Asset allocation – making choices that add up
Asset allocation is typically sold as a simple stocks-versus-bonds split, but there is much more to it than that if you want an effective result. Bhanu Singh points to a whole series of decisions to be made.
The step many people overlook in considering asset allocation is ensuring they are clear about their goals. If you already have a nest egg and are close to retirement, your approach is going to be more conservative than if your goal is total return.
The other frequent mistake is looking at the performance of individual asset classes in isolation. Your consideration is not how stocks, bonds, property and the sub-asset classes are performing on their own, but about how they work together and their contribution to your overall portfolio.
A third mistake is treating stocks and bonds as single asset classes. The fact is there are other risk premiums within those broad categories that allow you to tailor an allocation more closely to your risk appetite and goals.
So within equities, small caps behave differently to large caps. They add diversification and offer higher expected returns over time in compensation for their higher risk. Likewise, low relative price, or value, stocks behave differently to higher priced growth stocks and offer a higher expected return over time.
Within fixed interest, returns are driven by two dimensions of risk – ‘term’ (the maturity of the bond) and ‘credit’ (the risk of default). Depending on your risk appetite and goals, you can tilt more or less to these premiums.
A fourth common mistake is being too wedded to your home equity market. While a degree of home bias can be justified, the degree of concentration in the Australian market means most people could benefit from spreading their wings more widely.
Fifth, currencies add another complication. Hedging all your foreign currency exposure may seem tempting, but the investment case for doing so is not solid.
Finally, listed property behaves differently to equities and offers another layer of diversification. It is worth asking yourself what level of exposure you want and treating property as distinct from equities.
The equity-fixed split
Equities have been kind to Australians over the years. Chart 1 shows the real growth of wealth in bills, bonds and share markets over more than a century for major developed economies.
At the top in terms of overall growth of wealth is Australia, a country where investors traditionally have had a much higher exposure to equities than those elsewhere.
So if you are looking for more return, equity is still likely to be the growth engine of your portfolio. But keep in mind that this comes at the cost of more risk. The general rule is you can afford to take on more equity risk when you are younger.
In your 20s and 30s, you have many more years of work and income ahead of you. That human capital is like a bond in your overall retirement plan. That means in your allocation to financial capital, you can afford to take on more equity risk.
As you age, your human capital becomes a smaller proportion of your overall capital. This means volatility in your financial capital becomes progressively more important. And that is why, as you get older, you need to think about replacing that human capital with fixed interest and reducing your equity allocation.
Reducing home bias
While everyone loves the comforts of home and the familiarity of names we know, Australians frequently are unaware of how much risk they are taking by tilting their equity portfolios so much toward local stocks.
Australia makes up about 3 per cent of total world equity market capitalisation. By comparison, the US represents about 46 per cent, Japan and the UK about 7 per cent and emerging markets about 14 per cent.
Now, there are rational arguments for home bias. The most important of these for Australian investors is franking credits. Dividend imputation means we get a benefit from local shares denied to investors elsewhere.
But there is a trade-off. And that is a lack of diversification. Australia is not only a small market in global terms, it is a highly concentrated one. It is concentrated in a few stocks and in a couple of sectors - namely resources and banks.
Typically, Australian investors have about 60 per cent of their equity allocation in local stocks. That means an exposure to financials of 30 per cent instead of 20 per cent in a global market cap-weighted portfolio, and about double the natural weight to materials.
Chart 2 shows that in a typical 60 per cent allocation to Australian stocks. Commonwealth Bank represents nearly 6 per cent of the portfolio. That’s a bigger bet on one stock than the entire allocation to emerging markets, which represent 30 per cent of global GDP.
Chart 3 shows for this home-biased portfolio, the top five stocks make up about a quarter of the total, more than every other country outside Australia and the US.
This is an uncomfortable level of concentration. And keep in mind, too, that this typical allocation is a big bet against other sectors like information technology (Apple, Samsung, Google), which are an insignificant proportion of the market in Australia.
What can we do about this? Recall that we can increase the expected return of our equity portfolio by tilting to small cap and value names away from the well-known “glamour” stocks at the large and growth end of the market.
By doing this and by increasing our weighting to other countries, we are not only increasing the expected return of the portfolio, we are increasing diversification.
Chart 4 shows a resulting portfolio with a 40 per cent allocation to Australian equities. That is still a sizeable home bias, but a more diversified, less concentrated portfolio.
In this scenario, the top five stocks make up just over 9 per cent of the portfolio, instead of 24 per cent. As well, the weight of all countries outside of Australia and the US increases from 20 per cent to 33 per cent.
So what we are doing here is increasing the expected return of our portfolio by tilting away from large, growth stocks. A secondary effect is we are also increasing diversification, across stocks, across sectors and across economies.
Currency hedging
As you reduce your home bias and diversify, you have more exposure to global currencies.
Research shows no strong argument in terms of investment returns for hedging the currency exposure of an international equity portfolio. The evidence on the volatility of hedged and unhedged portfolios also is inconclusive.
The argument for hedging is more one of personal taste. Currencies are unpredictable and volatile. Individual investors can feel sensitive to that and seek to align their international returns with the currency in which they consume.
One answer to this is to hedge 50 per cent of the international equity portion of your portfolio and leave the other half unhedged. This means you neither win big from currencies, nor lose big.
Property exposure
Listed property or real estate investment trusts behave differently to stocks and bonds. In other words, they are not perfectly correlated. This means that adding property to the portfolio further adds diversification.
The degree of property exposure again is an individual preference, as is the extent of global diversification. But a degree of home bias is perfectly acceptable.
Summary
Asset allocation is the most critical factor in setting up a retirement fund. In reality, it is not one decision, but a series of decisions:
- Before you start, think about your goal.
- In choosing the asset mix, look at the impact of each on your total portfolio, not on an isolated basis.
- Over time, equities offer a higher expected return. They are your key growth driver.
- Consider your human capital. As you age, your financial assets become more important. Wind back your equity exposure and increase fixed interest.
- Within equities, small stocks and value stocks perform differently to large stocks and growth stocks respectively. These add another layer of diversification and increase expected returns at the cost of higher risk.
- Within fixed interest, term and credit are the key drivers.
- The extent of global diversification is another decision. In equities, a level of home bias can be justified, but the concentrated nature of the local market means this bias should be limited.
- The extent of currency hedging is neither a return nor volatility decision, but comes down to individual preference. A 50-50 hedged-unhedged decision takes the issue of currencies off the table.
- Property increases diversification and has good historical returns.
- Costs and taxes are an important consideration across the board.
The final point is there no perfect asset allocation. Everyone has different needs and risk preferences.
But whatever you do, ensure the risks you take are related to return, keep an eye on costs and taxes and remember that, apart from diversification, there is no free lunch.
Bhanu Singh is a portfolio manager at Dimensional Fund Advisors.
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