May 2, 2013
By Steve Blumenthal
The taxi pulled up to the Beverly Wilshire Hotel in Beverly Hills, California and the driver said, “You know, this was the hotel they used in the movie “Pretty Woman” ”. Richard Gere was the wealthy Private Equity guy and Julia Roberts was the pretty woman. Gere was a leveraged buyout master. There was money in buying and breaking up companies as well as hidden money found in over-funded pension plans (not the case today as I share below).
I was attending the 13th Annual Milken Institute Global Conference this week. In real life, Michael Milken provided the funding for many leveraged buy-outs in the 80’s and 90’s. He was known as the junk bond king having created the high yield junk bond industry in the 70’s. I have been trading the high yield trends up and down for over 20 years. Excited to learn from the powerful lineup of speakers, I smiled as I checked in.
Last week it was Delray Beach, Florida at a large advisor conference. I presented on valuations, ten year expected returns, currency creation, debt, currency wars and probable unintended consequences. This sounds endlessly depressing, I know, but hang with me as I see an outstanding opportunity ahead – it is just a question of which lens you are looking through.
I begin this month’s Viewpoint with the conclusion first; a singular opportunity exists ahead for you to help your clients and grow your business. The industry is 60/40 and that money will seek an Enhanced Modern Portfolio Theory solution. I express ideas as to how to present this message by answering an advisor’s question to me. If you are an individual investor, I hope you gain from this discussion as well.
I also take a look at probable outcomes and share a few insights gained from this week’s Milken Institute Global Conference. I particularly enjoyed the panel that included Mohamed El-Erian, CEO and co-CIO at PIMCO; Ken Griffin, founder and CEO of Citadel; Terry Duffy, president of the CME Group; Madelyn Antoncic, treasurer of The World Bank; and Willem Buiter, chief economist of Citigroup. The conversation between Tony Blair and Michael Milken was also stimulating. There really is great hope in the world. I provide the links below.
Conclusion first:
I spent several hours with Charles Passy from Dow Jones over the past few months as he prepared for the article that appeared in the Wall Street Journal last week. He talked about the trend in the industry away from 60/40 and towards broadly engineered portfolios and did a great job introducing the shift in the limited space he was allotted. The article was titled, “Is investors’ favorite strategy doomed to fail? Why the 60/40 asset allocation model may no longer work”, by Charles Passy, Wall Street Journal, April 23, 2013
BlackRock terms it “The New Diversification” My good friend, Professor Christopher Geczy, Ph.D., from the Wharton School calls it “The New 60/40 – 30/30/40”. Ray Dalio wrote an excellent piece titled, “Engineering Targeted Returns”, and in a recent piece, PIMCO’s COO, Douglas Hodge, CFA advises to “Think Alternatively” saying that “New sources of diversifying will grow more common in portfolios”. Indeed.
Ok – good news – the message is getting out. Hodge adds, “To compete, advisors will need to help investors think alternatively about risk and reward objectives. They’ll also have to offer strategies in mutual funds and other liquid structures that individual investors can easily access.” Better news is that a broader set of advanced liquid solutions exist.
I conclude that a singular opportunity exists ahead for you to help your clients and significantly grow your AUM. The industry is 60/40 and that money will seek an Enhanced Modern Portfolio Theory solution.
My answer to an advisor’s question
Last week I was in Florida presenting as the keynote to a group of super smart independent advisors from Cambridge Investment Research. This particular group is lead by the infectiously positive, Randy Verlin. The forum is a best practices forum and has become one of my favorite annual visits. I presented my view of Enhanced Modern Portfolio Theory, I call it 33/33/34, and explained how the creation of new investment products and advancements in technology has easily enabled advisors to help their clients in ways they couldn’t just five years ago.
My message: Advantage goes to the advisor who builds a better portfolio for his/her clients. Post my presentation, an advisor asked me how he might simplify the story in a way he could explain it to his clients (understanding that many individual investors don’t speak our language). I promised him a summary and what follows is my best attempt to simplify the message.
