<p>With current volatility in the markets, how should investors allocate their portfolios. Watch as three top experts discuss asset allocation strategies for the current market.</p>
<ul>
<li><p>Richard Golod - Chief Global Strategist at Provasi Capital Partners</p></li>
<li><p>John Ross - Senior Vice President, Investment Research at Segal Rogerscasey</p></li>
<li><p>Rich Nuzum - North America Regional Business Leader, Investments at Mercer</p></li>
</ul>
Video Image:
Duration:
0000 - 00:55
Recorded Date:
Wednesday, March 2, 2016
Transcript:
Asset Allocation MC Audio Transcript
Courtney: Broad strokes, let’s get to the finer points later, Richard, how should investors be thinking about asset allocation in this environment?
Richard Golod: [0:00:06] Well, what’s changed over the last seven years is The Fed now has begun to raise interest rates. And we know historically when that happens, volatility rises. When volatility rises, investors tend to seek quality. If there’s a central theme for investors this year, it’s quality, quality and more quality.
Courtney: [0:00:27] Alright, quality, okay.
Richard Golod: [0:00:28] And that really tells you where you to go, large, small growth of value.
Courtney: [0:00:30] Okay. So quality is informing your choices?
John Ross: [0:00:33] Similarly, I think making sure you’re managing in a diversified manner as well as thinking about your asset allocation actively. And by actively I don’t necessarily mean active management. We think about dynamic asset allocation so that you have a governance structure in place that allows you to react as … as much as is appropriate given your risk tolerances, as an institution or as an individual and doing so relative to changes in the markets, relative to changes in interest rates as Richard has mentioned and relative to other dynamics in the marketplace. So think diversified and be active in your decision making.
Courtney: [0:01:11] Think diversified and be active, distinct from active management, that’s an important distinction?
John Ross: [0:01:15] Yes.
Courtney: [0:01:16] And, Rich, your take.
Rich Nuzum: [0:01:17] Most of our clients are long term investors and the biggest concern they have right now is the prospect of long term deflation, long term low interest rates, seeing major developed economies with negative interest rates and concerned that actually this time might be different from what we’ve experienced in capitalist society over say the last 200 years, that we could really with globalization and technology, additional labor coming onto the global workforce that we could really see long term deflation in the way that we haven’t seen in a long time. And that challenge has a lot of investment theses.
Courtney: [0:01:52] So that’s a big concern for the DB and DC plans, the deflation issue. And you mentioned negative interest rates, Rich, Japan and Europe already have them. How much of that worry is bleeding into the markets?
Rich Nuzum: [0:02:03] Clearly it’s impacted returns year to date, both fixed income, we have a 10 year treasury now at 1.73, we ended the year at 2.3. We had 2.3 at Thanksgiving, consensus wisdom was that rates were going to rise. And instead we’ve lost 60 basis points at the long end of the curve. So I think that’s focusing a lot of attention. On the equity side also concern about are we going to see earnings growth? Ultimately earnings drive stock prices, earnings drive any growth asset price over the long term. So are we going to get that earnings growth if companies don’t have pricing power because of deflation?
Richard Golod: [0:02:37] Right, wait a minute. Rich, when you think deflation, are interest rates down because of deflation or are interest rates down because volatility’s rising in the US, interest rates is a safe haven destination? And because we have a global savings glut and we don’t have a lot of issuance. I look at the 2 year treasury, who issuing 2 year paper right now? Nobody. And yet there’s a lot of demands. You’re on the institutional side, you see that. And the 2 year kind of affects the 10 year, so is that … is it really deflation as far as the impact on rates? Now, of you want to talk deflation versus earnings, I’m with you.
Courtney: [0:03:13] So let’s bring it back to asset allocation, how are these risks bearing upon how you’re framing your asset allocation?
John Ross: [0:03:21] I think part of the consideration and Richard and Rich have both highlighted the fact that there are several moving parts around deflation, around the inflationary environment that either institutional or individual clients need to think about from an asset allocation perspective. Now, on the institutional side, to Rich’s point, defined benefit plans or 401(k)s either earning an expected rate of return or substituting income generation over time in a low interest rate environment certainly is a concern. We believe that if you look back a year ago today, the likelihood of a deflationary environment is higher today than it was a year ago. We still think it’s a remote probability. But nonetheless there is a directional shift that we think is important and relevant from an asset management … from an asset management perspective. So managing for those moving parts matters, and recognizing that there are different drivers, both geographically as well as domestically around those deflationary pressures and inflationary pressures matters to both types of investors.
Richard Golod: [0:04:35] Well, I guess I see things maybe a little differently, I work primarily in the retail environment. And they tend to be a little bit more emotional. You mentioned diversification, diversification doesn’t necessarily mean owning more things. It’s non-correlated, low correlated, so. And it’s tough because you build that great portfolio from day one but then the correlations change 3 months, 6 months, and unless you’re doing an attribution analysis, this as well, where’s that or the covariance, where you’re saying is that correlation still there? You don’t make the adjustments, what was a great portfolio today is highly correlated 12 months from now. That’s growth over value. Consistent companies with consistent earnings, low fixed cost, variable, more variable cost, more pricing power, it’s growth, not value. It used to be value but value is dominated by cyclicals isn’t it now, financials and energy? So at some point those are going to be great buys. At some point I’ll increase my allocation towards value this year. But right now I would be overweight growth over value, large over small, in fact not just growth, mega growth, which is what tends to outperform in the later stages of a bull market.
Courtney: [0:05:51] Alright. So you like a growth right now. Your views?
