How to apply Asset Allocation to your portfolio in current market conditions?

Why is it so important? Assets prices price performance varies year by year. Some years, bonds
will do great relative to equities, with performance often reversing in subsequent years. Hence
being allocated to various asset classes which offer the greatest volatility to the underlying
economic signals (growth and inflation) and being disciplined about re-weighting the portfolio will
allow the investor to benefit from these moves. The key here is being disciplined in rebalancing the
portfolio.

A disciplined approach is key as most retail investors let emotions run their allocation decisions,
which usually result in holding an increasing allocation of the outperforming asset too long and
suffering the eventual sell off, or cutting allocation to an under performing asset class just as it
starts to bottom.

So what are the core assets to have exposure to? Cash, Equities, bonds and real estate are the
most widely held assets, but there are others such as alternatives (private equity, hedge fund
strategies etc), art and commodities. indeed, anything that has an investible value.

The best risk adjusted returns are generated when one takes exposure to those assets classes
that are not correlated and which also offer the highest returns in certain environments.

Government Bonds, particularly those with long duration, do well for example in a period of slowing
growth and declining inflation. They are negatively correlated to equities over the long run.

Equities do best with rising growth and flat inflation.

Gold offers strong performance during periods of expected higher inflation or hyperinflation (such
as saw Germany in 1930, Zimbabwe in 2000 and Venezuela currently) well as coming out of
periods of deflation and/or currency debasement (during tail end of great depression).

Real estate does well during periods of improving growth.

Many other asset classes are correlated to equities. High yield corporate bonds, for example, are
closely correlated to equities and don’t, on analysis, offer much diversification benefits.

So what allocation should investors use? This depends on them, with their age, risk profile and
personal situation all being taken into consideration. While a 60/40, with 60% in equities and 40%
in bonds is considered by many a relatively balanced portfolio, I would advocate that this is not
suitable for most retail investor.

Equities can be extremely volatile and suffer from significant sell-offs and most retail investors tend
to be buyers at the top and sellers at market bottoms. While a disciplined process can mitigate this,
emotions get in the way.

Assuming a disciplined process of yearly rebalancing the typical 60/40 (based on US equities and
10yr Us Gov bonds) breakout would have resulted, based on data from 1972, in around a 10%
return but with a standard deviation of just over 11% and a worst drawdown of 15%. Hardly a
portfolio that can be described as sitting on the efficient frontier.

Substituting some government bond exposure for high yield, as many retail investors would do,
makes the numbers even worse. Assuming a 20% allocation to high yield, the standard deviation
increases even further (to over 12%) whilst the largest drawdown increases to over 22%. This is
due to the correlation that high yield has with equities. Clients have to sit on a roller coaster ride
whilst only enjoying sub-par returns.

In Robbins’s book, Dalio highlights the utility of a greater allocation to bonds, advocating only
around 30% in stocks, 40% in long government bonds, 15% in intermediate notes and 15% in
commodities and gold. Such an allocation generated a return of c.9% since 1972. While lower that
60/40 split, the largest drawdown was c.3%. Similarly, the standard deviation of the portfolio was
low at less than 8% making it very a very consistent performer and ideal for the nervous retail
investor.

For those wanting a little more juice in their portfolio, running a simple allocation tool would indicate
that adding in exposure to real estate is useful with a suitable split being equity at 30%, 10% in
Real estate, 35% in long dated US Treasury bonds, 15% in commodities (gold being 2/3 of this)
and 10% in cash.

Such an allocation would have generated a return of just over 10% and a standard deviation of
only around 8% while the worst drawdown is around 8%, based on data since 1972. A far better
result. [I deliberately exclude alternatives such as hedge funds due to lack of historical data but if
included, would allocate around 15% to this category, largely at the cost of equity exposure.]

The point being made here is that investors can generate very constant returns with very little risk
by having a well diversified portfolio with only around 30% allocation to equities.

