Asset allocation?

Aspiring Investor asked me about my asset allocation. It's a good question given that the asset allocation process has been shown to be a material factor in portfolio returns.

For better or for worse, I do not follow a traditional asset allocation model such as (X% in stocks, Y% in bonds or the well debated permanent portfolio.

Prefer cash flow producing risk assets: I am primarily a value investor with a tolerance for market volatility and a belief that continued inflation is more likely than deflation over the longer term. To that end, I prefer to have most of my savings invested in risk assets (real estate and stocks) that produce cash flows (rents and dividends) that have at least the potential to increase over time to more or less compensate for the effects of inflation. Relying on cash flows to pay our living expenses also reduces our need to time the sale of assets to maintain our lifestyle.

Currency matching: Further, I would prefer to have a significant part of those cash flows denominated in the same currencies as our expenses: mostly HKD and NZD with others depending on where we go for holidays. As a result, most of our assets are either Hong Kong property or securities listed on the Hong Kong Stock Exchange.

Cash reserves: Cash flows can get disrupted. Dividends can get cut. Properties can remain vacant (which is a real pain as outgoings like rates and mortgage payments don't stop). History tells us that such disruptions are more likely to occur at times when asset prices are low. I don't want to be forced to sell assets at unfavourable prices - especially after I have retired and no longer have employment income to fall back on. Accordingly, I intend to maintain at least two years worth of living expenses in cash or short term bonds that I can draw on if needed.

Some diversification: Lastly, I also recognise that having the biggest part of our assets weighted towards HK/China is a risk factor in itself. With this in mind, we are allocating some more of our savings to investments which are either (i) outside HK/China and (ii) in different asset classes. As an example, I recently unsuccessfully bid on another property in New Zealand, we have some exposure to gold and silver, we have invested in some ETFs which invest outside HK/China and allocated a small amount of money with Walton. Since I do not want to work for another five years or more, the allocation to these non-core assets is, of necessity, quite small

Estate planning: As a final point, we have avoided accumulating significant assets in countries which impose estate duties. Our investments in the US and the UK are limited as a result. Hong Kong and New Zealand do not impose estate duty.

Summary: In summary:

(i) mostly Hong Kong real estate and listed securities held for cash flow to fund daily living expenses;
(ii) a material allocation to New Zealand real estate and listed securities held for cash flow to cover daily living expenses while in New Zealand;
(iii) smaller allocations to other assets including ETFs, gold, wine and other investments to provide a degree of diversification; and
(iv) at least two years worth of expenses in cash or near cash to cover any disruptions to cash flow (and a willingness to hold considerably more in cash/near cash if suitable investments cannot be identified).

Diversification revisited - how and how much (2)

In my previous post on how and how much I should diversify the private portfolio, I concluded by identifying two risks that I should aim to reduce through diversification:

(i) the risk of positive correlation among asset classes; and

(ii) the risk associated with individual assets.

The latter risk is the easiest to address - I simply do not put a material amount of money into any single asset. In this respect, I am less concerned with real estate as the risk of a single property suffering total loss of value is (in my opinion) not material. Absent earthquakes, wars, nationalisation etc property does not disappear. Shares are another matter. Shares can and do go to zero value without any prospect of recovery. It happens all the time - even to very large well regarded companies. In terms of diversification against this risk, the largest allocation we have to a single property is 6.05% of net assets (our home) and the largest allocation we have to a single share is 0.9% of net assets (Westpac Banking Corporation) . Most of our shares are around 0.6% of net assets at the time of purchase. If one company I have invested in becomes the next Lehman Brothers, Enron etc the impact on the private portfolio will be trivial.

The risk of positive correlation among asset classes is much harder to address. During the credit crisis and the years which preceded it, most of the major asset classes showed higher degrees of positive correlation than is desirable from an asset allocation perspective. During the crisis itself, real estate, equities, corporate bonds and commodities all moved down sharply. Of the major asset classes only government bonds advanced (negative correlation) and gold more or less went sideways (low correlation).