Rich Nuzum: [0:05:55] Well, I think Richard’s right, that different investors focus on different parts of deflation and what matters to them. And, you know, our clients tend to have a much longer investment time horizon. They’re more worried about what’s going to happen over decades as opposed to what’s going to happen over the next quarter. John mentioned the concern about getting an expected return. And what we see is that for both defined benefit and defined contribution sponsors, holding high quality fixed income has become a very crowded trade, especially in the DB space, a lot of sponsors are loading up on corporate bonds because they can give that to an insurer and get rid of their liability. So if that’s not your objective, if you’re an endowment, a foundation, a DB sponsor who’s open or has an active liability, what we see sponsors doing is saying, “What else can give us stable high yields, higher yields than we can get from marketable securities fixed income? What can give us higher yields in that in a stable way on a buy and hold basis? And we’re willing to give up liquidity.” And right now if you give up liquidity, whether it’s private debt, it’s bank disintermediation type mezzanine debt, it’s infrastructure, it’s real estate, other things where you’re going to buy and you’re going to hold it with a long time horizon, you give up your liquidity but you pick up 3% against a similar credit quality asset that’s publicly traded and more liquid. And that’s at a point in time when liquidity for corporate bonds is dropping off a cliff due to the Volcker rule and other reforms and so on..
But still the corporate bonds are what the insurers will take, what the rating agencies and the state insurance regulators will let them take. They’re what’s used in discounting liabilities for both accounting and funding. It’s a very crowded trade. And if you don’t have to play in that space, if you can hold something that’s economically similar but less liquid and not in those same regulatory applied benchmarks, then you can pick 3/4/5% on yields and get diversification at the same time, because to Richard’s point about the covariance matrix, those do have different economic drivers than corporate debt.
Courtney: [0:07:58] Sure. And I definitely want to get to alternatives later in the program. But I want to just broadly, you know, as you mentioned, institutional investors have a much bigger appetite for long lockups, that might not be the same on the retail side.
Richard Golod: [0:08:11] Well, they say that but it’s interesting, they do tend to gravitate towards winners and avoid losers. They look backwards just like the retail investor because I do advise a few institutions. But yes, the retail client, I hate to say this, but I think their definition of asset allocation is that all things go up all the time. And if you’re any good at your job you should be able to find seven investments that go up. And they’ll actually they’ll give you a break, the two that don’t, let’s sell those. And of course those were the diversifiers, that was the insurance. And so it makes it very difficult to build an allocation because it’s only as good if the client stays with it, whether it’s institutional or retail, you have to stay with that program. And to me it means now being a little bit more tactical, the buy and hold, I just don’t buy it, it’s not time in the market, it’s not timing the market, it’s time in the market, you might have heard that phrase. There’s been long periods going back a 100 years where the market has traded sideways, from 97 to 09 would be one case in point. So the person that bought the index fund in 07, found that in 2009, 12 years later, 97 to 07, their dollars were the same.
Courtney: [0:09:24] But for the past 5 to 7 years, I mean bonds have done well, stocks have done well and maybe you could attribute that to quantitative easing and the inflation of asset prices. It feels like there’s a shift there.
Richard Golod: [0:09:34] Well, clearly.
Courtney: [0:09:35] So with that are you trying to find things that are less beta correlated when you’re allocating?
Richard Golod: [0:09:40] So how can you … so you’ve had the fourth best bull market in history. You feel like margins at peak levels, deflationary pressures from China that would make it difficult for companies to raise price. So I could see margins, earnings coming under pressure. How can you expect maybe to achieve your financial goals when you’re likely to see equity returns below average? How can you expect to … you’ve had a 30 some year, 35 year bull market in bonds. And now you’ve got a Fed that’s starting to raise and I’ve got wages and unemployment dropping below 5. I’ve got wages now starting to perhaps break out, inflation surprisingly upside in the first month, of this recent number. So I think to achieve your allocation goals using traditional investments is going to be very difficult. Why not arm your manager with the ability to go long or short? Commodities, futures, go wherever the opportunities are. One thing that we have to remember about asset allocation is we can’t really predict expect, you know, we can put together expected returns. But one thing that we can manage is risk. You can adjust your risk level. You can manage your risk level. And so the biggest question that I get on the fixed income side is what can I do for the client who needs income when I’m struggling going long duration, corporate? Find an investment that has the same risk level, the same standard deviation that doesn’t have the interest rate risk.
Courtney: [0:11:14] So you’re getting out of fixed income then?
Richard Golod: [0:11:16] Absolutely.
Courtney: [0:11:17] Because I mean if you’re talking about the yield on high yield then you’ve got all that risk.
Richard Golod: [0:11:21] Is there a buying opportunity in high yield?
Courtney: [0:11:23] Yes.
Richard Golod: [0:11:24] Trading opportunity, absolutely. For those that can pick that bond and that bond, buy the whole package probably? No, I don’t think so. You see that in the debt levels on corporate balance sheets. There’s a reason spreads are widening. In fact that to me is what’s affecting the stock market, is default risk. If you used that as a factor for stock selection last year, those that had high default risk, worst performers, lowest default risk, best performers. That’s why quality, it’s not that it just … that’s … that’s the factor that’s moving stocks forward right now. But on the bond side, when the world is basically 2% or less, if not negative, how can you say you’re justified for the holding period, whatever it is? So let’s find an alternative, let’s find a substitute, especially investment, they’re out there, CLOs for instance, Collateralized Loan Obligations did well in 08 and have a higher yield and don’t have the interest rate risk that … not the same interest rate risk.
Courtney: [0:12:26] Alright. So you like CLOs, John?