Fine you say but this is based on a relatively short history (45yrs) and does take into consideration
the current environment.

Following a number of years of low rates and quantitative easing, most asset classes are generally
expensive:

In a number of markets 10 yr yields are negative (Germany, Switzerland). Even markets on the
periphery of Europe such as Spain, have 10yr yields around 2%. Bonds generally have had a
terrific bull market for the last 30yrs.

Cash generates no yield whatsoever and large investors need to pay to hold Euro deposits.

Equities are also generally expensive relative to history.

In terms of the key asset drivers, economic growth and inflation, both seem pretty weak.

Not an easy market to make money in, but this again this highlights the importance of being
diversified and disciplined.

In my opinion, the key decision is to increase exposure to US government long bonds. This is not
an easy one for many including myself, given the low yield environment and the fact that, longer
term, I would see them as one of the worst investments to have exposure to. For the next few
quarters though, I would envisage them providing strong relative outperformance.

Core to my view is that the USD will continue to strengthen, US inflation will continue to fall and
global growth will disappoint, as will US corporate earnings.

Developed and Emerging market currencies have all weakened significantly against the USD over
the last few years. In the case of Japan and Europe, their central banks are undertaking massive
quantitive easing at a time when the US Fed is not. In the emerging markets, the fall in commodity
prices, is putting a lot of pressure on these economies and their finances. Furthermore, the
slowdown in China is likely to continue to exacerbate the situation and, should the Yuan need to
weaken which I expect it will to provide some support to the economy, the currencies of many of its
trading partners will weaken accordingly.

The exported deflation from Japan/Germany and China would then likely feed into the US,
reducing inflationary pressures and potentially raising deflationary fears. Hence, I expect the USD
is to remain strong.

The stronger USD will likely flow through into weaken earnings by US exporters which in turn
should, I would envisage, negatively impact stock valuations as earnings will come under pressure.
Of course, should this scenario play out, the Fed would likely quickly step in and provide further
QE, but this is likely a little further down the road. Also, should this be the case, they will likely
purchase the long bond, somewhat mitigating tis risk. [the Fed will look to reduce long bond yields
in order to reduce the mortgage rate, as this would be a key driver to stabilising the housing market
there].

So how to play this scenario.

While I was an equity bull through to 2013, I no longer see much safety in equity valuations,
particularly as USD strength starts to impact export earnings. Hence, I am far more cautious on
equities that I have been for the past few years.

In terms of Bonds, should inflationary concerns fall further the US long bond will rise as yield fall.
The long bond will also perform well if global growth weakens which I suspect it will, given a slower
China and a few ‘green shoots’ elsewhere.

If my scenario plays out, real estate would come under pressure due to weaker growth but low
rates would continue to be supportive. Retail investor should include the gross exposure they have
to property in any asset allocation decision and should, given the high correlation with equities,
reduce equity exposure if they are overweight this asset.

Gold would also be part of my ideal allocation. Gold has a low correlation to both equities and
bonds and while it would likely perform poorly with a stronger USD it would act as a nice hedge for
the long bond exposure in case the scenario as depicted doesn’t play out and inflation or fears of
currency debasement rises. Its interesting to note that Germany bonds and indeed the Reichsmark
where very well supported right up to 1921, right until investors lost confidence , with bonds and
cash being the worst investments to hold as hyperinflation took hold in 1922. Thus, holding gold as
a hedge is a vital part of any allocation and is good insurance against an overzealous central bank.

This is a critical point. What we have is a great battle between deflationary and inflationary forces.
Whilst the stronger USD and higher US policy will raise deflationary fears, central bankers wish to
avoid deflation and have the means to create inflation. In Germany’s case, this was at the cost of
the middle classes (those that save and are prudential) to the benefit for the borrowers and the
asset owners. We saw the same dynamic towards the end of the great depression in 1932, when
the US devalued the USD against gold and indeed more recently in Japan where we have seen
the Yen devalue by c.40% against the USD.