largest 500 stocks of the US equity market.

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My friend Carl Richards made an interesting observation in his last post:

Just when we need something to zig, they all zagged together!

FearSome people draw the conclusion that diversification no longer works. I strongly disagree.

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In his book Unconventional Success: A Fundamental Approach to Personal Investment, Swensen recommends the following allocations, for individual investors who want a “well-diversified, equity-oriented portfolio”:

30% Domestic stock funds

20% Real estate investment trusts

15% U.S. Treasury bonds

15% U.S. Treasury inflation-protected securities

15% Foreign developed-market stock funds

5% Emerging-market stock funds

In an interview with Yale magazine, Swensen said, economic conditions might call for a modest revision. He now recommends that investors have 15 percent of their assets in real estate investment trusts, and raise their investment in emerging-market stock funds to 10 percent.

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University endowments are important institutions. They play a critical role in maintaining the academic excellence of the universities that rely heavily on their income. Recently, these endowments have drawn much attention because of their superior investment returns compared to other institution investors, such as investment banks and insurance companies.

There is much diversity among university endowments. Ivy League endowments such as those of Yale and Harvard are well ahead of the pack in terms of investment returns.

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Once upon a time, the Yale University Endowment invested like the rest of us, in just two asset classes: US equity and fixed income. After taking over the reins in 1987, David Swensen, the chief investment officer of Yale Endowment, moved aggressively into non-traditional and often illiquid asset classes like foreign equity, absolute return, real assets and private equity.

Chart: The Yale Model asset allocation
[enable picture display to see this chart]
Picture credit: thedividendguyblog.com

His unconventional approach produced a 20-year unbroken record of positive returns, resulting in stellar growth of the endowment from $1b to $17b. No wonder rival school Harvard University studies him closely. Other institutional money managers trip over themselves trying to mimic him.

Yale’s six asset classes are defined by their different expected response to economic conditions, such as inflation, growth and interest rate. Here is my own simplified explanation and cautionary note about these asset classes in relation to us as individual investors.

Absolute Return is a class of investment that seeks to generate long-term returns not correlated with the market.It does this by exploiting market inefficiencies. There are two basic strategies: event-driven and value driven. Event driven strategies rely on specific corporate events such as mergers, spin-offs or bankruptcy restructuring. Value driven strategies rely on buying under-valued assets while at the same time short-selling over-value assets. Don’t try this at home! You might just be the inefficiency being exploited.

Private Equity is a class of investment that participates in leverage-buyout (“LBO”) and venture capital. Venture capital is money that funded Google. However, it also funded thousands of failed ventures. LBO partnerships engage in the exercise of buying badly run businesses, reforming them, and then reselling them for a profit. Good private equity funds are generally close to individual investors. However, many below-average funds (often with exorbitant fees) are being aggressively marketed by Merrill Lynch and the like to unsuspecting high-net-worth individuals.

Real Assets include real estate and commodities. They are tangible (as opposed to paper assets) and they’re a good hedge to inflationary forces. This asset class is accessible to individual investors through Exchange Traded Funds (ETFs) and physical property such as the houses they live in.

Fixed Income is an asset class that produces a stable flow of income. It provides greater certainty than other asset classes. Fixed-income investments will perform badly in an inflationary environment, with the exception of treasury inflation protected bonds or TIPS. This asset class is readily accessible to individual investors.

Foreign Equity includes both matured market equity and emerging market equity. With US economy becoming an ever smaller slice of the global pie. This asset class provides a great way to participate in foreign growth. However, their diversification benefit is over-rated. With the exception of China, foreign stock markets highly correlate with the US market. Foreign equity is very accessible to individual investors.

Domestic Equity needs no additional explanation.

By all mean let David Swensen enlighten you, but don’t fall all over yourself trying to mimic him. What is good for Yale is not necessarily good for you. This is an advice coming from none other than Swensen himself.

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David Swensen, Yale’s Chief Investment Officer and manager of the University’s endowment, discusses the tactics and tools that Yale and other endowments use to create long-term, positive investment returns. He emphasizes the importance of asset allocation and diversification and the limited effects of market timing and security selection.

In his book “Unconventional Success: A Fundamental Approach to Personal Investing,” David Swensen prescribes for retail investors an asset allocation markedly different from his management of Yale Endowment.