John Ross: [0:12:27] Well, and I think, Richard, to your point about quality, that does translate on the bond side as well, granted it’s at a different level than what we see on the equity side but it does translate on the bond side. Both of my colleagues’ points here around finding alternatives, finding substitutes for specific objectives that you as an investor are trying to meet, whether it’s income generation, yield, appreciation, recognizing the different asset classes and different opportunities can fulfill those needs in a given environment, is important. We also think that in the fixed income arena, bank loans was mentioned, we think structured credit is also a place where there are opportunities, again similarly from a quality perspective but also having that sensitivity to changes in interest rates. So while, to Richard’s point, in one perspective you want to remove that interest rate sensitivity, you can also incorporate future income needs by having things like bank loans and structured credit that are more sensitive to changes in interest rates and can … and can rise as interest rates rise. So there’s a component of that as well. And let me also perhaps bring up a white elephant in the room here around emerging market debt, in particular since we’ve been talking about some of the fixed income options. Emerging market debt, while it has its challenges and what I’ve heard very strongly across the panel today so far is the notion of what we refer to as the haves versus the have not’s, right.
And this global economy of … while we talk about divergence of monetary and fiscal policy globally, from country to country, we also see that the effect of that, both at the company level as well as the country level. So we have companies that will be able to take advantage from higher rates if they work themselves into the economy. And other countries and companies that will be disadvantaged as rates increase. So that notion of … that notion of divergence can work to your advantage. On the fixed income we think on the emerging market debt side in particular, and it can also work against you, currency clearly plays a key role there as it has more recently.
Courtney: [0:14:47] Are you hedging out currency risk?
John Ross: [0:14:48] We do, we think that’s part of that think actively component. Our default position is to have our institutional clients have an equal weight between dollar denominated and local currency denominated emerging market debt. I shouldn’t say that’s our default, that’s our benchmark. And then allow the managers to actively move on either side as he or she deem appropriate based on currency moves. So currency is an important component, but there too we see the opportunity for higher yield, with a lot of the emerging companies and countries higher risk for sure, greater volatility for sure, but greater opportunity as well for those that can stickhandle their way through some of those challenges.
Courtney: [0:15:36] Well, Rich, I mean John’s talking about all these opportunities in emerging markets, what about home country bias, is that stripping out some of the opportunities that people or institutions could be getting?
Rich Nuzum: [0:15:46] So Richard mentioned that a lot of investors of all types, not limited to retail, but institutions tend to be backward looking and trend following. It’s a behavioral bias that we’re all prone to as human beings and it can really get you in trouble in investing. The “smart” investors have not wanted to be home country biased for a long time. But, that didn’t get rewarded in the seven years through year end. And if you think about why, you know, it’d be nice -- I think we’re all US citizens -- it’d be nice if we thought there was something about the US that was intrinsically more innovative, intrinsically higher growth, intrinsically going to give a better expected return. But I don’t think we can really believe that. If we look at it, we had the fracking revolution and the US went from energy importer to energy exporter. And we had a manufacturing renaissance onshore. We had Apple and the whole Apple value chain, the entire tech revolution mainly on the West Coast but nationally really, really stimulated growth. And then we have a very … we do have a very flexible labor market in the US. So for whatever reasons, the US is at full employment and pretty healthy and has stomached this 25% weighted currency appreciation without going into a downturn, which is pretty miraculous if you think about it.
But is the next seven years going to look like that? And I don’t think we think it can. And so we don’t mind US assets. We’re not suggesting necessarily underweight in the US on a long term strategic basis. But you can buy twice the earnings per dollar of capital in the emerging markets today that you can buy in the US. And if you can stomach the ride, which could be really rocky from here… You know, some of those countries had borrowed in US dollars and now they’re going to have trouble paying it back. Others have borrowed in local currencies and investors have fled because they didn’t hedge the currency risk and they’re concerned. Some of those countries have piggybacked on the US dollar. You look in the Wall Street Journal for where are the pegs, where do you see the unchanged exchange rate? That’s somebody who had basically used US monetary policy as their local monetary policy. And these emerging markets, if they’re not … if they’re not in the same fortuitous position the US is with regards to what’s happened with energy production onshore, energy price stimulus, just in general it’s not likely that that monetary policy, the US monetary policy is the right one.
So now that the US is actually tightening those emerging markets are … you mentioned your thesis, that the place with the best … the most expansionary monetary policy is the place to invest. The emerging markets were a great place to invest when The Fed was throwing liquidity at the global markets. And now that The Fed has tapped the brakes they’re having real problems for fundamental reasons, because it’s the wrong monetary policy for them locally, but they’re pegged, they don’t really have their own monetary policy. And then they’re hitting it from a … you could call it sentiment or flows, they’re getting a double whammy. So there’s a lot of volatility there, but if you can stomach the ride you’re buying earnings at half the costs on a 10 year/20 year investment time horizon. That’s not a deal you usually get offered.
Courtney: [0:18:41] Yeah.
Richard Golod: [0:18:42] I can’t agree with you. I can’t agree with you more, for this reason. You said you hedge your emerging market debt because there is a strong likelihood that their currency is going to weaken which means capital flight. And usually you offset that by raising rates higher, so you’d have a loss position. I mean I’m sure there’s certain bonds. But as an overall asset class, emerging market equities and debt really worry me. And it’s one of the few asset classes on the equity side that I’ve ever had a zero allocation. I only did that one time and that was November of 07, went from 18% emerging markets to zero. Back to overseas home bias, when did it ever pay you, Courtney, to fight The Fed? And the answer is never.
Courtney: [0:19:30] Never. Never.