In Hong Kong I have a problem that low cost index funds are few and far between. US funds are not available and the next best thing (from a cost perspective) is ETFs listed in London which have higher transaction costs, involve FX conversion and (last time I checked) were not convenient to trade on line. In effect, by precluding difficult to access overseas products and high cost actively managed funds, I am currently limited to the following:

1. ETFs listed in Hong Kong which track indices linked to Hong Kong, China, Taiwan, India, and Russia. ETFs linked to the US, Japan, Asia and Europe seldom trade;

2. Equities and REITs listed in Hong Kong, Australia and New Zealand;

3. An ETF linked to a basket of commodities;

4. A limited range of high grade bonds denominated in HK$, US$, Euro, NZ$ and RMB. The spreads on these products are enormous;

5. ELDs over large cap Hong Kong stocks;

6. CLDs over a number of currency pairs;

7. Paper gold, silver and platinum;

8. Cash and bank deposits;

9. Real estate in Hong Kong.

In terms of reducing portfolio risk by diversifying among asset classes which have negative or low correlation, my options are a bit limited. Currencies by reason of being a zero sum game should have a low or negative correlation with equity markets over a period of time. ELDs offer some diversification benefits - especially if I write them sufficiently far out of the money. Bonds offer a degree of diversification benefit but the spreads effectively mean that holding to maturity is necessary to overcome those spreads. Commodities and real estate have shown themselves to be positively correlated with equities. Cash is a safe haven during downturns but a wealth destroyer the rest of the time.

In effect, I have concluded that the best I can realistically do in terms of managing the risks of having a portfolio of assets which are positively correlated are:

1. invest predominantly with a focus on income streams (dividends, interest, premiums, rent). If income is coming in then I should be less concerned about fluctuations in the value of the asset;

2. time the market. Invest aggressively when valuations are cheap and conservatively when valuations are expensive. In practice, this means buy equities when the market is down and shift to low yielding out of the money ELDs when the market is high;

3. consider using the commodity ETF, CLDs and paper metals more than at present.

Given that the range of ETFs listed in Hong Kong is expanding, I should keep an eye on these products with a view to achieving better diversification as and when additional products have enough liquidity to trade.

I am effectively concluding that modern portfolio theory is a good thing for me at this stage of my journey towards financial independence but that the obstacles to implementing that theory necessitate taking a different approach.

Asset Allocation - update

Back in January 2007 I reviewed our asset allocation in light of our retirement plan and concluded that (i) we were heavily overweight Hong Kong real estate and (ii) that the overallocation was in line with our retirement planning but (iii) greater diversification would be beneficial. At the time we had 73.7% of our household net worth invested in Hong Kong real estate.

Our current asset allocation is:

Home: 6.05%
Hong Kong investment properties: 38.64%
Overseas investment properties: 6.28%
Managed funds: 18.62%
Direct equities: 11.28%
Commodities: 1.6%
Cash and bonds: 17.53%

These numbers are calculated on a net basis - that is they reflect the amount of equity invested in a property at current mortgagee valuations rather than the total value of the property. The cash and bonds category is temporarily inflated as some of it will be invested in my employer's business next month and a bit misleading as it includes my ELDs and CLDs. The reality is that we are not holding much cash at the moment.

In any event, since January 2007 although we have added to the property portfolio, we diverted more of our income to other asset classes (managed funds and direct equities). While the timing was awful (too many funds were purchased near the market peak - we would have been better off buying another property), subsequent purchases starting in October 2008 have done extremely well.

In terms of our retirement plan to derive about half of our income from rent on properties and half from dividends on shares, because of the gearing effect we need to add more to the equities asset class than the real estate asset class. That said, the ELDs and CLDs have shown good returns this year and a good case for permanent allocation to these instruments can be made.

I have no particular views on what is the correct asset allocation for us at this time - or even whether there is a correct asset allocation at all. If I can identify properties which can be purchased at prices which provide an acceptable yield (very difficult in the current bull market), I would add to the property portfolio. Absent such opportunities, I am happy to add to the equity allocation or simply do more ELDs and CLDs.

Diversification revisited - how and how much (1)?

In my overview of diversification I commented that my attitude to risk was evolving as my financial objectives began to shift from wealth creation to wealth preservation. I concluded with three questions which effectively asked how much diversification is right for me and how should I structure my investments to achieve that degree of diversification?

The benefits of diversification can be summed up in two sentences:

1. opportunity to improve returns through periodic rebalancing of asset classes which have negative or low performance correlation. In effect there is an element of forced buy (comparatively) low and sell (comparatively) high built around the idea of having a target asset allocation;

2. potential to reduce risk by spreading wealth across multiple assets and multiple asset classes. This reduces the impact of material or catastrophic losses on overall performance.