- 1. To begin, we all recognize that it is important to have detailed insight into a client’s current total portfolio (likely 60/40 based on experience) and understanding of their goals, risks, needs and investment horizon.
- 2. I would next define Modern Portfolio Theory (next chart) and explain that 60/40 became the definition of MPT; however, it is a less diversified, two asset class portfolio mix and falls short of meeting the definition of MPT. There are now more tools to use to construct a targeted return objective.
- 3. I would then show that the forward outlook for 60/40 is likely just 4.37% and ask if that meets expectations. Walk your client through the next few charts.
- 4. Explain that a starting point of low dividend yields, low implied inflation and low bond yields means that the forward ten year expected return on that portfolio is just 4.37%. The lowest forward expected return in 14 decades. This time could prove different, however, the odds are not so good and the outcome could be costly.
- 5. Explain that the green line reflects the forward ten year expected 60/40 return going back 14 decades and the blue line shows what actually happened over the subsequent ten year period. Note how closely the actual performance (blue line) tracked the expected performance (green line). The important part of this chart is to properly set realistic forward return expectations. This then opens up a discussion on how to engineer better returns.
- 6. For the quantitatively-based client, the next chart details the math decade by decade. The formula is straight forward: add the beginning dividend yield with real long-term EPS growth and implied inflation to get the ten year expected equity return. The beginning bond yield is the yield on the ten year Treasury. By taking 60% of the expected equity return and 40% of the beginning bond yield, you get the expected 60/40 return. Simply, if your beginning dividend yield, inflation and beginning bond yield are low, then your expected forward return is low. I reflect the math as of January 15, 2013. See red box at bottom of next chart. There has been little change since then.
- 7. The idea behind 33/33/34 (or whatever you feel is the right weighting for your client) is to align with the principles of Modern Portfolio Theory. The goal is to enhance return and reduce the volatility ride your client experiences along the way.
- 8. Explain that the approach is not new as endowments, pensions and high net worth investors have invested this way for years. However, it is new to Main Street as most investors lacked access to broader solutions. Show your client/prospects the articles and white papers linked above.
- 9. Next I would touch on the risks that exist in the system but the biggest issue, frankly, is the low projected 60/40 return. The global risks are tied to too much debt, unfunded entitlements, continued deficit spending and a world trying to dig out of the same hole at the same time. The seemingly simple solution is to print and the global central banks are printing indeed. The road will be bumpy as the imbalance and response create consequences that are yet unknown and likely unavoidable. There is a better portfolio plan for the period ahead.
- 10. The following picture tells the story. A storm, some calm for awhile, another storm. The big ones are the EU, Japan and perhaps the smallest storm on the horizon is the US.
- 11. I would express that when the markets reset at higher dividend rates, higher implied inflation and higher bond yields, you look at the opportunity and make a shift back towards a higher concentration of equities and fixed income (60/40); we are just not there today.
- 12. Share that the goal with broader MPT construction is to enhance return and reduce risk as expressed in the next chart.
- 13. It is important to include a broad set of diverse investment return streams. The idea is to find mutual funds, ETFs and liquid managed strategies that have opportunity to produce returns while doing so in a non-correlated way.
- 14. Explaining correlation can be a bit tricky. Below is the definition. Simply, you want a mix of assets that don’t all move in the same direction at the same time. This is measured through correlation. In simple terms, correlation compares different return streams and you are looking for a reading of -0.50 to +0.50.
- 15. The next chart shows just how highly correlated various equity investments are to each other. Light blue looks at a longer-term period, while dark blue looks at the crisis period. Note how both show a very high correlation near 1.00 and that in crisis all moved even closer to 1.00. 1.00 is perfect correlation.
- 16. Focus on the S&P 500 at the bottom left. Look across that line from left to right to see how highly correlated all of the other equity categories (small cap, large cap, emerging market, international equities, etc.) are to the S&P 500. Also note how non-correlated the Agg Bond index is to all of the equity categories. It is why bonds have always been an important diversifier in a portfolio; however, be aware that today’s record low interest rates means that there is greater risk in bonds than ever before and you need to account for that in your portfolio construction.