  • Domestic Equity (30 percent) – Stocks in U.S.-based companies listed on U.S. exchanges.
  • Emerging Market Equity (5 percent) – Stocks from emerging markets across the globe. Brazil, Russia, India, China, etc.
  • Foreign Developed Equity (15 percent) – Stocks listed on major foreign markets in developed countries, such as the UK, Germany, France, and Japan.
  • REITs or Real Estate Investment Trusts (20 percent) – Stocks of companies that invest directly in real estate through ownership of property.
  • U.S. Treasury Notes and Bonds (15 percent) – These are fixed-interest U.S. government debt securities that mature in more than one year. Notes and bonds pay interest semi-annually. The income is only taxed at the federal level.
  • TIPs or U.S. Treasury Inflation-Protection Securities (15 percent) – These are special types of Treasury notes that offer protection from inflation, as measured by the Consumer Price Index. They pay interest every six months and the principal when the security matures.

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This post was written at the depth of the financial crisis. If you stuck to the Swensen Model through out the crisis, you would be ahead now. See our model portfolio.

– Michael Zhuang

Wall Street Journal headline: “Harvard Endowment Returned 8.6%”

In light of the events of the last few weeks when financial companies collapsed in rapid succession, an all-weather portfolio is what all of us need. Yale and Harvard University endowments have portfolios that do well in both good and bad times. You’d expect these smart people to know what they are doing. They do!

In any one fiscal year (ending in June) since 2000, The Yale Endowment has never had a loss. Don’t you wish you had a portfolio that could do so well? Sadly, your record is likely to be worse than that of S&P 500. Harvard’s endowment portfolio had only two years with small losses. The worst was in 2001. That was when it suffered a loss of 2.7%. Here are the details:

Table 1: Comparison of returns for Yale, Harvard, and the S&P 500

    Year Economic Cycle Yale Harvard S&P 500
    2000 Tech bubble 41% 32% 7%
    2001 Tech bubble bust 9.2% -2.7% -14.83%
    2002 Tech bubble bust 0.7% -0.5% -17.99%
    2003 8.8% 12.5% 0.25%
    2004 19.4% 21.1% 19.11%
    2005 RE bubble 22.3% 19.2% 6.32%
    2006 RE bubble 22.9% 16.7% 8.63%
    2007 RE bubble bust 28% 23% 21%
    2008 RE bubble bust 4% 8.6% -14.8%
    Average Return 17.8% 14.4% 1.6%
    Volatility 12.4% 11.3% 14.6%

How did Yale and Harvard achieve such return stability through two major cycles of boom and bust?

The answer lies in their unconventional asset allocation. The typical US investor allocates 60% to domestic equity, primarily in large-cap growth stocks, and 40% to fixed income assets. In contrast, the endowments allocate to six non-cash asset classes that have low correlation with each other. In particular, domestic equity and fixed income make up only a small percentage of the overall portfolio: see Table 2 below. This broad diversification across weakly correlated asset classes is the primary reason why the endowment portfolios did well in both boom and bust times. (I will discuss secondary reasons in the future.)

Table 2: Asset allocations of Yale and Harvard endowments

Asset Classes Domestic Equity Absolute Return Foreign Equity Private Equity Real Assets Fixed Income Cash
Yale 11% 23.3% 14.1% 18.7% 27.1% 4% 1.9%
Harvard 12% 18% 22.% 11% 26% 16% -5%

Both endowments allocate over 25% to real assets, such as real estate and basic materials. This allocation seeks to protect against the double threat of a weak dollar and inflation.

Chart: Evolution of Yale Endowment asset allocation

As the chart above shows, Yale Endowment significantly increased its exposure to real assets in the last three years. Average investors like you and me would be well-served to heed the unspoken message of these intelligently-managed endowments. And now for your take-home lesson:

1. Broadly diversify

2. Hedge against inflation and the weak dollar.

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What you need to know now the recession is here

Do you ever get that feeling that you’d rather just stay in bed? This morning was one of those mornings. We woke up to the painful news of stock market collapses across Asia and Europe. And then, more surprising, a sudden action by the Fed cutting the interest rate by three-quarters of a percentage point (75 basis points). We never know for sure whether we’re in a recession until National Bureau of Economic Research (NBER) makes it official. That could take up to six months. But the only conclusion I can draw from the immediacy of reaction from the Fed is that if we are not in a recession right now, it’s about to happen.

So what can we expect the stock market to do during a recession-and after it? I may not have a crystal ball to see the future, but I have made an in-depth study of all nine recessions since 1950. Even if history won’t repeat itself, looking at the past half-century should give us some perspective.

Things look gloomy now, but the future is not

How long does the average recession last?