Richard Golod: [0:19:30] So why would you fight the BOJ and the ECB? They are still active in quantitative easing, aggressively active, why would you fight that? And I think that’s one of the reasons people missed Japan from 2012 on, they kept saying, “Wow, the demographics.” It wasn’t about that. It was about weaker liquidity, weak currency, better earnings. But it really was about money moves markets. It rewards risk taking and momentum investing, it trumps fundamentals until it doesn’t. And I’m not trying to be cute but in the US it’s about fundamentals now, whereas Europe and Japan, other than what we’re seeing right now, I think once things settle down we’ll see those markets outperform going forward.
Rich Nuzum: [0:20:18] I think one of the big questions for a long term expected return, so I’m actually optimistic about long term expected returns. I think we’re in for an interesting ride the next few years. But because oil and other commodity prices have come down so far, because the monetary authorities still are effectively throwing money from the helicopter to try to stimulate things, because technology is improving labor portability and globalization. All these things that are deflationary are also long term stimulative for underlying economic growth, which will ultimately come through in earnings to growth assets. So I’m optimistic about that. Where I think there’s something for us to watch is can Japan and developed Western Europe become more portable with their labor force, have a more flexible labor economy in the way that the US does or China does? And can they get more flexible in the market for corporate control, particularly in Japan? Where hostile takeovers are still not something you can do, you can have an entrenched management team and they just go on and on and on with low ROE and you, you know, if those two …
And I think in smaller emerging economies, one reason I’m more bullish about the emerging markets, it’s not if somebody has a six month time horizon I’d have a really hard time, I like your zero weight thesis. But if somebody’s got a longer term time horizon, most of the emerging markets are too small to get their labor market and corporate control policies wrong for long. Because investors will vote with their feet and that economy’s just not going to do well. The government’s going to get voted out of office or taken out of office one way or another then you get reform. Japan and Western Europe are a bit bigger, a bit more stable. In France people do demonstrate, but they, you know, they haven’t really embraced reform in the way that they need to, to reward growth investors.
Courtney: [0:22:03] Well, Rich, when you talk about the portable labor force in Japan and Western Europe, they feel completely different, I mean explain that?
Rich Nuzum: [0:22:09] Yeah. Well again, I’ve spent a lot more time in Japan than other places. And you know, lifetime employment was really only ever real for the biggest companies, the smaller manufacturers of the big companies, restaurant, have always had a pretty competitive labor market. But it’s still nothing like as portable as in the US. One of the pieces of work we did in Japan was to help introduce Japan 401(k)s, DC into Japan. But the financial services lobby managed to intervene and keep the contribution limits so low that Japan is still a defined benefit market. So if you’re an employee and you know that you’re not going further in your career, you know your company’s not doing well, but you’re going to leave this huge defined benefit accrual and you’re forward looking expected accrual on the table to go work for another company. You can’t do it, it’s too big a part of your net worth, it just … Having defined benefit as the main form of pension provision in a country hurts labor mobility in a pretty … in a pretty fundamental way. So the emerging markets have generally skipped straight past DB. If they ever had it, they gave it up. But China, India, Singapore, Hong Kong -- these are defined contribution countries. And so an individual can switch jobs and they move their account from one provider to another, or in Singapore it’s with the government, they don’t even move it. And they go on accumulating assets.
One thing that we almost got into but didn’t is the hedge fund space. And I think Richard mentioned long short at one point and a number of us mentioned trying to get return streams into portfolios that are not correlated with other things. Hedge funds have not got a great brand these days. They’re seen as not having delivered over the last 5 years, the last 7 years as we had strong equity markets. But if you thought about, well, what kind of hedge fund portfolio will we want going forward from here as a bond substitute or equity like returns, with bond like volatility, you might look for hedge funds that have a beta below .4, that are not loaded up on credit risk as a particular risk factor because you get that every place else. You mentioned the correlation between default risk and stock returns. And you might look for hedge funds that are relatively liquid, so not … I’m not talking liquid alternatives daily, but I’m talking about that match the duration of their assets and liabilities, so if they say, “We can give you your money back within a year”, they actually have the underlying portfolio to where it’s reasonable that they could expect to do that. If you screen for those things and put a hedge fund portfolio together on that basis, the last 5 years, it’s not far under the 65/35 market line. And the last 10 years it would have beat MSCI equity.
So it would have beat global equity markets. And I think you’ve mentioned fourth strongest bull market we’ve had. The time horizon’s a bit different there, 10 years versus 7. But whether it’s 10/15/20 years or the rolling 5 year periods, there’s only one rolling 5 year period in the last 20 where hedge funds haven’t beat an equity bond market line, and that’s the most recent 5 years. We actually … it’s been a tough environment for active management because it’s been so dominated by monetary policy, and things that … you know, a long short equity manager takes a position and then The Fed or the ECB or the Bank of Japan announces something and they have to trade to manage their risk. But it’s not based on any information they had, it’s risk management generating transactions costs. If we get a more fundamental environment going forward at least in the US, if Fed policy is a bit less … a bit less throwing money from helicopters, because we are … we are kind of near full employment and moving into a phase where we can be less stimulative. That’s a much better environment for active management. So I think hedge funds are a promising place to allocate to. And as we see clients look at these low bond returns, these low expected returns in general, they’re bumping up their hedge fund allocations now to try to balance the risk with other things they’re doing.
Courtney: [0:26:06] Richard, where are you allocating?