- 17. Owning a mix of large cap value, small cap growth, emerging market, international and mid cap proved to all correlate to the S&P 500 before and in times of crisis. It might look like a broad mix of different investments on an account statement but it is really just one risk. The 60% allocated to equities is not as diversified as one might think.
- 18. The next chart illustrates my idea around 33/33/34. Again, you can shape your mix as you best see fit for your client. Note that I’m biased as I put our various Tactical Strategies in the 34% Tactical bucket. You can pick and chose and include other strategies in this section like REITs, gold, commodities, currencies, other tactical managers you favor, etc. The idea here is to be open to enhanced solutions and show that they exist today.
- 19. Next, show your client the correlation of the strategies above against the S&P 500 Index and Agg Bond Index. The first green box shows how the System Research Treasury Bond Program correlates with the CMG Opportunistic All Asset Strategy. The second green box shows the correlation between System Research Treasury Bond Program to the CMG Managed High Yield Bond Program. If you look across line 7 you can see how all of the strategies compare to the S&P 500 Total Return Index. This is what you are looking for – strategies that have the ability to create returns and do so in a way that is non-correlated to stocks and bonds and also non-correlated to each other.
- 20. When you build your Tactical bucket, you can include strategies and other assets you favor. This is where you might shape you forward views. REITs, commodities, short Yen, long gold, short Treasurys, etc. Of course, how you size your positions based on your particular views is equally important.
- 21. I would again revisit the definition of Modern Portfolio Theory and explain that the key is to find a diverse set of valuable non-correlating return streams. Note: we can help you create the portfolio you favor (that expresses your views and includes your favored strategies) to be able to present it in a way that tells the story to your client(s). We have the expensive software in house and the research bandwidth to help you in this way. If you are working with us, we want to help you with important value added resources to help support you in the growth of your business. Talk to your CMG sales rep to learn how to leverage your relationship with us.
- 22. I would next explain to your client that in engineering a stronger portfolio, ultimately you are trying to create three diverse return streams as reflected in the next chart.
- 23. Then the idea is to blend the return streams together in a way that adds value and meets the intent and objective of MPT. Combining a set of diverse and non-correlating return streams together into one portfolio.
- 24. I’d conclude that there is a temptation for many investors to want to chase from equities to fixed income or from equities or bonds to tactical and back again. If we all knew all the time which category we should place our chips on, we’d be endlessly rich. Ray Dalio is outstanding yet he has set in place something he calls his “All Weather Portfolio” so his heirs, lacking his skill set, can do well after he passes without having to mess with the mix. Even Ray wouldn’t go all in on one risk.
The very best minds in our business debate what will play out and when. It takes a great deal of conviction to stick to a particular bet and we sure do love it when we get it right. It is just that we humans don’t always get it right and even when we are right, we sometimes get it wrong. Hard to stay the path when the heat is cranked up in the kitchen (the position is in significant decline, i.e. subprime in the glory days). Ultimately it paid off, though few stayed in the trade. It is a tough business.
The good news is that advancements in trading technologies and the creation of ingenious investment instruments are real, dramatic and liberating. They give you portfolio solutions that were previously available only to institutions and high net worth investors.
Build more resilient portfolios. The 60/40 mix remains challenged and the good news for the growth of your business is that 98% of our investment industry is 60/40. Advantage goes to the advisors who create Enhanced MPT portfolios.
Probable Outcomes and Unknown Consequences
Unmanageable debt, $1 trillion plus deficits (spending that is financed by newly created debt, funded by newly printed money), increased regulations, increased taxes, EU, Japan, and a dysfunctional political system here at home that is simply broken. Oh, and pensions are even more underfunded than I believed prior to the Milken Institute Global Conference. Ugh.