Since 1950, a typical recession lasted for ten months. The shortest one lasted for six months and the longest one lasted for 16 months. (See column 2, Table 1 below.)

What have been typical returns during past nine recessions?

Five of the nine recessions saw the S&P 500 index increased during the downturn (See column 3, Table 1 below). The average index return during recessions was 3.14%.

One year into the start of a recession, the S&P 500 index, on average, increased an anemic 2.95%. (See column4, Table 1.) Yet there are only three instances during this period when the index dropped, and the largest of these was by a painful 27%. However, the remaining six first-year periods saw the index increase. The best of these was by 25%.

By the third year of the start of a recession, the S&P 500 index on average increased 28%, which is slightly below the normal rate of return for the index. There was only one instance when the index was below the start of the recession. (See column 5, Table 1.)

Ten years into the start of a recession, the S&P 500 index on average increased 139.6%. There were no instances of the index being below the start of such a long recession. It’s worth noting 139.6% for ten years is still below the normal rate of return for the S&P 500 index. (See column 6, Table1.)

Table 1: S&P 500 returns during and after recessions

Recessions # of months During R 1 year 3 year 10 year
Jul 1953 – May 1954 10 17.94% 25% 100% 179%
Aug 1957 – Apr1958 8 -3.94% 6% 26% 107%
Apri1960 – Feb 1961 10 16.68% 20% 28% 50%
Dec 1969 – Nov 1970 12 -5.28% 0% 28% 17%
Nov 1973 – Mar 1975 16 -13.13% -27% 6% 73%
Jan 1980 – Jul 1980 6 6.58% 13% 27% 188%
Jul 1981 – Nov 1982 16 5.81% -18% 15% 196%
Jul 1990 – Mar 1991 8 5.35% 9% 26% 302%
Mar 2001 – Nov 2001 8 -1.80% -1% -3%
Average 10 3.14% 2.95% 28.20% 139.16%
Current recession started Dec 2007 18 -34.8% -39.2% -9.9% ?

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Small cap value stocks will do better, if history repeats itself

I’ve used the Small-Cap Value Index constructed by Fama and French to study the effect of recession on small cap value stocks for the last nine recessions since 1950.

On average, the Small-Cap Value Index returned 11.39% during a recession. During those recssion periods, the returns of the Small-Cap Value Index ranged from barely dropping (-2.17% in the ’69 recession) to strongly rallying (38% in the ’81 recession). (See column 2, Table 2 below.)

One year into the start of a recession, the index on average returned 13.21% with only one instance of index decrease. (See column 3, Table 2.)

Three years into the start of a recession, the index on average returned 76.21%with 31% being the worst return. (See column 4, Table 2.)

Ten years into the start of a recession, the index on average returned 506.26% with 312% being the worst return and 1183% being the best. (See column 5, Table 2.)

The reason I recommend my long-term approach and staying with small cap value stocks is because of these results.

Table 2: Small cap value returns during and after recessions

Recessions
During R 1 year 3 year 10 year
Jul 1953 – May 1954 10.11% 21% 100% 362%
Aug 1957 – Apr 1958 -0.56% 18% 63% 517%
Apr 1960 – Feb1961 21.72% 32% 46% 343%
Dec1969 – Nov 1970 -2.17% 7% 31% 312%
Nov 1973 – Mar 1975 17.81% -13% 86% 1183%
Jan 1980 – Jul 1980 3.11% 15% 96% 499%
Jul 1981 – Nov1982 38.29% 0% 95% 387%
Jul 1990 – Mar 1991 5.52% 9% 83% 448%
Mar 2001 – Nov 2001 8.68% 31% 86%
Average
11.39% 13.21% 76.21% 506.26%

How shall we learn from history?

We can take the short view. In the last six months, the S&P 500 has dropped more than 15%. The Small-Cap Value Index has dropped more than 25%. Should we conclude that at this rate, all investment in stocks will be lost in two to three years?

Should you panic now?

The answer is no. But that’s precisely what many investors are doing now by taking money out of the market or rotating them to stocks they perceive to be safer. There is a better way to learn from history.

Take the long view

If you want to sleep well while building your wealth for the long term, you must take the long view of history. Then you’ll be more like Warren Buffet and John Bogle who see the current market madness as normal and transitory. William Shakespeare could well have been talking about the emotional turmoil of the market when he wrote,

It’s like a tale told by an idiot, full of sound and fury, but signifying nothing.

Sleep well, take the long view.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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