Richard Golod: [0:26:08] Well, when I think about what you just said, Rich, you know, being long only reminds me of [inaudible] the Green Bay Packers, we’re going to run left, we’re going to run right. If you do it to perfection you can win football games. I doubt they’d be winning a lot of football games today. You know, I’d rather have a manager that could pass and do a lot of different things. So as far as an investment approach, would you like just one way to do it? Long only, that’s how we’re going to do it. And hopefully we’ll go on the right spots. Well, that’s tough if the market’s falling. And on that, let’s face it, when the market broke, when the Dow Jones broke 15666, it actually kind of confirmed the bear market. So in bear markets, markets fall, the medium decline is 30%. Now, this could be a bear market without a recession. In those environments the market falls 19%. So you might want to rethink, you know, buying on dips as opposed to selling on rallies, as far as investing right now. I’d want to have both long and short, use various asset classes. Now, who’s the smartest … where are the smartest investment people on the planet right now besides the three of us here? The rest of the world. Are they running ETF? No. Are they running mutual funds? They’re the hedge fund world. Why? Because the compensation’s better. So if a hedge fund failed it failed for other reasons. But it wasn’t because of the lack of brain power.
So then the question is, alright, so in fact if you look last month in January, which I think was very telling, almost every hedge fund strategy, whether we’re talking managed futures, global macro, long short, had positive returns but certainly beat the S&P. And we can go back, so okay, that’s a brief window. But the fact of the matter is why not, if I want to make money, I need volatility not … I need volatility. So you run towards vol, you find managers that know how to operate, that have different investment strategies. A lot of times, different investment strategies will lower the overall risk of the portfolio. So you can be in a volatile risky space, but by having different management approaches reduce the overall risk to the portfolio. It’s kind of the way investors try to reduce risk now. I’m going to have large and small and growth, well, except for the correlations are all so high, except for the ones that you’re selling. So yes, I think specialty investments, you could call them alternatives. I don’t like that term because when I think of alternative living and alternative medicine, and anything other than stocks, bonds and cash is an alternative. No, these are strategies have been around for years.
Courtney: [0:28:51] You call them strategic investments?
Richard Golod: [0:28:52] We do.
Courtney: [0:28:53] Okay. And walk me through, I know you like CLOs and some of the others.
Richard Golod: [0:28:56] Love CLOs, absolutely, and I love global macro right now. Why? Because if I thought if I could just make … reach my financial destination in US equities long, that’s simple, it’s easy to explain, we understand it. I don’t think that’s the answer. So I want to go broader. I want to give that smart person a chance to take advantage of opportunities around the world. So yes, I like managed futures and global macro a lot.
Courtney: [0:29:23] What percentage are you allocating in general terms to strategic investments?
Richard Golod: [0:29:28] And that’s one thing I don’t answer as far as well, it’s 20% is the magic number. It really depends on the person’s risk tolerance. I will say this, I worked for a pretty big firm at one time and it had a 2% position in timber. I’m like, what does that do? Make it meaningful. Have enough that it’ll actually make a difference in the portfolio or quite frankly, don’t bother.
Courtney: [0:29:49] Alright. So you like a little bit more concentrated than the just over-diversification model, if you will?
Richard Golod: [0:29:56] Yes. I don’t think you need 20 different things in a portfolio to have a well diversified portfolio personally. There’s enough … you can do it with fewer assets in my opinion.
John Ross: [0:30:07] And, Courtney we would echo that especially when you think about the cost of some of the vehicles. And I mean generally speaking we are constructive around hedge funds, certain strategies, certainly to Rich’s point, more relevant today than others. I mean but the cost is something that needs to be considered, not only in terms of the individual hedge fund performance but also relative to other opportunities that the portfolio could take advantage of, either … and they’re either existing in their portfolio today or other opportunities in the market. Things like multi asset class solutions, and the way that they can … they can take some similar approaches as hedge funds do at a much more attractive, if you will, pricing point or cost.
Courtney: [0:30:56] Very different than a 2 and 20.
John Ross: [0:30:57] Absolutely. Absolutely, 70 basis points, 60 basis points versus 2 and 20 with the ability to … to kind of taper or tailor the approach to those multi asset class solutions depending on clients’ specific objectives and risk tolerances. We know that generally they have three benchmarks that they manage, do either cash, CPI or some other strategic kind of 60/40 blended portfolio.
Courtney: [0:31:24] What’s the average correlation there?
John Ross: [0:31:25] Correlations are relatively low. I’m going to say about .2. Now, you kind of would expect that, it has its built in diversification as do hedge funds across in many ways. And multi asset class solutions is … it feels a little bit like a name … a new name, but they’ve been around for a long time to the extent that things like GTAA have been considered as multi asset class solutions, or completion portfolios are often referred to. Or you bring in a manager to look at the rest of the portfolio and say, “Here’s where they are, here’s how I can complement what they are doing or not doing”, either from a return enhancement perspective or to Richard’s point, from a risk mitigation perspective at the total portfolio level. So thinking globally, thinking about opportunity sets relative to your risk tolerances and preferences also makes a difference.
Courtney: [0:32:17] So when we’re thinking about allocating to alternatives or strategic investments or multi asset, how important is it to think about, we do have volatility, are they working more as an alpha generator or a volatility mitigator or are you only allocating where they’re really doing both?
Rich Nuzum: [0:32:34] We start with: can you take a liquidity risk? Do you believe in skill? Can you tolerate complexity? And then there’s fundamental attitudes around fees. And we think that to get alpha you need to be willing to pay 20-30% of your expected alpha in fees, that that’s the going rate. And if somebody’s offering it for less than that, there might be something wrong there. They might not be the most talented. They might, you know, there’s a market clearing rate we think for skill. And so … but then the other conversation, once we’ve got those parameters is well, what’s your return objective? And then we can lay out the risk return trade-off and nail that down. We talked earlier about high credit, high quality fixed income being a crowded trade for all kinds of reasons. Long only equities, which are the mainstay of most portfolios, that’s a crowded trade, that’s a crowded trade for people who don’t want to pay two and 20 regardless of the level of skill they perceive. They can’t take any illiquidity risk. They can’t tolerate complexity. They get put off by labels. So, if you don’t share those characteristics, if you’re in the boat where you say actually I’m okay with all that, I’ve got the governance to … I think I can play there. Then you get sort of a frontier of risk return trade-off where you might start as high as … you asked how much would you allocate, you might start as high as 40-60% hedge funds and then move out to where you’re 40-60% in private illiquid assets, private equity infrastructure, real estate, private debt, timber and beyond that frontier, and your long only equity exposure is down around 20%.
