From the September 2007 issue of Wealth Manager Web • Subscribe!

Decisions, Decisions

Asset allocation is a cornerstone of strategic portfolio design, but is its value diminished if everything is running higher?

There's reason to wonder after a lengthy stretch that's notable for a conspicuous lack of red ink in markets around the globe. Yes, some asset classes are showing signs of stress midway in 2007. REITs swooned in June, for example. But measured over the past several years, gains still dominate losses as we go to press. That's worrying some investors. As veteran money manager Jeremy Grantham of GMO recently put it in a research note to clients, "It's Everywhere, In Everything: The First Truly Global Bubble."

No one's complaining, of course--at least not anyone sitting on tidy gains. In fact, some analysts take issue with the use of the word "bubble." Rising prices are warranted, thanks to a resilient global economy and relatively low inflation, to name but two reasons cited by the bulls. But the fact that the major asset classes have been running higher since 2002 (see chart at right) inspires contrarian-minded questions, starting with: How much protection will a conventional multi-asset class portfolio provide in the years ahead?

Asset allocation's value proposition flows from the historical record that shows that owning a mix of assets with low and negative correlations provides superior risk-adjusted returns in the long run compared with a relatively undiversified portfolio. Does the proposition break down if everything has taken wing at the same time?

Few questioned the outlook for multi-asset-portfolios in the past, in part because the strategy's merits looked obvious. That was due in no small part to the fact that a revolving mix of winners and losers was almost always common among the broad, conventional asset classes. In the unusual cases when everything posted gains, the trend didn't last.

In contrast, the current bull run is remarkable for its duration and breadth. "So many asset classes have had massive run-ups and almost everything is highly valued, or overvalued," says Milton Balbuena, chief investment strategist at Contango Capital Advisors, Berkeley, Calif. "At some point, diversification isn't going to work very well [for conventional long-only portfolios]," he predicts.

Perhaps, although statistically minded strategists may find comfort in the varied matrix of trailing returns correlations between the major asset classes. By that reasoning, one could argue that the diversification value of holding the major asset classes still looks compelling (see table on next page).

But correlations are just one factor in portfolio design. What's more, low and negative correlations don't preclude future losses. Neither do they insure that yesterday's diversification will prevail tomorrow.

For instance, based on recent history, REITs and commodities still offer substantial degrees of independence relative to the broad U.S. stock market. But all three asset classes have posted strong gains in recent years, with only fleeting interruptions. For some, the bull markets trump the correlations for calculating assumptions of future risk and return.

Real estate and commodities "are losing their luster," opines Jerry Miccolis, senior financial advisor at Brinton Eaton Wealth Advisors in Morristown, N.J. "As diversifiers, they're not as good as they used to be."

In search of causes, some analysts blame the securitization craze, which has transformed commodities and real estate, for instance, into publicly traded products. The fear is that as a rising slice of the planet's assets are repackaged as ETFs and mutual funds, Wall Street's cycles of boom and bust will drive more segments of the economy.

Another theory holds that globalization--and the related surge in liquidity around the world--has spawned international bull markets in everything from stocks and real estate to commodities and art. Highlighting the spirit of the times is China's recent decision to diversify its foreign reserves by purchasing a stake in the Blackstone Group, a private equity firm in New York.

Whatever the reason, independence among asset classes seems to be falling. Perhaps it's only temporary, but some worry that when the cycle eventually turns--and the bears take charge--the synchronous state of bull markets will unfold in reverse. If so, portfolios that look diversified on a historical basis will in fact be harboring far more risk than is generally assumed.

How should strategists respond? For many, the answer will be more of the same: Diversification among the traditional asset classes, tempered perhaps with higher allocations to the original zero-correlation asset--cash. Others may embrace a more frequent rebalancing strategy to exploit any sudden surge in price volatility.

More ambitious types say that more fundamental change is in order. "In a world where all the major asset classes are moving together, what do you do?" asks Steve Persky, chief executive officer of Los Angeles-based Dalton Advisors, which manages money for wealthy clients and runs several limited partnerships with specialty equity strategies. "You turn things a little bit away from the traditional, accepted theory."

For Dalton, that means shifting a portion of assets to equity strategies that don't fall under the usual headings. That includes putting money into one or more of the firm's proprietary funds. One is what Persky calls an activist, concentrated approach on Japanese small- and mid-cap stocks that are thought to be undervalued. The strategy builds stakes in a half-dozen or so firms and "works with management" as a lever for increasing share prices. "It doesn't fit neatly into a broadly diversified index strategy" and therein lies the appeal, he reasons. "It's volatile and it's concentrated, and it's a way of diversifying a portfolio."

