As I write this article, summer is blazing and half the world is on vacation. The financial markets, meanwhile, are swinging like pendulums. Another day, another 300 points on or off the Dow, which seems to be climbing back from the abyss. For now.
In spring the real estate crisis moved in for good and the headlines took on an apocalyptic cast. In June the stock market, which had been gradually declining, went into free fall. Skyrocketing oil prices were one factor. Staggering losses by banks and the freeze-up of the credit markets were another. Escalating grocery bills didn't help. "It feels like there was a switch that occurred overnight; we went from one regime to another," says Mohamed El-Erian, co-CEO of PIMCO. The markets flipped from optimism to pessimism, plenty to scarcity, liquidity to de-leveraging, disinflation to inflation, stable asset prices to volatility. "The reality is that there's been a number of changes that have been going on for a while. They reached a critical mass and then started interacting with one another, and the dynamics became nonlinear," El-Erian says. The financial innovations that had propped up a whole highly levered world went down like dominoes, and the party they underwrote-the houses, the buyouts, the hedge fund fees-was over.
As you read this article, you've probably finished your summer break. Now you can't escape the fact that the capital markets have shifted, and continue to do so. When the cleanup is over, we'll be in a new New Economy, and unlike the New Economy of the 1990s, this one doesn't promise to grow to the stars. We're hamstrung by debt, as a nation, as a financial system and as individuals, and we'll need to devote time, resources and creativity to digging out. At the same time, the rest of the world's economies will be giving ours a run for its money. "There are some fundamental tenets of good investing that won't change-develop a plan, stick with the plan, make it dispassionate and unrelated to current market events," says George Gatch, president and CEO of JPMorgan Funds Management. "But there is a fundamental change, which is we've entered a different era in terms of expectations for returns of traditional asset classes."
Your clients will need you all the more, to build and preserve wealth; you'll owe them discipline and foresight. "Our job is to make sure the client has no problem if something's going down," observes Harold Evensky, chairman of Evensky & Katz in Coral Gables, Fla. "The silver lining of these times is that many of us are refocusing on what we're all about."
The Next Normal
You could say that we're on the road to the next normal. At a certain point the financial markets will stabilize, and when they do, they will most likely look quite different.
"Some of the things we have taken for granted as the way things are may not be the way things will be," points out Dennis Stattman, manager of the $29 billion BlackRock Global Asset Allocation Fund. "The one that's really becoming apparent is access to cheap oil. That has become the minute-to-minute focus of the stock market at this point, because people have come to realize that expensive oil is here to stay."
Expensive oil on its own would be inflationary, but not disruptive. "The degree to which it's expensive is what we don't know," Stattman continues. "It's going to be harder for us than for some of the other developed economies. Forty years ago we were the world's largest oil producer and so when energy got expensive in the 1970s, a heck of a lot of the wealth transfer that occurred was from the nonproducing states to the producing states. This time it's a more pronounced transfer from the U.S. to the oil-producing nations."
Growth and wealth have dispersed to other countries, and in many ways that's a good thing. "The world has become over- reliant on the U.S. as the engine of growth and of consumption," El-Erian says. "Think of the image of a plane in flight. The world could be imagined as a plane with one engine: the U.S. consumer, who is exhausted. The plane hits an air pocket. There's a bumpy transition and the plane loses altitude. In the plane, it feels awful." But you're still in the air. And new engines-that is, new markets-are coming online to provide lift for everyone.
Will the new normal require new rules? If anything, it will force planners to hew even more rigorously to the old ones: diversify, globalize, watch the downside, minimize expenses. Here's how market leaders are thinking about these disciplines today.
Diversify...Farther
Most portfolio strategists will argue that today, the traditional 60/40 equity and fixed-income portfolio is incomplete. "In 1997, JPMorgan Private Bank essentially invested in four asset classes on behalf of its clients: cash, bonds, U.S. stocks, international stocks. Today, the allocation is 21 separate asset classes," Gatch says.
Adding fuel to the fire for new, noncorrelated assets is the fact that domestic stocks have underperformed for so long. "From July 31, 2000 to the end of July this year, if you simply held the S&P 500 you only made 1.7% annualized—if you reinvested your dividends," says David C. Reilly, director of portfolio strategy at Rydex. In other words, he says, the asset most investors count on to provide long-term appreciation and beat inflation has spent most of the decade as dead money.
