May 7, 2007
LOOKING FOR A SIGN, WAITING FOR A CLUE
Strategic investors looking for explicit opportunities for rebalancing portfolios among the major asset classes are still faced with modest opportunities, at best, so far in 2007. As our table below documents, bull markets continue to prevail across the spectrum. That's good news for tabulating past performance. It also gives diversification a good name. But the trend doesn't necessarily impress when it comes to formulating a guess about expected returns.
Asset allocation is nothing if not a strategy for deploying capital that assumes humility about forecasting the future. Indeed, if investors knew what was coming, asset allocation would be about as relevant as carrying back-up ice cubes in Antarctica. But the future is, in fact, unknown, contrary to what you may have heard elsewhere. As such, owning a variety of assets, preferably those that move with a degree of independence from the others, is the only game in town for investors intent on the twin goals of growing capital while minimizing the associated risks.
That brings us to the current dilemma of finding alluring asset classes for fresh injections of capital, or redeploying money from assets that have run up to those that have fallen. On the one hand, there are obvious areas to pare, particularly for investors that long ago made commitments to some or all of the markets noted above. The problem comes in deciding how to redeploy. Alas, there are no asset classes that have fallen recently, at least not among the publicly traded ones with related index funds and ETFs.
This is a bit of an unusual state of affairs for asset allocation strategy. Quite often, there's always something that's fallen, which is why asset allocation has a history of delivering smoother risk-adjusted returns. But ours is not a world where history provides an easy guide. True in politics, true in economics and, as is becoming clear, in finance too.
So, what's an investor mindful of risk management to do? There's always cash, an asset class that promises what its competitors don't: clarity on the future. The tradeoff is that the clarity is all but assured to provide modest returns that may end up being negative after adjusting for inflation. Accordingly, there's a limit to how much one should allocate to cash.
Of course, when the competition's prospects look modest, at best, one might reason that forgoing reasonable cash limits has a certain appeal. Minds may differ over whether this is one of those moments, but the case for overweighting cash is arguably higher today than it was a year ago.
Meanwhile, among the remaining asset classes, we find that equities around the world are leading the race. Foreign developed stocks have been especially strong, with the iShares MSCI EAFE advancing by 10% so far this year. Even by the impressive standards of recent years, that's an amazing record. Emerging market stocks aren't far behind. U.S. stocks, while trailing, have still managed to deliver a stellar performance so far in 2007, relative to the historical record.
Commodities continue to roll higher as well. Although there has been a belief recently that commodities were due to correct, so far that expectation has been dashed on the rocks of global demand. And for all we know, the buying won't stop any time soon, or so suggests one of the world's great investors in a new interview.
"The best way to profit from the rise of China is to buy commodities," advises Jim Rogers in the latest issue of CreditSuisse's online magazine. "Because the Chinese NEED commodities....You can of course also buy the shares of natural-resource companies, and if you are really good at it and pick the right stocks, you will make a fortune in China. But then you will have to worry about the stock market, the management, the central bank, labor unions and a hundred other things. If you simply buy nickel, you don't have to worry about any of that."
Your editor, by contrast, knows nothing of what the future will bring in terms of prices. That's hardly extraordinary, although our admission may in fact be astonishing to the extent that we actually confess our ignorance to the world. That said, our lack of knowledge about the morrow leads us to hug asset class diversification as tightly as ever.
But with the opportunities for rebalancing growing thinner by the day, even yours truly must consider alternatives. That includes what some call alternative betas, which just happen to be a growth industry in terms of dispensing packaged products for the masses. The allure, at least in theory, is that alternative betas compliment traditional betas, as listed above, by offering low and in some cases negative correlation. Yes, one must choose wisely because not all alternative betas are what they profess to be.
What are these alternative-beta products? For the moment, we'll sidestep the question by promising to return to it in more depth in a later post.
In the meantime, we'll monitor the bull markets and try to embrace the contrarian philosophy of the moment, namely, that price volatility is only dormant, not dead. Exactly when it's scheduled for a return engagement is beyond our powers, but we're expecting no less.
Posted by jp at May 7, 2007 9:48 AM
Speaking of asset allocation, anyone know where I could get some free/cheap software or Excel tools to plot an efficient frontier?
Posted by: Hak at May 7, 2007 12:43 PM