Same story – we are all getting numb to it though we shouldn’t be – risk remains elevated. The biggest forward risk I see today is the bubble in the bond market. As the major developed economies struggle towards solution (currency creation is the clear path), there are far too many unintended consequences. Some we know, some we simply don’t yet know.
I see rising rates ahead; just not yet as the demand for bonds almost doubles the new issue supply. The great and powerful Fed; but alas not alone as Japan’s liquidity creation plans are nearly triple ours. The plan is to create inflation. I think they’ll win.
Low interest rate bonds and the risk of rising inflation and rising interest rates are real. As we debate deflation vs. inflation, to me the reality is that both are supremely bad and we may just get both. A smooth landing seems highly improbable. In this is opportunity if positioned correctly and trouble if not.
The portfolio problem is a 1.70% ten year Treasury yield that is earning less than inflation (so it is producing a negative return) and runs risk of significant loss should/when rates move higher. Is it worth the bet that rates drop to 1% before they move to 4.7%? Not for me. I’ll take the other side and short the long-term US Treasury Bond (coming, not yet).
Should rates move higher to 4.7%, ten year bond exposure will lose approximately 23%. 40% of a portfolio exposed to ten year bonds or floating maturity bond funds is a significant risk. Of course, your client can hold on to it for ten years. Personally, I think that is unlikely as the emotional pain of loss will be too powerful. If an investor can stay the course, then he loses out to inflation. Neither are good options. The next chart shows the risk.
My two cents is to shorten bond maturities, remain patient for higher yields and consider tactically managed and flexible bond funds. Decrease exposure bonds and increase portfolio exposure to the tactical bucket. Maybe look to add a small targeted risk exposure to a short government bond ETF – just not yet as it is a bit early in my opinion.
As it relates to gold as a currency and/or inflation play, I continue to believe gold is a 5% (maybe 10%) piece in a portfolio. Currency manipulation creates imbalance and we are in a global currency battle of unprecedented proportion. The battle is between the deflationary forces of deleveraging and the inflationary forces of money creation.
I read a great deal about hyper-inflation and will share more in next week’s On My Radar. I thought James Montier from GMO did an excellent job in a piece he wrote titled “Hyperinflations, Hysteria, and False Memories” – February 2013.
James concludes, “To say that the printing of money by central banks to finance government deficits creates hyperinflations is far too simplistic (bordering on the simple-minded). Hyperinflation is not purely a monetary phenomenon. To claim that is to miss the root causes that underlie these extraordinary periods. It takes something much worse than simply printing money.
To create the situations that give rise to hyperinflations, history teaches us that a massive supply shock, often coupled with external debts denominated in a foreign currency, is required, and that social unrest and distributive conflict help to transmit the shock more broadly.
On the basis of these preconditions, I would argue that those forecasting hyperinflation in nations such as the US, the UK, or Japan are suffering from hyperinflation hysteria. If one were to worry about hyperinflation anywhere, I believe it would have to be with respect to the break-up of the eurozone. Such an event could create the preconditions for hyperinflation (an outcome often ignored by those discussing the costs of a break-up).”
When does the bond bubble pop? Does the EU break? Don’t know. Much depends on the liquidity forces of the global central banks and how far they push up asset prices. Much depends on whether global policy makers and the depth of austerity (taxes, trade gates, etc.). Can they put important structural fixes in place? We’ll see.
What I can say for sure is that 1.70% on a ten year Treasury is a ticking time bomb but it might hit 1% before it goes to 6%. My best guess is inflation and higher rates begin to set in sometime in 2014 or 2015. In any event, the biggest bubble of all time is likely the bond bubble and super low yields mean super high risk.
This all points back to the need for a broadly diversified portfolio. Maybe you include small exposure to some targeted bets but have the major focus on getting the asset allocation expanded so that a targeted bet or two doesn’t down the ship. I would love to look back and say I was a genius on shorting the yen, buying gold and shorting Treasury bonds but those are targeted bets. I could be wrong so I focus on sizing properly.
