Dec 06, 2010

A Radical Approach to Asset Allocation

During these trips I have been asked to look over dozens of institutional portfolios and to comment on their structure.  In most cases the asset allocation is heavily weighted toward long-only investments in the developed markets.  While bond portfolios have been trimmed, the allocation to higher yielding fixed income securities is small.  Few institutions own gold or other commodities.  Many have a quarter of their portfolios in alternatives, but the split among hedge funds, real estate and private equity varies widely.  I believe few of the portfolios I reviewed are constructed to perform well in the investment world that exists today.  The investment committees overseeing these assets have made incremental changes over time but they have failed to step back and say that the future is likely to be very different from the past and our asset allocation should recognize that fact.

For most of the twentieth century and particularly since the end of World War II, the United States has been the engine of growth for the world.  Gross domestic product across the globe is going to increase about three percent in 2010 with one point coming from the United States, one point from China and one point from everywhere else, mostly from the emerging markets like Brazil and India.  If you believe, as I do, that growth creates opportunity, a major focus of investors should be on the developing world.  These markets are extremely volatile and subject to varying degrees of political risk.  The companies in these countries often have less transparent accounting than those in Europe and the United States.  But China is growing close to 10% annually; India, 7%; and Brazil, 6%.  These countries have relatively low sovereign debt and a strong entrepreneurial spirit.  When you travel in the developing world you get a clear sense of optimism and hope from the people you meet.

The developed world seems depressed by comparison.  Almost every country is talking about an austerity program to meet the challenges posed by the debt accumulated over the past thirty years.  The European Union is in danger of dissolving and the political parties in the United States are at odds over whether some kind of stimulus or tax reduction is the answer to the unemployment problem.  I believe there are important investment opportunities in the developed world.  In the United States valuations are not excessive, the likelihood of a further recession is low, the dollar is cheap on a purchasing power parity basis, we have the greatest universities in the world, innovation is still vibrant and promising companies are being formed constantly.  But unemployment is high, and the debt burden is heavy.  While interest rates are still low, the prospect of rising yields on U.S. Treasury securities is high because we are so dependent on foreign sources of capital to fund our debt.

Europe is bifurcated; the northern countries – France, the Netherlands and Germany – which have well-developed manufacturing capabilities and strong export revenues are doing relatively well.  The southern tier, notably Greece and Portugal, as well as Italy and Spain are in a troubled financial state, as is Ireland.  Japan has been in a deflationary recession for most of the past twenty years.  Its debt to gross domestic product ratio is the highest of any major developed country.  During the past year industrial production has improved and exports have been robust in spite of the fact that it is a high labor cost producer in a low labor cost region.  Growth is positive but slow.  Valuations are reasonable but the prospects for impressive performance from either the economy or the market there are minimal.  I think it is unlikely that Japan, Europe or the United States will grow faster than 3% any time in the next five years, but I believe the developing world will grow in excess of 5%, and I think institutional portfolios should reflect that difference in growth and the investment opportunities that derive from it in an important way.

Aside from a shift of economic power from the economies of Europe and the United States to Asia, there has been a profound change in the nature of the investment environment itself.  When I entered the business the major investors were mutual funds, independent money managers and pension funds.  Today hedge funds and private equity firms play a major role.  Because the fee structure of the alternative investment firms is so much more favorable to the manager than that of traditional money management, there has been a migration of talent away from conventional firms.  The majority of the money managed professionally is still in the hands of conventional managers but cash flows in the past decade have favored alternative vehicles.

I believe the policy portfolio approach that was pioneered by the leading academic institutions has to be rethought.  In the past an asset manager could assign an expected return and anticipated volatility to an asset class and with reasonable assurance construct a diversified portfolio that would meet his or her objectives with an acceptable level of risk.  I think historical rates of return and volatility may not prevail in the future and an effective portfolio with an acceptable level of risk and return may look very different from its past counterparts.  Those of you anticipating a reversion to the mean and a reprise of the U.S. equity returns of the 1982–99 period may have a very long wait.  The past decade may be more indicative of the future than the final two decades of the twentieth century. 