And you’re still holding the global cap weighted portfolio there, that’s actually where you get your liquidity. But that’s a reasonable place to be if you’re a very sophisticated very long term investor. Most investors aren’t. If they’re honest with themselves… to do that you have to be ready to re-underwrite your investment thesis at the worst possible moment. So you have to put yourself back in the mindset of February 2008. The world’s coming to an end, and would you then be buying more private equity, buying more hedge funds at the bottom? If you can’t answer yes, then that’s too risky a portfolio.
Courtney: [0:34:44] Okay. So I imagine that that degree of allocation would probably not happen in the average retail portfolio there, Rich.Richard Golub: The firms won’t let them.
Rich Nuzum: [0:34:51] Which is why it’s a crowded trade, because individual account-based investment dominates long term savings now. It’s much bigger than DB. It’s bigger than E&F. It’s getting bigger every day, and retail investors don’t have access to these asset classes yet.
Courtney: [0:35:08] Even at the high net worth, even at the qualified purchaser, accredited investor and it just seems like the appetite is not there for that level of concentration in illiquid or am I wrong?
Richard Golod: [0:35:21] No. Well, some of the endowment funds have certainly done that and some of the, certainly wealthy investors have done that as well because the results are there, the returns are there. And they don’t have that fear that, oh, I need to be a 100% liquid. That seems to be a problem with the retail investor. And in fact, I have a lot of advisors say, “Well, is it liquid?” Well, liquidity is not your friend. If I look at retail investor returns for the last 20 years, it’s a little over 3%, well below the market. And you say, “Well, why is it?” It’s liquidity. The challenge that I have and advisors have with retail clients is you have to build a portfolio that eliminates the client hitting the eject button. And we tend to find that when their portfolio’s down 15-20% that’s when they change the rules.
Courtney: [0:36:14] It’s that inopportune selling?
Richard Golod: [0:36:15] Absolutely, at the wrong time. And that’s where these specialty alternatives, whatever, whatever you want to label it, those strategies, if they do anything, they’ve certainly shown in history at times to outperform stocks and bonds, but it’s not even about building wealth, it is reducing those big drawdowns in the portfolio, and that they can do if they’re selected properly, there’s good and bad hedge fund managers as there are anybody that’s managing money, it’s not easy. So yeah, you’ve got to do your homework.
Courtney: [0:36:52] Alright. And I want to shift it actually back to the long only construct. You have a proprietary sector tilt model for when to go into large cap value, large cap growth, small cap growth, small cap value. Can you tell me about how that model works?
Richard Golod: [0:37:08] Yeah. It’s the best asset allocation model I’ve ever seen and I’ve been studying it for over 20 plus years. And I’ve seen the construction and we all can do it where, oh, I’ve got this and I’ve added this and this works. The fact of the matter is for the last 35 years there’s been a pattern of asset class outperformance that works 76% of the time. And it’s … the outperformance stays there 1-5 years. And if you were to draw a four square box and put large value in the upper left quadrant and large growth in the upper right, small mid growth lower right, small mid value lower left, so you have value on the left, growth on the right, large cap north of the equator, small cap, mid cap south, it moves clockwise between those four asset classes, so when large value is the best performer, large growth is the next best performer and then it goes small growth, small value. Now, what interrupts that pattern is QE. Since 08 it hasn’t been as effective because in the 70s, 80s and 90s it was 80/90% predictive. There’s not only a pattern of outperformance, there’s a pattern of underperformance. So whenever large growth is the best performer, small value is the worst performer. So if you thought about that four square box, it would be a diagonal and vice versa. So last year best performer large growth, worst performer, small value, difference, about 1200 basis points, difference in the last 5 years, over 5,000 basis point difference between best and worst asset class.
There, if you could have capitalized on that difference you could have made a difference in a client’s wealth as well as risk. So because I believe large growth would be the best performing asset class, I believe you’re on all four asset classes, I don’t believe you play hopscotch on all four. But why wouldn’t you put more money in the in style box, large growth. And then in the outer style box which would be small value right now, you would underweight that. You don’t go to zero but you would underweight and I think you’ll find that, and I’m not blind to fundamental quant and technical data, so I look, well, it’s telling me large growth is going to be best performer. And then I’ve got 12 metrics that are confirming, yeah, large growth should be the best performer based on the things we’ve talked about, slow growth, where interest rates going, quality, predictable income streams. But it’s actually been working overseas now for over 15 years. I don’t have data that goes back further than that. So I would also buy large mega cap growth in Europe and Japan, predictable earnings, paying dividends, increasing dividends, I think clients would fair very well in that environment, so.
Courtney: [0:39:58] Interesting. Well, with that let’s segway to geographies, I know we’ve kind of touched on all of them but I kind of want to go through the big ones, US, Europe, Japan, and emerging markets. And I’d like to get everyone’s view on those four areas, let’s start with you Rich.
