Brent Sheather: Sleep at night and still make money

Two weeks ago we looked at the problems that some experts are having with asset allocation, and reflected that anecdotal evidence suggests that, in the past year or so, the more effort you put into determining asset allocation, the more money you lost.

Financial theory tells us that risk should be measured in terms of the standard deviation of returns - the variability of a portfolio and this depends, among other things, on the correlation of the various assets in the portfolio.

This is a great theory but because correlations are dynamic it is frequently better not to know anything about an asset's correlation than to know what isn't so. We looked at a critique of current asset allocation practice by the editor of the US Financial Analysts Journal, Richard Ennis.

This week, we look at what Ennis proposes as an alternative solution to deciding what asset classes we should own and how much of each to include in one's retirement portfolio.

Ennis begins by assuming that investors want three things:

1: They don't want to lose all their money.

2: They want the benefits of owning shares but at the same time don't want to compromise number one.

3: They would like to perform better than the average, but numbers one and two are more important than number three.

Ennis then argues that you really need only three asset classes to achieve these objectives:

Government bonds, as these provide risk control so you won't lose all your money.

A global stockmarket index fund, which will give you substantially all the benefits of owning shares without losing too much to fees.

A portfolio of actively managed funds designed to exploit market inefficiency and to capture liquidity premiums.

By "capture liquidity premium" he means that some investments like property and private equity are relatively difficult to deal in so the market requires higher returns.

Ennis concludes by saying that he doesn't answer how one determines the proportions allocated to each asset class but says the problem involves reconciling your desired degree of safety with the confidence that one has in finding managers to identify superior strategy.

In other words, the issue is: "How big must the bond portfolio be so we can sleep at night and how great is our confidence in our active fund managers?"

The benefits of what Ennis labels "parsimonious asset allocation" include low fees and simplicity.

So Ennis sketches a broad plan as to how we might structure our portfolio but doesn't tell us exactly how much to have in each asset class. We can, however, get an insight into the issue from looking at what fund managers have done in New Zealand.

That is easy - every quarter the AON Consulting group publishes a bar-chart of the asset allocation profiles (AAP) of most of the big players in the local superannuation and savings field from which we can calculate a simple unweighted average AAP. That position as at February 2009 is illustrated in the pie-chart.

This information is based on the actual portfolio of the likes of Tower, AMP Capital, AXA Global Investors, ASB Bank Investments, ING and Tyndall Investment Management and it relates to some $1.9 billion of portfolio assets. It is particularly useful because for the past 10 years or so the average AAP has bounced around the 40 per cent bonds/10 per cent property/50 per cent shares range.

In the past few years New Zealand managers have been busy switching a bit of their bond portfolios into what is called "absolute return" strategies, however, fortunately, not enough to really hurt returns like some overseas managers have done.

But what about the average New Zealand investor who manages his or her own savings, perhaps with a stockbroker or financial planner? What do their portfolios look like?

Often asset allocation just "happens" as a consequence of many smaller, discrete investment decisions, like what IPOs happen to be on sale the day people rang their advisers or what news item caught their eye in the Business section of the Herald.

Anecdotal evidence suggests that, of those people who do own shares, many have relatively high weightings.

There are a number of reasons why many wealthy New Zealanders have too much in shares:

Bias. The intermediaries who assist private investors - financial planners and stockbrokers - are remunerated by fees and commissions and more often than not these fees are higher for equity than debt. Even fee-based advisers are potentially affected - because most of their clients pay a monitoring fee based on the capital value of the portfolio, it is often in the adviser's interest to bias the portfolio towards capital growth and minimise income (which clients tend to spend) - this means shares. Last, but not least, the standard annual fee structures are so high that they would be unsustainable in anything but a high return (equity) environment.

Taxation. Many New Zealanders have a pathological fear of paying too much tax. Because we don't really have much of a capital gains tax, all someone wanting to pay less tax need do is buy shares.

Higher returns. Common sense tells you that shares in the long run will probably give a better return than bonds. So that's it - three asset classes, keep it simple, no consultants, no alternative investments, just the mix of bonds and shares that let you sleep at night.

One of the best reasons for getting your risk profile right is to ensure that when the inevitable meltdown occurs, your equity weighting is not so high that you feel under pressure to sell down, usually at the very worst time.

Look at the graph and ask yourself what you would have done with your share portfolio in August 1932? How would you explain to your wife that the $100,000 in shares was worth only $10,000.

If you bought into the US stockmarket in August 1929 it would be around 25 years before the capital value got back to square one. Now that's a bear market.

Individuals with relatively high weightings in shares should reflect on what level of the only genuinely low-risk asset class, bonds, they need to own to get a good night's sleep. This will depend on how much money you have and your own and your partner's tolerance for risk, not how much you are paying in annual management and monitoring fees.

* Brent Sheather is an Auckland stockbroker/financial adviser and his free adviser/disclosure statement is available on request.