Diversification has been described as the only free lunch there is when it comes to investments. Academic studies point to the fact that a diversified portfolio which is periodically rebalanced will produce better risk adjusted returns than an undiversified portfolio. I certainly do not have the academic or professional qualifications to dispute this. However, it seems to me that diversification has some disadvantages:

1. more assets means more time spent researching, monitoring etc;

2. more asset classes means that a wider range of knowledge and experience will be needed to monitor a portfolio;

3. more assets and more asset classes means less time spent on each investment decision;

4. more asset classes and more assets mean more money allocated to investments which are not the first choice assets.

After a fairly long debate with myself, I ended up deciding to view diversification as a means of managing two different types of risk:

1. risk that the portfolio will be impacted by negative correlated returns (which is what happened from late 2007 to late 2008) - effectively that all of my asset values move against me at the same time;

2. risk that individual assets will have large negative returns (e.g. individual companies become insolvent).

But, I find that I am still comfortable having a degree of concentration that is inconsistent with traditional portfolio management. Specifically, I prefer to have a high concentration of assets invested in economies that are growing rapidly and have governments that manage their finances prudently (i.e. are not heavily in debt and perpetually spending more than they can afford without resorting to punitive taxation).

Some investors have ready access to very broad asset class mutual funds with very low expense ratios (Vanguard etc) which enable them to construct very simple portfolios and rebalance very easily. Sadly, such funds are either not available to Hong Kong residents (e.g. Vanguard) or are difficult to access or are subject to offshore taxes (e.g. US ETFs). While there are some ETFs available in HK for a number of reasons it is not possible to construct a properly diversified portfolio made up exclusively of such products. There are plenty of actively managed funds that come complete with front end loads and very high expense ratios - which render them unappealing. In short, the easy solution is not readily available.

So how, and to what extent, should I address the two identified risks using diversification?

Diversification revisited - overview

It was almost three years ago that I set out my views on diversification and concluded that diversification is mostly a good thing. I did highlight some problems with diversification, the most significant being the fact that diversification protects you from many risks, including the risk of becoming wealthy (to paraphrase Max Gunther). In effect, the more you diversify, the smaller the chances of a spectacularly successful investment having a meaningful effect on your wealth.

Since publishing that post, four things have happened which are relevant to my views on diversification:

1. our household net worth has increased significantly: in effect we now have more to lose. Diversification may be an impediment to wealth creation but is also provides a degree of protection against wealth destruction. Although the degree of correlation between asset classes during the current financial crisis was much higher than many people either anticipated or desired, diversification did provide a degree of protection from the declines in asset values experienced from mid-2007 to late 2008. In particular, gold and government bonds provided good diversification benefits during this period;

2. we have experienced a financial and economic crisis: we lost money. We lost a lot of money. Our two main asset classes (Hong Kong real estate and emerging market equities) were both hit hard during the crisis. We were not diversified enough and suffered greater losses than we would have suffered had we been more extensively diversified;

3. we experienced a significant rally in equity prices and Hong Kong property prices: we invested heavily in emerging market equities beginning in October 2008. Since we sold very few of our investments during the crisis, this effectively amounted a doubling down on this asset class. Those investments have performed extremely well since then (outperforming most other asset classes over that period). This is a clear case of benefiting from not diversifying;

4. the timetable to my retirement has (roughly) halved: put differently, a combination of high income, a good savings rate and very modest returns on investment will more or less get me to my "number" by the end of 2011 or 2012. This means that making high returns on my investments will not make a meaningful difference to my target retirement date but taking losses would have an adverse impact on my target retirement date.

To sum up, my views on the pros and cons of diversification have not changed. I believe that diversification is an effective way to reduce risk but excessive diversification is an impediment to wealth creation. Another way of looking at diversification is to say that you should have less diversification when you are attempting to build wealth (particularly if you want to do so quickly) provided that you have the time and expertise to research, manage and monitor your investments (and a few other things as well) but more diversification when you reach the stage were preservation of wealth starts to take priority over wealth creation.

What may have changed is the application of diversification to my personal circumstances. This raises some further questions which I will address in future posts:

1. what steps should I take to minimise the risks associated with using limited diversification?

2. how should my invest my assets when I wish to place more emphasis on wealth preservation than wealth creation?

3. how much diversification is right for me? What is the right balance between the protective benefits of more diversification and the wealth enhancing possibilities of less diversification and how should I invest my money to achieve that balance.

