Tactical Asset Allocation Series: Part 1 (Introduction)

Anyone who has spent time pondering how to invest is undoubtedly familiar with the concept of diversification, which is a fundamental concept underlying modern portfolio theory.  Indeed, the mantra “don’t put all your eggs in one basket” is one that has been familiar to investors for thousands of years, at least intuitively, perhaps since ancient Roman entrepreneurs diversified against the loss of their cargo by shipping trade goods on multiple merchant ships, rather than on a single ship.

When one is properly diversified, one is not overly concentrated in one investment area.  The diversified investor spreads his risk over many different areas, capturing the returns from multiple asset classes, while reducing the volatility of individual return streams.  This generates more consistent and stable overall returns for the portfolio.  It is in this sense that diversification provides the only “free lunch” in financial markets, since it reduces the risk per unit of return generated.

In today’s sophisticated global financial markets, there are countless possibilities available to the creative investor.  You could invest in anything from Apple, Inc. or Exxon Mobile Corporation, to Zimbabwean credit markets, agricultural land in Mongolia, or Brazilian ore mines.  Perhaps in an ideal world, you might strive for exposure to every asset class under the sun, but from a practical standpoint, this is an impossibility.  The question then becomes one related to choice: which asset classes should you select for investment?  Next, what steps must you take to make the investment, and at what cost?

For insights into which assets classes may be worth considering for a portfolio, we look to the world of endowment investing, and in particular to the Yale Endowment, the gold standard for institutional investing.  Yale’s targeted asset classes are broadly broken down into a handful of broad categories (we include Yale’s allocations to each for fiscal 2013) : Private Equity (35%), Real Estate (22%), Absolute Return (18%), Foreign Equity (8%), Natural Resources (7%), Domestic Equity (6%), and Bonds and Cash (4%).

Source: http://news.yale.edu/2012/09/27/yale-endowment-earns-47-investment-return

At first glance, this appears to be a pretty wide-ranging list of asset classes, and in scrutinizing the individual categories, it seems several might create implementation challenges for the average individual investor.  For example, it is not obvious how best to establish exposure to Private Equity, an asset class characterized by high fees, illiquidity and variable performance by managers.  Yet Private Equity is Yale’s largest asset allocation!  And what about investments in additional esoteric areas, like for instance in, say, timber assets?  Investing in physical natural resource assets presents numerous management challenges for the investor that can effectively take them off the table as viable investment options.  The complexity can quickly overwhelm our ability to make sensible, discrete choices.

“Any intelligent fool can make things bigger, more complex, and more violent.  It takes a touch of genius, and a lot of courage, to move in the opposite direction.”
-E.F. Schumacher

As Schumacher points out, it can be very easy (and even intoxicating) to make things more complicated than they need to be, whereas sometimes the best solutions to problems are the simplest.  Here at Turnkey Analyst, we believe that simpler is often better, especially when it comes to investing. But simplicity requires discipline, and nobody wants to sit around and “do nothing.” Take Van hoisington’s 30yr zero bond trade–buy-and-hold. As Van Hoisington said at Grant’s Interest Rate Observer this year, “I don’t do anything and I don’t know anything.” The willingness to do nothing and the courage to admit a complete lack of understanding, are two of the greatest traits of the best investors. Why? Mainly because overconfidence is the root of all investment evil.

Individual investors should accept their own limitations and not feel compelled to invest exactly how Yale invests.  Instead, investors can reduce the number of asset classes for consideration to a manageable number, in which investment can be readily achieved, even while maintaining the lion’s share of the benefits that accompany a much greater degree of diversification.

In our approach to achieving diversification, we have reduced the number of target asset classes to the “core six:”

• U.S. Equities.  These are stocks of publicly traded companies in the United States.
• Developed Market Equities.  These are foreign stocks in developed markets such as Europe and Asia.
• Emerging Market Equities.  These are foreign stocks in emerging markets such as Brazil, Russia, India and China.
• Real Estate Investment Trusts.  REITs offer exposure to ownership in office buildings, hotels and other real estate.
• Government Bonds.  So-called “risk-free” securities, these are direct obligations of the U.S. Government.
• Commodities.  Any commodity index will do (and many are better suited for investment), but we include the GSCI because of how popular it is as a benchmark.

Now that we have established the six classes to which we want to allocate our assets, the next step is to determine how to invest to achieve the desired exposure.  Exchange-traded funds (“ETFs”) offer a compelling option.  The primary advantages of using ETFs are that they are both cost- and tax-efficient, and offer deep, highly liquid, and broad-based exposure to our chosen core asset classes.  These are investments made with a mouse click, and you won’t have to choose a hedge fund manager or manage physical assets.  While in subsequent posts we will discuss our own ETF preferences, for those who are inclined to do some research on their own, Yahoo offers an excellent ETF screener (http://finance.yahoo.com/etf/browser/mkt) that allows users to sort by asset category, volumes, expense ratio, turnover and the like.

Thus far we have limited our discussion to the concept of asset allocation – how not to put all your eggs in one asset basket but to diversify by putting eggs into several baskets, and some discussion of the baskets you might choose (our “six horsemen”).  The next stage of our discussion involves tactics you might employ in your asset allocation process.

If you look back up the page to Yale’s allocation percentages for fiscal 2013, you’ll find that they use different weights for each asset class.  For example, domestic equities are 6% of the target portfolio, while foreign equities are 8%.  Why the disparity between the levels of exposure?  Furthermore, Yale’s allocations for 2013 differ from those targeted for 2012.  Why the change in allocation targets?  These are tactical decisions that reflect perceived opportunities and risks associated with the various asset classes.  Yale is constantly tactically re-allocating, in order to manage risk and take advantage of prevailing market conditions.  So how do they do it?

David Swenson, the Chief Investment Officer for the Yale Endowment, has dozens of analysts and economists working for him, as well as many specialized investment companies and third party advisors all providing him input and perspective on how to allocate.  Do you have a similar network to help inform your decision-making?  If you’re like us, and the vast majority of the investing public, the answer is a resounding “no!”  But that doesn’t mean you can’t tactically allocate like the pros, but your approach has to be different.

At Turnkey Analyst, we offer a selection of rules-based tactical asset allocation tools and methods that can assist the average investor in positioning himself across our six basic allocation buckets.  The methods are based on academic and empirical-based research, and provide month-to-month tactical allocation guidance by assessing market conditions for each asset class.  Each model has features that may make it appropriate for different types of investors, and we hope to introduce you to to our models in detail in the coming weeks so you can make the judgment.  It’s up to you to choose the model that makes the most sense and is the best fit based on your temperament, requirements and preferences.

Good luck and, as always, feel free to reach out to us with questions or comments. Our mission is to give “retail” investors access to simple and efficient tactical asset allocation programs for free. In the old days, paying 150bps might have been a reasonable idea in a world with 8-10% returns, however, in a zero rate interest rate environment, returns going forward will likely be in the 4-6% range–1.50%/6% is 25% of your expected return!!!

In our next series of posts we will outline each of the tactical asset allocation models described on our software platform–https://alpha.turnkeyanalyst.com/turnkey_asset_allocation–and describe how they perform. Stay tuned…