Contango's Balbuena holds up to 35 percent of client portfolios in so-called absolute-return strategies. Contango uses a number of funds and strategies, including Franklin Mutual Recovery. This mutual fund has a broad and flexible mandate for investing in stocks and bonds in pursuit of opportunities in bankruptcy/distressed companies, risk arbitrage and undervalued stocks.

Brinton Eaton's Miccolis hasn't moved beyond the conventional asset classes, but he's considering the possibilities. Among the choices under review: Covered calls and customized structured notes for tapping risk/return profiles not otherwise available in publicly traded vehicles.

Other possibilities include what Miccolis calls the alternative commodity indices, such as the recently launched Rydex Managed Futures, a mutual fund that tracks the S&P Directional Trading Index. S&P DTI seeks to replicate the returns of the managed futures industry with a mix of long and short positions in financial and commodity futures.

Although Miccolis hasn't made any final decisions, the fact that he's looking beyond the conventional long-only betas speaks to the times. "All the things that we've been invested in are getting more correlated," he says. "Meanwhile, there are more of these alternative/hybrid/synthesized asset classes coming on line every day."

On paper, some of the recent arrivals post the magical mix of low correlation to traditional asset classes and respectable performance. For example, last September's IPO of PowerShares DB G10 Currency ETF uses futures to replicate the so-called carry trade--selling currencies with low yields while buying currencies with higher yields. The ETF tracks a Deutsche Bank index that's always long the three highest yielding currencies and short the lowest yielding ones among the G10 nations. The ETF is less than a year old, but the index's paper history boasts a low correlation with the S&P 500 and equity-like performance.

The concept of adding something unusual, something different to the standard asset allocation is pre-sold in 2007. One reason can be found in the celebrations of David Swensen's success in managing Yale University's endowment fund over the past 20 years. His use of alternative betas/ portfolio strategies is hailed as proof that moving beyond the usual suspects can enhance risk-adjusted results.

The past is clear on such choices, but the future may be more complicated. One challenge is deciding if yesterday's strategic triumphs will look as impressive if the crowd follows Yale's path. History, after all, suggests that as money chases performance, opportunity has an irritating fondness for receding.

There are other risks in trying to adapt Swensen's ideas for portfolios with individual clients--even wealthy ones. What's available for large institutional portfolios with long-term time horizons can be problematic (if not entirely unavailable) for retail accounts. Swensen's use of private equity in the past, for instance, is a tactic that's still missing-in-action in its pure form for the retail market.

Meanwhile, a related caveat comes from the pen of Harry Kat, a finance professor at City University in London. Although he's a veteran advocate of the idea that a fair degree of hedge fund returns can be minted with passive and semi-passive strategies, not every effort on this front is a clear winner. It's a timely reminder now that new products have started capitalizing on investable hedge fund indices. But caveat emptor still applies, Kat warned in a recent essay that asserts that some of the new benchmarks aren't as alternative as some might think.

"The only [hedge fund] indices that can be replicated with reasonable accuracy are the indices that contain so many different funds that there is nothing hedge fund-like or 'alternative' about them anymore," Kat wrote.

His counsel comes just ahead of mutual fund and ETF launches tied to said benchmarks. But decomposing the underlying factors that drive investable hedge fund indices reveals a set of fairly conventional betas, such as the S&P 500, Russell 2000, MSCI EAFE, MSCI Emerging Markets and U.S. Dollar Index exposures, according to Kat's analysis. In turn, that recipe minimizes--if not destroys--the argument for using investable hedge fund indices exclusively as diversification agents.

Yet the list of alternative betas/strategies repackaged in mutual funds and exchange-traded securities is growing, raising the possibility that genuine innovations will become available. Perhaps, then, the bigger challenge will be deciding how to finance a reallocation to alternative assets from an existing portfolio of conventional design.

A recent paper in The Journal of Portfolio Management, co-authored by the acclaimed institutional strategist Martin Leibowitz, asserts that choices about which asset classes to cut back on are as important as which asset classes to add when it comes to managing a portfolio's overall risk/return profile. As an example, the article reviews three ways to add a 20 percent REIT allocation to a 60/40 stock/bond portfolio. The first reduces stocks to a 40 percent weighting; the second cuts bonds to 40 percent; the third takes 10 percent each from stocks and bonds. The result: the three new portfolios exhibit different expected betas, volatilities and total returns despite the fact that all hold a 20 percent REIT weighting.

Then again, for all the worries about asset allocation these days, the strategic decisions will eventually become clearer for those who can wait. What might bring about a rise in clarity? A bear market in one or more asset classes. History is no iron-clad guide to the future, but the past offers reason to think that there'll be a lot less ambiguity about risk/reward tradeoffs in the wake of the next prolonged sell-off.

JAMES PICERNO (jpicerno@highlinemedia.com) is senior writer at Wealth Manager.

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