Here is my view of a portfolio that I expect to do well in the world as I see it today.  It may be somewhat more volatile than what you are accustomed to or would prefer, but the returns should be worth it.  Since each institution has its own specific ideas about what proportion of the portfolio it wants to hold in cash reserves, I have not attempted to prescribe an ideal cash balance.  If you want to hold funds for future obligations or portfolio protection, decide what total exposure you are comfortable with and use my guidelines as a template for your asset allocation.

Asset Class

Weighting

1.   Large capitalization, multinational growth equities in developed markets

10%

2.   Hedge funds across a broad range of strategies

20%

3.   Emerging market equities, primarily China, Brazil and India

20%

4.   High yield fixed income including bank debt and mortgages

20%

5.   Private equity

10%

6.   Real estate

10%

7.   Gold

5%

8.   Commodities

5%

Total

100%

Asset Class

Weighting

1.   Large capitalization, multinational growth equities in developed markets

10%

2.   Hedge funds across a broad range of strategies

20%

3.   Emerging market equities, primarily China, Brazil and India

20%

4.   High yield fixed income including bank debt and mortgages

20%

5.   Private equity

10%

6.   Real estate

10%

7.   Gold

5%

8.   Commodities

5%

Total

100%

For some time I have resisted the temptation to commit significant capital to large capitalization, multinational growth stocks like Coca-Cola, General Electric, Unilever and Siemens, but at the end of this past summer I found their valuations and yields compelling.  I do not view these stocks as a proxy for investing in the developing world, however.  While over 40% of the revenues of the Standard & Poor’s 500 comes from abroad, a large portion of this is from developed countries in North America and Europe.  I just believe these companies have great products, strong brands and promising prospects, and they are selling at attractive price earnings ratios so they should do well even if the majority of their sales come from slowly growing economies.  While this segment of the asset allocation plan is totally committed to these stocks on a long-only basis, I expect the overall portfolio exposure to this sector to be even greater because some of the long/short hedge funds are likely to have holdings in these stocks.

In the volatile markets I expect to see over the next decade, I think a substantial exposure to hedge funds across all strategies will provide satisfactory returns in favorable markets and significant protection in turbulent times.  The experience of professionally managed funds of hedge funds supports that view.  While many long/short equity managers are more comfortable picking stocks to own rather than short, hedge funds managers have demonstrated a keen sense of risk and, with some exceptions, have been able to show an ability to suffer substantially less than the market in a declining period for the indexes.  Moreover, in an increasingly complex transactional environment where derivatives, program and high frequency trading can increase market and individual stock fluctuations, various hedge fund strategies have proven effective in dealing with these conditions.  There are also arbitrage and distressed security funds that take advantage of anomalies in subsectors of the markets as they appear.  I recommend a diversified portfolio of hedge funds or the use of a fund of funds managed by a team with a proven record of hiring (and terminating when necessary) individual managers.

By this time it must be clear that I continue to be enthusiastic about the opportunities in emerging markets.  I am not the only strategist with this view but it is not yet a crowded trade, in my opinion.  Although the developing world accounts for 35% of the world gross domestic product, it accounts for less than 20% of the world market capitalization because of the large number of family-held private companies in Latin America and India and the large state-ownership position of Chinese companies.  Still the typical institutional portfolio has less than 10% in emerging markets, and I believe many will be expanding their positions over the next few years.  Happily there are an increasing number of well-trained, experienced investment managers on the ground in the developing world to help institutions navigate in these sometimes difficult markets.  I would not invest in this sector without local expertise or someone who has demonstrated an ability to perform in these markets over time from London, San Francisco, New York or some other city.  There are long-only, long/short, sovereign debt and other specialized managers operating in these markets and their number is likely to continue to increase as the asset class gains in acceptance. 

I am not naïve about the emerging markets.  China has serious problems in environmental pollution, social services, its legal system, intellectual freedom and human rights.  India has a weak infrastructure, excessive regulation and a cumbersome legislative system.  Brazil has serious crime and social problems.  In spite of these issues, I think investors can benefit from the rapid growth of these countries.

