The Investment Scientist

Posts Tagged ‘Asset Classes & Allocation

New Year's investment resolutions

New Year’s investment resolutions

After working as a financial advisor for six years and after reading tons of research, I have developed a good sense about how the average investor loses money. As the New Year approaches, I think it’s good to share my insight so that readers can determine if they are making these mistakes.

Conflict of interest

I cannot emphasize this enough: Wall Street firms don’t work for you. If you have a Merrill Lynch or Morgan Stanley advisor, expect to give away 2.5% of your money every year – about half of it will be in explicit fees, the other half will be in hidden fees. If you invest through insurance products, expect to give up 3.5 percent of your money.

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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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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
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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.

This is based on an interview David Swensen done on Fox News Network.

david swensen

David Swensen

1. Have a strong decision-marking process

Investing success requires sticking with decisions made uncomfortable by the variance of opinions. In his own words:

Think carefully how it is that you are gonna allocate your assets and stick with it. Too many individuals were excited about the equity market 18 months ago and were despairing 3 months ago. It should have been the other way around. They should have been concerned about valuation 18 months ago and excited about the opportunity to put money to work at lower prices 3 months ago.

2. Sell mania-induced excess, buy despair-driven value

On his favorite area of despair-driven value, David Swensen has this to say:

I think the most interesting area is the credit market. Bank loans are trading at extraordinary low value. High-grade corporate debts, below investment grade corporate debts associated with companies that are gonna survive this are extraordinarily cheap. It’s not the only place to find value, but that would be the top of my list.

3. Make decision based on thorough analysis

Know where you belong …

There are two ends of the continuum in the investment market. You should be in one extreme or the other. There is no room for success in the middle. At one end of the spectrum, you get investors who committed resources to do high quality jobs in active management … At the other end of the continuum are purely passive investment vehicles – index funds. The vast majority of players are in the middle and the vast majority of players end up failing. Be at one end or the other and almost all investors belong to the passive end.

4. Watch out for the “fee-ing frenzy

This one should be obvious but ignored by many investors.

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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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