Dollars and sense of investing

Source : Business Times – 19 Dec 2009

Are some long-held principles on the markets merely myths?

THE depths of the financial crisis between 2008 and 2009 called into question a number of investment principles that have been accepted almost as truisms – until recently.

Are those principles simply fair weather crutches? That is, they work in a rising market but fail horribly in a bear market. Or worse, are they simply myths?

Here are some of them and what some analysts think.

Diversification

Not putting all of one’s eggs into a single asset is common sense. Portfolio construction typically works on the expectation that correlations among assets are stable based on historical trends. Assets are chosen for their low correlations with one another, so that not all should tank at the same time.

Between mid-2008 and the first quarter of 2009, however, the worst case scenario happened. The unravelling of the credit crisis triggered massive waves of selling and liquidity dried up. Correlations converged to one for almost all assets.

There were exceptions. US Treasuries proved to be the safest of safe havens, for instance. Gold also rallied, thanks to fears that the financial system was on the brink of collapse.

Diversification is still seen as a form of risk mitigation, and widely recommended by advisers. Perhaps the biggest lesson of the crisis, however, is that liquidity has been under-appreciated. Many portfolios were invested substantially in structured products that proved horribly illiquid, or worse, that actually unwound and caused heavy losses.

Says Christian Nolting, lead strategist (Asia-Pacific) for Deutsche Bank Private Wealth Management: ‘We see value in the asset allocation approach and have implemented the same in our private client portfolios. An appropriate distribution of wealth among different asset classes, with an individual strategy geared to the risk-return profile of the client – complemented periodically by dynamic and tactical decisions – is key for a sustainable and satisfying portfolio return.’

‘Time’ diversification

This principle says that the longer your horizon, the more equity risk you can take. In particular, it is common that presentations by banks and fund houses show long-term returns of an index, usually the S&P500, to justify this thinking.

Boston University professor Zvi Bodie believes that the fallacy of time diversification is perpetuated as part of the fund management industry drive to sell funds.

As he told an audience at the National University of Singapore recently, if stocks became safer in the long run, they would not carry a risk premium. An indication of how risky stocks are can be gleaned from the cost of protection, which rises as the time horizon lengthens. Conventional advice, he says, based on the mistaken principle of time diversification, leads to portfolios that are riskier than most consumers realise.

Buy and hold

This mode of investing in markets may truly be one of the biggest casualties of the bear market.

Almost all strategists now say that shifts in tactical asset allocation – that is, shifts around a long-term strategic mix of assets – have become more frequent since the crisis began. They expect 2010 to be no different, as uncertainties remain on the economic outlook and the manner and timing in which central banks will begin to withdraw the massive stimulus.

Financial advisers such as Providend and New Independent have launched portfolio services that actively allocate to exchange traded funds.

Such portfolio services are typically aimed at generating a positive absolute return. The rub, however, is that retail investors with modest sums may not have access to such advice, where the minimum capital for a portfolio can start from $100,000.

An absolute return objective is also not a panacea as a lot will depend on the fund manager or adviser’s skill and ability to time markets.

Schroders’ Asia-Pacific head of multi-assets, Al Clarke, says buy-and-hold is still a sensible strategy ‘as asset allocation is a difficult endeavour that requires time, technical understanding and discipline’.

‘An investor should construct an appropriate asset mix that will deliver the return and risk objectives they need for that investment . . . At Schroders, we believe we can add value through making sensible changes to the asset allocation based on value, cycle and liquidity.

‘What may not make sense is suggesting the best asset allocation to meet the investor’s objectives is 100 per cent equity and leaving this as ‘buy and hold’. This will lead to volatile outcomes and as history has demonstrated, can deliver sub-standard returns for prolonged periods of time.’

Balanced and target date retirement funds

These are marketed as core holdings in a retirement fund that investors can effectively buy and hold. While balanced funds are a staple in the CPF menu, there are not many target date funds here. The latter refer to those designed with a maturity that should coincide with your retirement. Assets are automatically rebalanced such that as the fund nears maturity, it should be invested in more conservative instruments.

In the US, target date funds, in particular, are under tough scrutiny as the market plunge in 2008 caused severe losses among funds that are near maturity. Bloomberg has reported that target date funds labelled 2000-2010 lost an average of 23 per cent last year, with some dropping as much as 41 per cent. The average 2050 fund declined 39 per cent in 2008, while the S&P500 fell 38 per cent.

Prof Bodie heaps particular scorn on target date funds as ’silly, counter productive and disingenuous’. Such funds, he says, do little to provide investors with a secure income in retirement.

The upshot of this is that retirement planning should start with a projection of one’s desired income in retirement, and then choosing assets that are likely to deliver and protect that income stream. This is how institutions with a stream of future liabilities invest. This approach would favour direct investments in bonds, in particular inflation indexed bonds. There are no inflation-linked bonds here. Many investors also sniff at Singapore government bonds whose yields are low. Corporate bonds are also not as easily accessible to retail investors, as they require minimum investments of at least $200,000.