Building portfolios in times of tumult can be very challenging, even for the most seasoned of advisors. Given what’s currently unfolding in the credit markets and economy, and higher volatility in the equity markets, should advisors change what they are doing as they build clients’ portfolios now? One advantage for those who are veterans of advising clients is the experience that comes with participating in economic and market events as they unfold, and noting the effects of their strategies on investment portfolios. That kind of context can be invaluable now, as many uncertainties remain in the mortgage, credit, and currency markets, and the financial sector as a whole, and as clients still demand–and in many cases need, as never before–consistently good performance from their portfolios.
How fortunate then that a cadre of advisors is willing to candidly share their views on building portfolios now, wisdom other advisors may adapt for their own clients, advice that will undoubtedly prove important as advisors move with clients through these stormy seas and, if the consensus is correct, the lower returns that may lie ahead.
Taking the Very Long View
Rob Arnott is a man who seeks investing wisdom by looking back, not months, or years, but centuries, using scads of historical data to give context to current markets and forge a tempered long-term outlook. “Invest where you can get a premium yield without necessarily being involved in the assets that are afflicted by subprime contagion,” advises Arnott, who is chairman of Pasadena, California-based Research Affiliates, the asset management firm he founded in 2002. His firm developed the Research Affiliates Fundamental Indexes (RAFI), which use company fundamentals–sales, cash flow, book value, and dividends–to weight indexes, instead of using market capitalization. “In general, what you want to do as an investor,” according to Arnott, “is invest where people are afraid, invest where the risks are obvious and are probably already in the price, and shy away from things that have some possibility of hidden risks and where you aren’t getting much in the way of incremental reward for your risk. That’s one of the things I found fascinating about subprime–people went to it because of a surprisingly skinny yield premium, even though they had never been tested in a recession.”
One place Arnott is finding premium yield is emerging markets debt. “We find local-currency, emerging-markets debt to be awfully interesting. You get a premium yield and you get the added kicker of a decent likelihood of currency appreciation…that can turn a relatively high-yield asset into something that has really quite an attractive total return.” One change he made this fall was that “by September 30 we had ramped up our exposure to local-currency emerging-markets debt, both short-term and intermediate maturity, not so much on the long side, partly because there’s not much of it, [and] partly because of concerns about the risk of rising rates.” Arnott’s a fan of emerging-markets debt because “in many of these markets you get 2% to 3% premium yield, and you get the possibility of currency appreciation instead of depreciation. Credit quality is pretty good; the notion of subprime contagion spreading to emerging markets makes no sense at all–they’re totally different economies…the health of their economies is frequently linked to commodities; commodities have done fine.”
As far as the equity portion of portfolios, Arnott advocates “modest to moderate allocations to equities,” tilting toward value, large cap, and quality, “because that’s what does well when the markets are expensive.” Advisors who use indexes to capture beta might want to consider whether cap-weighted indexes–the more expensive the stock, the higher the cap weighting in a cap-weighted index–are the way to go, or if exposure to the market via fundamentals-based indexes might be in order. “Of course, I’m a big fan of fundamental indexing because that’s what we invented, but if you have to have stocks–and most investors do–it makes sense to make sure that there are earnings, and sales, and dividends, and book value standing behind that investment, so that the valuation multiples aren’t out of sight, so that you aren’t buying a hope and a prayer of future growth.” But, cautions Arnott, don’t go blindly into growth just because value has done well over the past several years. “Value is a useful foundation. Looking for growth is good, but paying vast sums for growth that has not yet materialized is dangerous, especially if we roll over into a bear market,” which, in Arnott’s opinion is, “more likely than not.”
Moving Toward Growth
Not everyone believes value stocks are the place to be right now, though. Traditionally a “big believer in U.S. equities,” Lincoln Anderson argues that “the underlying fundamentals are very good, and I think we’ve got record–or near record–high pre-tax earnings, near record-high tax payments, near record-high after-tax earnings, record high dividends, and then companies are buying back huge amounts of stock.” Anderson, chief investment officer of Linsco/Private Ledger (LPL) in Boston, says he advocates “a big tilt towards growth and away from value,” citing a “huge performance run over the last five-and-a-half years on the value side of the stock market. I think it’s riskier than investors perceive, and I think over on the growth side there’s much less risk, so I think, paradoxically, the risk-return characteristics on the growth side of the market are much better than on the value side.”
As much as he believes in U.S. equities, though, Anderson is moving “away from international.” Typically, he recommends an allocation of “somewhere in the 15% to 20% range, and that’s a high allocation in my opinion because for LPL clients, at least, this is retirement money.” But, “when it’s retirement money, all of the future liabilities are going to be dollar-denominated; its not like many people are planning on living in Spain in retirement, so when you have the dollar exchange-rate down at the all-time record low here, to have heavy international investments now is quite risky. We’ve cut back our percentage–we’re down to 10% or under for international assets. “I just think it’s very risky…people are advocating 50% exposure; now is not the time for that.” Anderson adds that with large-cap exposure such as the S&P 500 Index, “50% of sales are overseas, so you get a lot of indirect international exposure that way, and exchange rate exposure.”
For Ibbotson, Stocks Will Do
Though he agrees with Anderson on a migration toward growth because of the long run of value, Roger Ibbotson likes the idea of a “rather diversified portfolio from a global perspective,” including debt and equities. “I might advocate up to 50% because of the fact that 50% of the global market is foreign, but we can’t realistically go that far.” Ibbotson is the founder of Ibbotson Associates, which he sold to Morningstar in 2006; a professor at Yale University’s School of Management; and chairman of Zebra Capital, a hedge fund based in Milford, Connecticut.
“In the long run, in general, my favorite asset class is stocks,” he declares. Small cap, and value, “had a wonderful run from 2000 through part of this year, but that run seems to be over; I don’t think [they] are particularly attractively priced right now,” so he suggests migrating toward mid- and large-cap stocks. “The thing that’s potentially looming here is a recession, people put [odds on that] at 30% or something–if we actually do have the recession it would not be good for the stock market.”
Regarding the mortgage-backed vortex, “the thing that does get hurt is the dollar,” notes Ibbotson. It was “pretty predictable that they would weaken the dollar, but a weaker dollar doesn’t hurt U.S. corporations. To the extent that they’re exporters, it’s easier to export when the material prices they might get here in the United States are now lower, and they can export, effectively, at lower prices.” For the fixed-income portion of clients’ portfolios, “we’ve definitely migrated away from lower-credit bonds, and from REITs to some extent,” adding that “higher credit bonds are doing very well,” though shorter durations may be called for now. “Foreign debt, particularly in foreign currencies, and gold can be attractive in an environment with a falling dollar,” Ibbotson explains, concurring with Arnott on that.
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