Thus, I circle back the sound principals of MPT and not based on “get rich” exposure. The message here is you can design a portfolio that targets a return and risk profile no matter what storm might come next.
Milken Institute Global Conference:
Following I share some thoughts from the conference and provide a few links.
To begin, it was one of the most thought-provoking conferences I have ever attended. Many of the sessions wove a diverse set of interests together on one panel providing an environment for opinionated debate.
For example, one of my favorite panels discussed “Global Markets in Uncertain Times”. The panelists were: Mohamed El-Erian, CEO and co-CIO at PIMCO; Terry Duffy, president of the CME Group (as in the Chicago Mercantile Exchange, Chicago Board of Trade, NYMEX, COMEX and KCBT); Madelyn Antoncic, treasurer of The World Bank; famed hedge fund manager, Ken Griffin, founder and CEO of Citadel; and Willem Buiter, chief economist of Citigroup.
Watching the body language of El-Erian in polite disagreement with Buiter was telling. Each with strength of conviction, Buiter saying the Fed has got this one – no worries… full speed ahead. El-Erian expressing the Fed has bid up equity prices well beyond reasonable fundamentals and says the Fed’s actions are “highly experimental”. At one point, El-Erian says to Buiter, “if I listened to you, I’d sleep well at night”. Buiter’s response, “perhaps you should listen to me more”.
El-Erian sees a 50-50 chance the Fed can land this thing. Trouble sleeping indeed. Here is the link to the panel discussion: http://m.youtube.com/watch?v=rij-DmF4h9c&feature=plpp
The next link is to a session with Tony Blair and Michael Milken. Blair is outstanding. You’ll feel better after watching, I promise: http://m.youtube.com/watch?feature=plpp&v=NE9GcRPBnoo
I sat at the table just next to Boone Pickens. Watching Boone tap his wife’s arm when Blair touched on the closed-mindedness of many politicians was telling.
Over the next few weeks, I’ll provide some additional links to the sessions I found most interesting. You can go to www.milkeninstitute.com to learn more.
In Summary
I’d like to leave you where we began. Through my lens, I see optimism and great opportunity. Expand the construction to include a broad diverse set of risks and shape your story is such a way that makes it easy for your clients and prospects to understand.
Bumps remain ahead; we’ll have recessions and expansions, periods of overvaluation and undervaluation, rising rates and falling rates, inflation and deflation rates, and many opportunities. You can minimize the bumps.
Read Dalio’s piece, study Geczy, and look at what PIMCO is saying (links above). Share my Viewpoints and charts with your clients as you best see fit.
A 60/40 mix today equals a ten year 4.37% expected return. Low dividend yields, low implied inflation and low (negative less inflation) interest rates are the culprits. Yes – it might be different this time. Though, I argue it is a tough bet to make. Use the expanded tool kit available to you and modestly shift the weightings to create more resilient portfolio(s).
Have a great upcoming weekend. I think I’m going to have to re-watch the movie “Pretty Woman”. The service at the Beverly Wilshire Hotel was simply outstanding. The area and the conference were well worth the time.
I traveled last night down Highway 5 to beautiful San Diego where I am attending the annual Shareholders Services Group (SSG) Independent Advisor Conference. I have two full days ahead and dinner tonight with my friends Mark, Mike and Craig from Sterling Global Strategies. I hope to get down to the ocean and watch the sunset. That will be nice.
Philadelphia doesn’t quite match up to the sun and beauty of Southern California but the taxes are better so we have that going for us. Great – I know.
If you have any questions or comments, please feel free to email info@cmgwealth.com or simply reply to this email. Wishing you the very best.
With kind regards,
Steve
Stephen B. Blumenthal
Founder & CEO
CMG Capital Management Group, Inc.
Suburban Philadelphia
1000 Continental Drive, Suite 570
King of Prussia, PA 19406
steve@cmgwealth.net
610-989-9090 Phone
610-989-9092 Fax
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