That might be an invitation to dive into equities. But it's also no surprise that asset allocators have added alternatives to the mix, including commodities, real estate, perhaps currency. "In terms of a portfolio, there are two reasons to add alternatives, says Peng Chen, president and chief investment officer of Ibbotson Associates in Chicago. "First is if those portfolios give you added exposure to areas traditional stocks and bonds don't cover—merger arbitrage, currency or commodities. The second reason is to add alpha, which is pretty expensive and hard to identify and manage."
Chen suggests seeking out alternative beta-pure market exposure via index funds, ETFs and ETNs. Products, both active and passive, are multiplying. Alternative instruments have become so plentiful that in August, Morningstar announced that it would start covering alternatives as an asset class, along with domestic stock, international stock, taxable bond, municipal bond and balanced. It's easier to diversify than ever.
The active management menu is also expanding, as funds of alternative funds enter the retail space. "We offer a mix of satellite asset classes and alternative strategies which have been difficult for investors to get their arms around," says Douglas Beck, managing director at DWS Investments. DWS's year old AAA+ Fund includes global REITs and emerging markets securities along with more traditional commodities like precious metals.
In his book, When Markets Collide, El-Erian printed his own asset allocation: 42% stocks (15 percentage points in U.S. equities, 15 in other advanced economies and 12 in emerging markets); 7% private equity; 14% bonds (5 percentage points domestic, 9 international); 27% in real assets (6 points in real estate, 11 in commodities, 5 in inflation-protected bonds, 5 in infrastructure) and 8% in what he terms special opportunities—which could be speculative plays such as distressed debt or long-term, high-concept gambles like carbon credits. El-Erian still stands by this allocation, with two adjustments. Because commodities are more expensive than when he wrote the book, he would fill that category gradually: "There's a long-term case, but you want to leg into the trade," he says. And if private equity is out of the question, he continues, just redistribute that portion of the portfolio among the other asset classes.
Globalize...More
Every portfolio is global today, just because that's how business is done. So the real question is not whether your clients should have international investments, but how much and what kind. "We have believed for a long time that it is very important for U.S. investors to have a significant amount of international diversification," Stattman says. "Unfortunately, the terms of trade are less good than a few years ago. So if clients don't have international assets already they're going to have to bite the bullet a little bit."
There are still some bargains to be had, Stattman says. The dollar doesn't buy a lot in Europe now, but it still buys a good bit in Japan and Asia. He also likes emerging markets, particularly Brazil and India. Nevertheless, Reilly argues, "international equities are a good diversifier, but they are still stocks; and the correlation between international and domestic equities is going up and up over time."
Cover the Downside...Thoroughly
If there were ever a time to crave portfolio insurance, this is it. Absent that, it helps to stay liquid. "Have enough cash that you're not a forced seller," advises El-Erian. If your clients are approaching or are in retirement, this becomes crucial.
Another way to cover the downside is through hedging, and various asset managers are introducing hedged products for the individual investor. JPMorgan's Gatch views market-neutral and long-short funds as the technological response to volatility; he also favors TIPs, or, for taxable porfolios, his company's Tax Aware Real Return fund, a high quality portfolio of municipal bonds that hedges inflation with a CPI swap.
Watch Costs...Vigilantly
In 2002, Harold Evensky won the Journal of Financial Planning's Call for Papers competition with a paper that demonstrated that the risk premium for equities, which had been so outsized in the 90s, was going to be much smaller going forward, and that wealth managers should be revisiting their strategies with the intention, among other things, to minimize the drag of taxes and fees. After completing his research, he says, "we concluded that our net return was going to be roughly 2.5%. If we could save 0.5% for clients, it would make a huge difference." Evensky moved his clients' portfolios to low-cost passive investments in an effort to find that 0.5%. "It turned out that was the only return we had," he continues. "Almost everyone I talk to agrees that returns are going to be lower, but no one is changing their portfolios to account for that. I don't understand it."
What Evensky learned from his study was "control things you can control, such as taxes and expenses," he says. "From a marketing standpoint, its boring and the pits. People have a preference for active management because it's a better story. But our job is to develop a policy on allocation; then, to implement it. In most areas in domestic equity, passive wins. Everything we look at says it's the right way to do it."
Evensky's core is roughly 80% of his portfolios, and is divvied up among ETFs and index funds on the equity side, TIPs and global bonds in fixed income. Roughly 30% of the equity allocation is international. "To the extent we're doing anything different, it's in the satellite portion of the portfolio," he says.We have PIMCO developing money market, 120/20s, 130/30s, Rydex short 30 Treasuries. That's where our bets are, but they stay small."
Taken together, Evensky's bets, like those of the active managers interviewed here, map the new global, hedged investment marketplace. But that's normal—now.
