Monday, March 17, 2008

Asset allocation in a low return world

The rules of asset allocation have changed. Two of the new imperatives:
  • Using tactical asset allocation (TAA)
  • Investing in real assets
These are among the best strategies for individual investors in an environment in which U.S. stocks are expected to average annual returns of 6%-7%. This is what I took away from "Asset Allocation in A Low Return World," a March 13 presentation to the Boston Security Analysts Society, by Adrian Cronje, vice president and director of asset allocation, Wilmington Trust.

Tactical asset allocation doesn't deserve its bad rap

Everyone says, "Don't try to time markets." But TAA is not market timing, said Cronje. "It is not about forecasting turning points." Instead, it is a form of rebalancing that can boost your returns.

You might think of rebalancing as buying and selling assets to return them to predetermined percentages. That's not what Cronje meant. He spoke instead about adjusting allocations to take advantage of changes in risk premiums.

"Dispersion among sub-asset class returns reflects risk premiums that are not stable, but cyclical," said Cronje. He talked about sub-asset classes because he looks at distinctions finer than large-cap vs. small-cap or growth vs. value. He'd prefer to invest in narrowly defined subsets, such as value as defined only in terms of book value or growth in terms of earnings.

Sub-asset class outperformance can be significant—what Cronje calls "large amplitude"—and last one to four years. That's often enough to justify the transaction and tax costs of TAA.

Cronje believes it's possible to identify when there has been a strategic shift in sub-asset class returns, so you can change your allocation once the new cycle is already under way. That's a lot better than suffering for getting in too early.

TAA can deliver returns that made Cronje say, "Beta is not always boring, cheap and alpha's unloved cousin."

Investing in real assets is essential for individual investors

"Today, traditional stocks and bonds just aren't good enough any more," said Cronje. Individuals should diversify into real assets and alternative assets. These are asset classes that can deliver real sustainable earnings power.

In one sense, real assets can be defined as physical or tangible assets. But more importantly, they're assets that offer a hedge against inflation. For example, inflation-linked bonds, real estate securities, and commodities. Since the debut of ETFs, these asset classes have become much more accessible to individuals.

A typical Wilmington Trust client might have 10%-15% in real assets. But they're a lot wealthier than your typical individual investor. Cronje didn't describe the profile of the individual investor who should consider these techniques. Presumably there's a minimum level of investable assets required.

Alternative assets—hedge funds, private equity, and private real estate—are also expected to outperform over the long term. They're not as accessible to individuals. In fact, even institutions must compete to invest with top performers. Although Cronje didn't discuss them, there are new investment vehicles—such as mutual funds that pursue long-short strategies—that alternative investments more accessible.

Cronje based these asset class recommendations on a long-term, inflation-adjusted forecast for returns. He called forecasts for periods of 10 years or more "highly reliable." Of course, he's not looking for accuracy down to decimal points. What's important is which asset classes will outstrip others, and in what order.

Follow Cronje's advice, and perhaps your portfolios will be better positioned for today's uncertain environment.

Susan B. Weiner, CFA
Investment Writing
Writing that's an investment in your success

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