Rich Nuzum: [0:40:11] So long term I’m bullish on all four because … because energy prices have dropped, because the globalization pressure’s going to keep up. And that creates volatility, it’s rocky for individual economies. But as a growth engine globally it’s been pretty reliable and pretty miraculous over the last 25 years. And then the fact that the US dollar and the Chinese Renminbi have both appreciated by so much against the rest of the world, is like a massive fiscal stimulus for Western Europe and for Japan. Their exporters are much more competitive today because of that, and yet the US hasn’t fallen off the cliff. China is introducing a lot of volatility because there’s concern that China could. But now that the Chinese government has started to delink the Renminbi, you know, there’s a bit more flexibility for that to adjust if it needs to hopefully. If I’ve got a client with a long term investment time horizon we’re going to overweight emerging markets against this global cap weight. We’re probably going to be slightly underweight the US just because things have been so good and the US probably has the least risk in it. So less risk, you get paid less to take it. Europe and Japan you’re buying more earnings per dollar of capital. You’ve then got to hope for improved policy. You’ve got the currency tailwind. You’ve got the monetary stimulus tailwind that Richard mentioned. So, I’d weight them in that way.
Courtney: [0:41:32] Okay. John, your take.
John Ross: [0:41:34] Yeah. And let me just build on that China comment briefly. We think there’s two primary drivers there and Rich captured a couple of them very astutely. The financial savvy as well as the political resolve to make changes, the financial savvy we think has largely come into place, certainly more than it has been in the past. The political resolve, make no doubt, there is as we might expect, plenty of political resolve to make sure that things get changed, that reforms get instituted and instituted properly. So we’re modestly as well favorable on China and I hesitate to use the phrase overweight versus underweight, that’s not kind of what we do. But we think in relative space for sure. And if I could disaggregate Europe into the UK versus the rest of the Euro Zone, UK looks a little different we feel. It’s kind of chugged along and it’s 2% growth rate, might get a little pricy, might feel a little pricy right now, Rich made a comment that he’s focusing on longer term. Over the short to intermediate term we think UK is a little pricy, some of the other Euro Zone countries certainly, and that notion of the haves versus the have not’s, there’s some opportunity there, recognizing there’s greater risk in volatility.
Courtney: [0:42:56] Southern and Eastern Europe?
John Ross: [0:42:58] Exactly. So recognizing that it might be a bit of a bumpy ride there, we still think there’s some opportunities outside of the UK. Valuations matter as well, not only within Europe, within the Euro Zone but also in the emerging economies. So we think there’s opportunities within the emerging economies similarly over the longer term, short to intermediate term is going to be a bumpy ride for sure, with an eye towards currency – currency changes and other drivers of differences in yield curves and credit environments.
Courtney: [0:43:34] Richard, your take on.
Richard Golod: [0:43:36] Wow! I guess I’m the other side of the … emerging markets, number one, economic growth does not determine stock market performance. Even in the US the correlation between economic growth and the S&P is .05. It just … so to say, yeah, emerging countries will grow more. But in China, but I know … and I make decisions based on probabilities, if I can’t quantify the risk, I don’t make the recommendation. So we know the emerging markets are negatively impacted by lower energy prices, falling commodity prices, rising interest rates, tighter financial conditions and a stronger dollar. What am I missing? I see a stronger dollar. I see the potential for rising rates. We have tighter financial conditions. There’s never been a country on the face of the planet, and I’m talking about China where 50% of growth was driven by investment growth. Japan got up to 32% in 89 and then it took them a decade to get down to 19%. And they’ve already said, “We want to move to consumption.” What they haven’t said is investment growth creates 12 jobs per million dollars of GDP and consumption creates 3 jobs. They haven’t even started their deleveraging process. Let’s look at the companies’ balance sheets. They’re as bad today as they were in 08. They’ve increased their debt levels, they now lack pricing power with falling demand and more debt that they can’t service, and the government has not let them really go out of business yet, so they’re kind of doing what Japan did, propping them up.
So the deleveraging process is just starting. At some point I think it will be time to own. And there are countries that I do, I like India over China, because I think the growth is a little bit more real. But China is kind of … impacts the rest of that asset class. I think you’ve already seen the … the decade of emerging markets the last 10 years. I think the next 10 years it’s going to be about developed markets. Why do I like Japan? Not because so much because I think because the dollar strengthens against the yen. But I’m also seeing government pension funds doubling their allocation towards equities, in an environment with negative interest rates. They’re basically playing a waiting game with investors saying, “So how long do you want to make negative returns on your money? Here’s a stock market with a dividend yield.” And I agree, they’ve got some problems but that’s priced in. Is it getting worse or getting less bad as I like to say? I think things are getting less bad. And I’m seeing more shareholder focus, share buybacks, increased dividends than I’ve seen in the past. It’s still too soon but markets tend to respond when things are less bad. Europe too, Europe has … doesn’t have peak profit margins. Europe’s a replay to US just with German subtitles. It’s the same story. It’s just going to take longer because they’re not as flexible in their labor markets. But I think they’re still moving towards the same end. And because of the valuation gap between European stocks and US stocks, all I can say is historically it’s at a level when Europe outperforms - substantially outperforms the US. So I would have an overweight in those markets longer term. If you want to ask me in the next 6 months, I’d overweight the US, commodity price.
Courtney: [0:47:00] Okay, but longer term?
Richard Golod: [0:47:00] Yeah. But longer term I’d want to have more money overseas, except emerging markets, and there I would be country specific only.
Courtney: [0:47:08] That’s a really good point. So I mean you’re more constructive on developed markets. You’re more constructive on emerging markets than Richard is. But you know, the BRICs, is not a monolithic trade anymore. I think it’s important to parse out, as you said, you like India. Where in emerging markets do you like?
