Thursday 25 April 2013

Why Strategic Asset Allocation Is A Flawed Concept

Strategic Asset Allocation (SAA) is the current orthodoxy for portfolio construction. It involves building a portfolio with a set mix of assets based on a client's risk profile and goals.
For example a 'balanced' (medium risk) investor might be given an asset allocation as follows:
10% commodities,
30% equities,
10% property,
45% fixed interest,
5% cash.
As asset prices change given market conditions, the portfolio needs to be re-adjusted in keeping with the client's risk profile and policy objectives.

Whilst I agree that knowing a client's goals and attitude to risk are of crucial importance when dispensing advice, I don't think it good practice to consign a client to a mix of assets based solely on the outcome of this information. The following are reasons this strategy could prove detrimental.

1. This methodology fails to take into account the relative value of one asset class compared to another. For example during the dot com boom in 1999-2000, the FTSE 100 was trading at a PE ratio of 30 (over double today's value), anyone with a modicum of sense could see that equities were grossly overvalued, yet strategic asset allocation would have heavily exposed an 'adventurous' investor to this asset class resulting in subsequent catastrophic destruction of capital. While equities will always be volatile, it can be argued that investing in them when they are cheap (relative to earnings/net assets) is a lot less risky than investing in them when they are expensive.
As with the above example, the risk of any asset class can change with circumstance. For example it could be argued that long dated government bonds (typically a low risk asset) pose a far higher risk now than they did 7 years ago, before bond markets were subjected to QE intervention from central banks.
At a time when bank solvency is in question it might also be argued that the risk involved in holding cash has increased.

2. The re-balancing of a portfolio, to keep it in line with a clients risk profile, may lead to selling at a bad time. A popular piece of investment advice is to cut your losers and let your winners run. SAA is almost the antithesis of this strategy. Also if portfolios are being rebalanced too often, a hefty amount of trading costs will be incurred, thus negatively affecting returns.

3. People's attitude to risk tends to vary over time given their recent experience. For example clients who have just witnessed an extended equity bull market that has significantly increased their wealth are more likely to be more bullish when filling out a risk questionnaire, and if SAA is used they may be left with a high exposure to equities at a time when equities are overvalued.
Conversely if clients have just been subjected to a long period of negative returns during a recessionary period, they may well be more bearish when filling out a risk questionnaire, thus reducing the proportion of equities in their portfolio at a time when equities may represent very good value.

A variation on this approach is Tactical Asset Allocation (TAA), which allows a range for the percentage of capital in each asset class. For example the range for equities in a balanced portfolio might be 25%-35%. This approach allows an adviser some room to incorporate asset class valuation into the asset allocation strategy. The downside to this (and a big plus to SAA) is that many advisers are terrible at timing the market, and TAA brings the danger of human error into the equation.



Monday 15 April 2013

Gold Price Collapses

As I write this on the 15th April 2013, intraday gold prices are down 9.22% (silver 11.8%). The yellow metal is down 25% from its high of $1800/oz back in October. I've been bearish on gold for quite some time having written a couple of posts on the topic which I will provide links for below.

The reasons I gave for my bearishness were as follows.

1. Gold is a non productive asset. Therefore unlike a let property or a dividend yielding share of a company, you get no return for holding the asset. The only way you can make money on it is if the price rises. In the long run productive assets have outperformed gold by significant amounts.

2. It can cost a lot to store in any quantity, thus giving it a negative yield. Compounded over many years these costs would offset a proportion of any nominal price rise. You could call it a destructive asset in this sense.

3. It is already historically very expensive. Yes huge gains have been made over the past 10 years, but will this trend continue? Lots of gold ETFs (Exchange Traded Funds) have been set up which have to have a physical underpinning of the underlying asset. Such is demand for these products that recently banks have had to build more high security bunkers to keep all this gold in. Interestingly the UK has become a global hub for private storage of the world's gold. What if we manage to muddle through our economic problems and financial meltdown never materialises? Will people decide that paying good money to store their unproductive gold is possibly a bad idea and sell? There could be a massive rush for the proverbial exit from these highly liquid ETFs.

4. If people do start selling how low will the price fall? What is the intrinsic value of gold? Last time gold was relatively this expensive was in 1981, if you look at the graph above again you will see that 1981 was a pretty bad year to buy gold, if you bought then over the following 20 years you would have seen a gradual erosion of your investment.

5. How safe is an investment in gold anyway? During the great depression the US government brought in Executive Order 6102 which more or less banned the ownership of gold. The government ran a compulsory purchase programme, forcing people to sell at $20.67/troy ounce. The rationale was that the hoarding of gold was making the recession worse. Punishment for non conformity was a fine of $10,000 and up to 10 years imprisonment.

In the second link I posted above, I even mentioned trying to profit from the demise of gold via my CFD account (Contract For Difference). Unfortunately I didn't have the conviction to put on the trade, and I still don't. Gold is a highly volatile investment and its value is only based on what the market will pay for it, nothing more. It is possible that this could be a pullback and the Ponzi rally will continue later, I simply don't know and am not willing to risk any money on it.

P.S. I do find it amusing when gold bugs fool themselves that the extraction cost of gold (approx $1100/oz) might be the lowest possible price floor that the metal will reach. They are not taking into consideration the mountains of gold that are stored in the ETF holding facilities across the world. 'Extracting' that gold will cost a LOT less than $1100/oz! Also the demand for gold is highly volatile and has the potential to dry up in an instant, causing massive oversupply. Is the tide going out on this investment? Are you swimming naked?


Friday 12 April 2013

Making A Mint Out Of Murray (In Investment Trusts I Trust)

A couple of weeks ago I sold my second tranche of house builder's shares, which consisted of half my shareholdings in Barratt and Taylor Wimpey. Having notched up some impressive gains in this sector, I was keen to lock in some of the profit. Both shares were showing gains of around 150% since purchase.
House builders now have only a 5/6% weighting in my portfolio, down from about 20% before the recent bout of sales.
With the proceeds I topped up my holdings a little in AstraZeneca and GlaxoSmithKline, and made a new acquisition in the form of Murray International Investment Trust, which now accounts for 5% of my portfolio. I still hold about 5% in cash.

I like Murray International for several reasons.  Firstly the manager's name; Bruce Stout. That's a winners name if ever I heard one. He's also hails from Scotland, a nation renowned for its production of quality managers (Sir Alex Ferguson, David Moyes, Paul Lambert, Malky Mackay).

The fund is a global income fund with a decent yield of 3.4%, notably it also holds some fixed interest holdings, although these currently only account for a very small portion of the portfolio as Bruce shares my bearish views on global bond markets. The fund has performed admirably during his 9 year tenure, boasting impressive returns as shown from the graph below (NB graph is 5Yr). It also picked up a 'Best Global Income Award' from the Investors Chronicle recently.

performance chart

Unfortunately the fund's huge popularity with investors has resulted in it trading at a significant premium to NAV as shown by the difference between the yellow and blue lines on the graph.
I never like to overpay for anything, but I wanted this fund to be part of my portfolio and I don't see the premium gap narrowing any time soon. I intend to hold this fund long term, and hope in the greater scheme of things, overpaying a little for it will not matter.

For more info on investment trusts check out my old post here.

If you're interested check out this link to a video of Bruce Stout explaining his strategy.