By David Pett
Modern portfolio theory and the traditional 60/40 split of stocks and bonds at the heart of portfolio asset allocation for the past 50-odd years has come under fire from a growing number of investors who want a much more diversified mix of assets in order to boost returns and better manage risk.
Fortunately, retail investors can now buy into a range of alternative strategies and exchange-traded funds that allow them to access many of the same investments that institutional and high net worth clients have long been privy to, including hedge funds and real assets such as agricultural land. Perhaps the only exception is private equity, an asset class that continues to grow in importance institutionally, but is still largely unavailable to the average person.
While no portfolio is exactly alike given our individual goals, risk tolerance and liquidity needs, below we present our take on the type of portfolio that investors should be constructing.
Stocks remain a core asset class for investors, but their slice of the portfolio pie should be far less than it has been, said David Kaufman, president of Westcourt Capital Corp. in Toronto. He said a 20% allocation – or slightly higher depending on short-term prospects – is appropriate for most people and stresses the importance of equities. “An equity allocation including global exposure has a massively positive diversifying effect and reduces risk,” he said. “It is very seldom that all equity markets work in tandem over the long term.”
Like equities, bonds are still a key component in portfolio construction, but their overall importance is diminished due to near-zero interest rates. Tiger 21, a peer-to-peer network of high net-worth investors in North America, said members’ exposure to fixed income continues to decline, pulling back 2% in the second quarter of 2012 to just 13%, the lowest level since tracking began in 2007. John Nicola, chief executive of Nicola Wealth Management in Vancouver, said his balanced portfolio for clients allocates nearly 30% to bonds, which includes a smattering of government, corporate and foreign offerings as well as preferred shares.
20% Real Estate
Insurance, pension and sovereign wealth funds are allocating much more than normal to real estate investments because they can achieve better yields than high-equity government bonds. Retail investors are also slowly buying more real estate equities and mortgage debt using exchange-traded funds. Mr. Nicola, who suggests allocating 12% to mortgages, said real estate investment trusts (REITs) may also fit the bill, particularly for those who don’t mind volatility over the long term. “Real estate is a little trickier of an asset for the retail investor,” he said. “We’ve seen some products that are technically available to retail investors that we wouldn’t touch with a 10-foot pole.”
Investments such as hedge funds offer another source of diversification because they are often non-correlated to stocks and bonds. Mr. Kaufman suggest allocating 10%-20% to market neutral strategies – which exploit differences in stock prices by being long and short within the same sector, industry or market – and managed futures. Very simple covered writing is also an effective alternative strategy, adds Mr. Nicola. “It doesn’t improve your return, but it reduces your volatility by a third and outperforms in bear and flat markets.”
10% Real Assets
Real assets such as commodities and infrastructure – but excluding real estate – are very much in demand because of the high volatility in the financial markets and concerns about higher inflation rates. Josef Auer, an analyst at Deutsche Bank in Germany, said real assets can provide effective inflation protection. “Long-term trends, such as the growth of the global population, increasing urbanization and the growing economic importance of emerging markets, favour investments in real assets such as infrastructure or agricultural land,” he said. Mr. Kaufman suggests an allocation of roughly 10% in commodities such as gold or timber, both of which can easily be bought through ETFs.
Cash holdings for Tiger 21 members hit 13% in the second quarter, much higher than the 5% that has historically been the case. Mr. Kaufman considers an increase in cash as adding more dry powder at a time of growing uncertainty about the global economy. “I believe you have to be a tactical investor,” he said. “As your macro outlook changes, you want to be able to adjust your strategic allocation in order to achieve short- and medium-term goals.”