Rich Nuzum: [0:47:22] Yes. So I think the BRICs became a crowded trade and people who fell into that have been punished for it. I think emerging markets are a good place to have active management. And as a label, it’s becoming increasing less useful. If you think about natural resource dependent economies that export versus those that are importers, not natural, they’re net importers and rely on flexible labor markets and just a competitive labor force. If you think about who is pegged to the dollar and who has an independent monetary policy, who has just ratios of external debt and the US dollar versus local currency denomination, you can come up with a bunch of ways to clearly cut the emerging markets. And you end up with very disparate groups. I think Richard did a great job of articulating the concerns around China and also the short term headwinds for a lot of emerging markets, kind of regardless of the cut I just tried to make. But long term if a client of mine wants to get an 8% expected return and I can buy that earnings yield in the emerging markets, I can’t buy it now in the US, Japan or Western Europe, if I can buy that in emerging markets and I really believe that that client’s not path dependent. So if emerging markets drop another 20% in the next three weeks they’re not going to be coming back to me saying, “Sell that thing we just bought, and by the way you’re fired.” You know, because if they fire me they’re going to revamp the whole portfolio, not that I’m getting fired when I’m right in the long term.
But you know, they have to be able to re-underwrite the thesis in the short term and the emerging markets both individually and as a group could go down before they come up. But if I can get 8% plus earnings yield over the long term, for a lot of clients that’s going to be a fit, if they’re really path independent and they’re not going to second guess themselves if we get another China shock or any kind of surprise announcement and emerging markets ratchet down another 30%.
Courtney: [0:49:11] So this also comes back to time horizon differences between institutional and retail. Well, this has been so fascinating, gentlemen. Unfortunately we’re out of time, but before I let you go I’d love to get everyone’s final takeaways. Let’s start off with you, Richard.
Richard Golod: [0:49:23] I would focus on quality this year, even though I’ve been bullish since 08, 09, actually March … April, I missed the first 10% of the bottom. This isn’t a time to roll the dice and try to be cute. We’re getting conflicting data. The market’s telling us one thing, economic data is I think telling us another in the US. And because of that I would tread lightly and focus on quality right now. And that just means large, it means growth, it means dividends, increasing dividends. The [inaudible], I like that structure. But I also like something that people avoid. Roger Ibbotson said something I thought very clever, the most popular investments have had the lowest returns and the least popular. So think about what you don’t like and it’s probably … and illiquid or misunderstood complexity, find four or five different strategies that fall into that space and I think you’ll find you’ll have much less volatile returns, that would be the best advice I could share.
Courtney: [0:50:32] Alright, quality, John, your final takeaways?
John Ross: [0:50:33] Thanks, Courtney, we started the discussion today around asset allocation in general. The governance process and I think Rich mentioned it briefly is, we think, hugely important in terms of managing your asset allocation, both over the short to intermediate term as well as the longer term. Part of that we think, and especially it wasn’t a new phenomenon but it was amplified I think in 2008, is making sure you take time perhaps every year if you’re an institutional client, focusing one quarter per year on just strategic asset allocation. Setting aside manager considerations and just thinking strategically about are we still driving the bus towards meeting our objectives? And have our objectives changed? Has our risk tolerances or preferences changed? We think that’s very important in terms of just managing your strategic allocation, making sure you know what your tolerances and preferences are. And doing so with an eye towards, and Richard mentioned earlier, with an eye towards managing that downside risk in particular. If there’s one thing we know is it’s the downside risk that hurts us more than marginal performance on the upside. So managing for those outlier events and even more so for just the down events, having a broadly diversified portfolio, recognizing opportunities when they’re available and structuring your portfolio with managers that can take advantage of those opportunities.
Courtney: [0:52:00] Yeah, governance is a great topic and managing for the downside, Rich, your final takeaways.
Rich Nuzum: [0:52:06] Well, the main thought I have coming out of the panel that I didn’t have coming in is I’ve got a much easier job than Richard, because my clients tend to have a longer time horizon or at least say that they do. They tend to be able to take some liquidity risk or at least say that they’re able to. And I think John’s right, that the key thing is to really step back once in a while and think about objectives, risk tolerance constraints, where we have competitive advantage, how are we going to govern this thing and then invest appropriately? I think what’s changed is that, you know, we didn’t have the benefit of perfect hindsight seven years ago. But for seven years, an unsophisticated investor that did 65/35 US stocks, US bonds, they did pretty well. They probably got their return goal plus something. On a forward looking basis, it’s very unlikely that most of our clients are going to get their return goal with that kind of mix. So what do you do about that? And then I think looking at scenario specific outcomes, if we get strong growth and nominal interest rates rise, that’s great, and then nobody’s going to have a problem achieving their investment objective. One of the reasons we’re so focused on deflation risk is that that’s the scenario where it’s most difficult to achieve a return objective. So thinking about, okay, across my scenarios I want to weight to the one that could kill me because the high growth scenario isn’t a problem for anybody. I’m going to exceed my goals. I’m going to have no problem, you know, doing what I want to do financially if that happens. But what if this happens and how do I mitigate that? And that goes to some of the asset classes that we’ve talked about.
Courtney: [0:53:43] Yeah. And if I can have a final takeaway it’s that your jobs have all gotten harder in the past few years where we had that nice beta trade that worked so easily. It’s a little more challenging now.
Richard Golod: [0:53:53] I used to have hair, I pulled it out.
Courtney: [0:53:58] Alright, well, thanks so much gentlemen. And we want to continue this conversation about asset allocation. Follow us on our social media, on Twitter, LinkedIn and Instagram. From our studios in New York I’m Courtney Woodworth.
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