Perhaps the most controversial section of my asset allocation is the 20% I have placed in high yield fixed income.  I recommend no exposure to U.S. Treasurys because I believe we are likely to see higher yields in these securities going forward with mark-to-market losses offsetting the current coupon.  While high yield bonds have performed well over the past two years, the current return is still in high single digits and is attractive in a business environment where the default risk is low.  If you want even higher yields with somewhat greater (but not excessive) risk, these are available in bank loans and performing mortgages.  These securities are less liquid than conventional fixed income securities, which partially explains why their yields are high, but if we avoid another recession and housing doesn’t suffer a significant further decline, then this asset class could make an important contribution toward helping an institution meet its overall return objectives.

Over the years private equity has proven to be a rewarding area for investment, more than justifying the lock-up periods associated with this asset class.  While stock picking in a slow growth environment may be difficult, there are always opportunities for a disciplined and patient private equity investor.  Large companies are continually divesting themselves of divisions that no longer are consistent with strategic objectives.  Entrepreneurs often want to sell when their company reaches a certain stage and retire or go on to something else.  Some companies need capital to move to the next level and do not want to or cannot raise it themselves.  A private equity firm only needs to make a limited number of investments in the course of a year.  If it is skillful, it should be able to earn a multiple of the client’s investment over a reasonable time period.

In contrast to earlier cycles, real estate has come back from the recession/financial crisis of 2008–09 faster than one might have expected.  Usually it lags in a business recovery, but over the past year commercial rents and occupancy have first stabilized and then improved and hotel occupancy has moved steadily higher and room rates are also starting to rise.  The reasons for this are probably related to the limited construction activity that took place prior to the downturn.  As employment has modestly increased and business travel resumed after the recession, the health of the real estate industry has been restored.  Today high-quality properties can be purchased at or below replacement cost and capitalization rates are attractive and likely to provide capital gain opportunities.  The residential market remains problematic and uneven, however.

As a kind of insurance protection against a dislocation or calamity in the market for financial assets, I recommend a position in gold.  I do not believe you should own it because of a potential rise in inflation.  I do not see that happening at any point in the next several years in the developed world.  I just think that the major industrialized countries have large debt obligations, expansive monetary policies and the prospect of declining currencies.  Investors are going to want to have some portion of their portfolios in real assets and while you can argue whether gold is truly “real”, it has generally been accepted as a repository of value for centuries.  I also like silver, palladium and platinum.  These have broad industrial uses in addition to their value as precious metals.

Finally I believe the standard of living will continue to rise throughout the developing world.  This will result in improving diets as well as more and better clothing.  The demand for agricultural commodities should increase faster than the ability to increase production and the price of cotton, wheat, soybeans and corn should rise.  We have already seen the price increases in industrial metals as the infrastructure in the developing world has improved.   Cotton has benefited because many of the emerging market countries are warm.  The demand for grains will increase as people eat more meat.  While commodities tend to be more volatile than financial assets, the improvement in the living standards of the developing world is part of a secular trend and these assets have a legitimate role in institutional portfolios going forward.

I have the confidence of knowing that there is probably no institutional portfolio that looks exactly like the one I have just presented to you.  I have discussed this allocation of assets with a number of institutions already and while they might have one or two categories which conform approximately to what I have suggested, the bulk of the portfolio differs considerably.  I do not expect anyone to adopt my recommendations completely.  My purpose here is to encourage you to rethink your asset allocation in view of the changes that have taken place in the investment environment over the past decade and are likely to continue into the future.  If I am right about my perception of the shift in economic influence and growth, you will be glad you did.

The Blackstone Group L.P.
345 Park Avenue
New York, NY 10154
212 583 5000
http://www.blackstone.com/

Contact Information:
Byron Wien
The Blackstone Group
345 Park Avenue
New York, NY 10154
Tel: 212.583.5055
wien@blackstone.com