Book Review: Understanding Asset Allocation

Asset allocation was one of two investing topics which I had resolved to learn more about some time ago. I picked Victor Canto's "Understanding Asset Allocation" from several books on the subject at my local books store not only because it came with solid recommendations (and not just by those whose reviews were printed on the dust jacket) but also because it was the shortest of the choices available. I was hoping for a relatively light easy-to-read introduction to the subject.

While I did find Canto's take on the subject interesting, it was heavier going that I had hoped for. I put this down to an expectation issue on my part rather than a criticism of the book.

On the whole I did get a good introduction to an important subject. Canto explains different asset allocation models (strategic asset allocation and cyclical asset allocation) clearly and supports them with historic case studies showing how the different models worked in different market conditions. The major take away I took from this book was the importance of anticipating and participating in asset cycles. Of course, this requires an ability to successfully cycle into the asset classes which will outperform during the following period of time (usually measured in years) and to avoid the asset classes which are likely to underperform.

One of the more interesting points raised is Canto's view on the debate between active and passive fund management. In Canto's view active management tends to (or perhaps has a better chance of outperforming) during small cap cycles while passive managment is the better option during large cap cycles. I wasn't wholly convinced as too much seems to depend on your choice of active fund manager, but in spite of my reservation, Canto presents a reasonable amount of data to support his views.

While the explanation of asset cycles was useful and something to consider in my investment decision making going forward, two issues remain.

The first issue is a practical one. Outside the United States, the ability to invest in low cost funds which track the relevant indexes is quite limited. Certainly, there is nothing available in Hong Kong that would enable the type of diversification and asset allocation that Canto describes to be implemented.

The second issue is a conceptual one. If asset allocation is a methodology that in effect attempts to generate above market returns, by definition it is impossible for every investor to successfully implement. This does not mean that the attempt should not be made, but the bottom line is that for every investor who beats the market by cycling out of asset classes that will underperform and into those which will outperform, almost by definition there must be someone who, consciously or not, is doing the reverse.

On the whole a useful book that introduced my to another way of looking at asset selection.

Frustration with Funds (2)

I have previously written about the problems Hong Kong investors have with accessing funds which have no load and low MER (management expense ratios). The situation is improving and I summarise my current understanding as follows:

1. many fund houses will only offer actively managed funds. MERs are typically in the 2-3% range. While this is very high by US standards and has a material negative effect on returns, in part it is justified by the relatively small fund sizes;

2. most fund houses still try and charge 5-5.5% front end load. This can usually be negotiated down to 2% and "specials" of 1.5% have been seen. This is still outrageously high. I've managed to get one reasonably good fund house down to either 1% or 0.5% but it took a while to get there;

3. most of the overseas ETFs and no load index funds I have looked at are either not available to Hong Kong residents or the returns are subject to a withholding tax of up to 30%. As much as I hate paying the front end load and the high MER, because of the withholding tax issue, I think I am marginally better off over the longer term paying the load and MER than going with an overseas no load index fund. This conclusion is not an absolute one - the result depends on what the actual return on the funds is and does vary a bit with the actual MER, the actual load and the time period of the investment;


4. there is a small range of ETFs listed on the Hong Kong stock market. Of these, only the ones which track the Hange Seng Index (TraHK), the FTSE/Xinhua A50 Index, the Hang Seng China Enterprises Index and the BSE Sensitivity Index have enough liquidity for me to feel comfortable investing in. I hold TraHK, but do not hold either of the two China related funds or the India fund. The latter is one that I only recently became aware of. There are also ETFs which track other China indices, the MSCI Korea Index, the MSCI Taiwan Index, a Hong Kong bond index and a pan Asia bond index. However, these ETFs have either no or inadequate trading volume making them inaccessible. Lyxor (part of the SocGen group) has announced that it intends to list other ETFs in the near future and, if there is enough trading volume, I look forward to that;

5. there is one hedge fund available: the AHL Managed Futures Fund. This has no load but a high MER (including profit share). I do not hold this fund. Based on past performance, a decision to invest would have done reasonably well;

6. there are some REITs listed in Hong Kong, but I am not allowed to invest in these.

Asset Allocation - A Random Thought

On the subject of asset allocation I have been wondering if the text book approach of using asset allocation as a tool to manage risk and improve returns without considering the circumstances of the individual is best or whether my asset allocation should reflect (at least in part) my personal retirement plans.

As an example, our retirement plans include a reasonable amount of travel. Europe is certainly one place we would like to visit more often. The problem is that Western Europe is very expensive. Meals, hotels and the like cost a lot more than we would pay for a holiday in Asia or many other places.

