Intelligence

Asset Allocation

Milton Ezrati

Chief Economist

With the Trump administration introducing a raft of new policies, investors have wisely rethought their asset allocation. Market commentary is replete with advice on the subject, telling which assets will likely gain or lose in 2017. The effort is commendable, but such advice can easily misdirect people. A prudent investment portfolio cannot simply add more likely winners and unload likely losers. It must also shape itself to meet other critical criteria, the investor’s time horizon, for example, his or her objective in investing in the first place, tolerance for risk, the currency or currencies denominating the portfolio’s future liabilities, whether there are needs for income, possible tax obligations, that sort of thing. These will constrain how far an investor can tweak his or her portfolio for the tactical particulars of 2017.

Such considerations would seem to make a general discussion of asset allocation impossible, but all is not lost. One way to talk about 2017 positioning in more concrete terms than just more or less is to start with a basic or neutral portfolio and then consider how it might change tactically to account for the special features of the coming year. By making the circumstances of the hypothetical investor explicit, a reader might well interpolate this weighing and the tactical tweaks for a different basic portfolio set up to meet other needs and preferences.

Accordingly, this discussion will start with a basic or neutral allocation for a common sort of investor. For these purposes, this portfolio assumes the need to accommodate a very long time horizon for investing, say a young person investing for retirement or a pension fund. It assumes some willingness to take on risk, though nothing excessive. It further assumes an expectation that the portfolio’s future liabilities will occur in dollars and that the portfolio has no need to protect gains and income from taxes, again a pension fund or a personal retirement account. After explaining that portfolio generally, the discussion can then turn to how that allocation might adjust for the particulars of 2017.

Reasoning on the Basic or Neutral Portfolio

  1. Stocks constitute the largest part of this portfolio because: 1) Over time stocks generally outperform other asset classes and this portfolio has a long time horizon. 2) It is dollar based.
  2. Despite the lower allocation for small capitalization stocks, this percentage is relatively high given the relative size of that market segment. This is because small-capitalization stocks outperform large capitalization stocks generally over time, though with greater volatility, which is why the allocation is not larger.
  3. European stocks get a small allocation because they correlate highly with US stocks and so offer little diversification benefit. The only reason there is any allocation at all is to give the manager latitude to buy stocks opportunistically.
  4. Stocks in developed Asian markets are less correlated to US equities than European stocks and so offer diversification advantages. The region, except for Japan, is also faster growing than Europe.

 

  1. Emerging market stocks, though risky and volatile, offer superior growth potential over time. Their risk recommends a thorough diversification among these markets.
  2. High-grade dollar-dominated bonds have little role in such a portfolio except to offer diversification and stability.
  3. Lower-grade dollar-denominated bonds (including those issued by foreign entities, including emerging economies) have a slightly larger allocation because over time they typically pay a yield premium that more than compensates for the risk.
  4. Municipal bonds have no role here because this portfolio has no tax considerations. If it did, then for a dollar-based investor municipals would take up the bulk of the bond allocation.
  5. European bonds are here mostly for diversification and stability, much like the high-grade dollar-denominated bonds.

  1. Emerging market bonds in their own currency are here mostly for diversification, though like low-grade dollar-denominated bonds they tend to pay a yield in excess of the risk.
  2. Commodities and precious metals are generally better captured by using stocks that move with their prices, e.g, mining companies.

Reasoning on Tactical Portfolio Adjustments

These allocation changes are based on the expectation that the enthusiasm over Trump de-regulation, tax reform, and infrastructure spending is justified and will not face a countercurrent from excessively protectionist measures.

  1. Both large and small-capitalization US equities would benefit, but small disproportionately because: 1) they tend to move more violently than large stocks with accelerations and decelerations in the economy, and 2) they should benefit disproportionately from de-regulation.
  2. European stocks are vulnerable to the many economic and political pressures on Europe and if they break from the usual correlation with the U.S. equivalent, they are not likely to outperform. Nor is there a strong likelihood of currency gains.
  3. The same would be said about stocks in Asian developed markets though they face less extreme pressure than Europe this year.
  4. Emerging market equities might well suffer from a protectionist Washington, but they have suffered enough in recent years to have put a lot of such pressure into the price anyway.
  5. Despite their diversification rule, dollar-denominated high-grade bonds offer low yields and a great likelihood of capital losses this year as the Federal Reserve (Fed) raises interest rates.
  6. The same could be said for lower-grade, dollar-denominated bonds except the improvement in credit quality brought from accelerating economic growth will partially protect these bonds from the full extent of the losses suffered by high-grade bonds.
  7. Municipal bonds have an outlook much like the low-grade bonds but the lack of a need for tax protection counts them out of this portfolio anyway.
  8. European bonds have even lower yields than dollar-denominated bonds and, if they have less chance of capital losses in 2017, they are unlikely to add a capital gain to those piddling yields.
  9. Emerging market bonds in their own currencies have a similar justification to emerging market equities, especially since the currency depreciation against the dollar is likely to slow or stop altogether.
  10. Industrial commodities have a role because accelerating growth in the United States and relief of China crash fears could lead to price uptick.
  11. Precious metals seem to have little potential to outperform in 2017 unless the world really does come to an end.

 

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