In order to hedge against the cost of travel to Europe, I am considering ensuring that an adequate portion of our retirement income is derived from assets denominated in euros or pounds. There have been a few occasions when I have considered buying a property in London but have been deterred by the difficulties in managing a property in another jurisdiction (I have enough problems managing back home where I can rely on relatives to help out if need be) and limited knowledge of the local market. If I rule out direct investment in UK or European property, I am left with allocating a portion of my equity investments to dividend paying European equities. At least some of these dividends would be spent on our European travels.

Similar considerations apply to some other parts of the world that we would like to spend more time in.

This approach to asset allocation is different from the text book approach which focuses on allocation solely for the purposes of reducing risk and increasing returns in a portfolio that exists independently of the circumstances of the individual. Quiet frankly, I am not sure if it matters too much since I would inevitably include equities from a number of countries in my portfolio anyway. However, it did strike me as an interesting question.

My Asset Allocation - A Change In Strategy?

At the end of 2006 our asset allocation was as follows:

1. Hong Kong Real Estate: 63.6%
2. Overseas Real Estate: 10.1%
3. Managed Funds: 14.7%
4. Direct Equities: 5.0%
5. Cash and Cash Equivalents: 5.0%
6. Other Investments: 1.7%

The "Other Investments" are my paper silver.

This is not exactly a model portfolio. We are clearly overweight property and underweight equities.

Our financial plan aims to derive roughly half our retirement income from rental properties and half from dividends on equities. The original intention was to acquire the required number of properties as quickly as possible. The rental income would then be used to pay the mortgages off while savings from our jobs would be used to build the equity portfolio.

After spending some time educating myself on the importance of asset allocation, I am considering directing a greater portion of our savings to managed funds now. The additional properties will still need to be acquired, but the acquisition would be delayed until an indefinite time in the future. The advantages of delaying acquisition are:

A. I am finding it difficult to identify properties that show an adequate yield (after expected vacancies, rates, management fees and other outgoings). By delaying the acquisition of the balance of the properties, I give the market more time to generate better opportunities;

B. I achieve a better asset allocation in the shorter term. In 2006 the returns on our investments as a whole, while good, would have been even better with greater exposure to equities. I am trying hard to ignore the effect which greater allocation to equities would have had on our 2006 returns - I do not want to end up in a position where I am effectively chasing last year's top performers (historically this has been a bad strategy);

C. My debt levels will be kept lower. I will only be taking on debt if I buy additional properties. At the same time, all our mortgages except one are on principle and interest terms so the amount of existing debt is being reduced each month. As much as I like debt as a tool to enhance returns, I look forward to the day when we have no borrowings at all.

The only downside to delaying the purchase of the additional properties is that he delay will mean that there is less time to pay off the mortgages used to acquire them before I retire.

Frustration with Funds

I am finding that the range of low cost no-load funds in Hong Kong is extremely limited. In fact, so far I have identified precisely three such funds. All the other funds which are available to retail investors are actively managed funds which charge a front end load. MERs are typically in the 1.5-2.5% range and the front end load is usually 2% (if you negotiate down from the advertised 5-5.5%). To make matters worse, many also charge exit fees. This is pretty outrageous and is a sad reflection on both the Hong Kong fund management industry and Hong Kong investors' understanding of the effect of such charges on their wealth. This may also explain why the penetration rate for funds in Hong Kong is low by developed market standards.

I have looked at the no load funds which are available (TraHK which tracks the Hang Seng Index and China Tracker and A50 China Tracker which track indicies relating to China shares). I hold TraHK. The other fund is the AHL Diversified Futures Fund which has no load but a quite steep MER and a trailing fee for the first 3 years. The AHL fund has averaged about 13% pa after fees and the returns appear to have a low correlation with general share market movement. I am having a close look at this one.

I have looked into some of the low cost funds which available in other countries and run into a brick wall - the fund managers will not sell to me because I am resident in Hong Kong unless I invest a very large sum of money in each fund (typically US$100,000). I have never been given a reason for the refusal. I will keep looking but I am starting to get rather disillusioned with the whole exercise.

As much as I hate the front end load and the high MERs, I feel that I need to invest in some of these actively managed funds. The alternatives leave me with too little diversification in the private portfolio.

In an ideal world, I would invest directly in stocks and create my own index or theme portfolio. Unfortunately, the terms of my employment prohibit dealing in listed securities (index tracking funds excepted).