Financial Thinking

Corporate governance received a lot of attention during the scandals that followed the tech wreck, specifically Enron, Worldcom and Tyco. Who was supervising these corporations? Where were the checks and balances for the corporate executives? The theory is that a board of directors is elected to represent shareholders, to support and challenge the CEO and to take ultimate responsibility for everything that happens in the company.

In practice, boards of directors have varying compositions and effectiveness. They don’t all see their role in the same way. Because each company is unique, every board needs to determine what role it should play and how it can best support the company. The most important role, that every board has in common, is to bring a long term perspective to management, who might otherwise focus solely on short-term actions and results.

A board is made up of directors who are selected by the shareholders and the existing board members, often with advice and support from the CEO. Some CEOs will set up a board that can act as a sounding board, listening to ideas and strategy in order to offer constructive advice and criticism. The CEO can benefit from feedback in order to consider all aspects and better match his plans to the needs of the company. Some boards are constructed as a network, composed of directors who are CEOs of other companies or representatives of key suppliers, clients and partners. In this way, the CEO has direct access to a network of people who can help to implement the company’s strategy.

A board of directors may include, or be composed entirely of, representatives of shareholders. This seems to happen especially with institutional ownership. For example, a mutual fund or, more likely, a pension fund will put forward candidates for directorship in order to have input and feedback on efforts to make a company more profitable. This is one way that a fund can have more control over investment outcomes. Boards often ensure that directors are shareholders by requiring them to buy stock in the company, but in some cases it is merely a token gesture. In the case of a proxy battle, however, large and influential shareholders can sometimes get an entire slate of directors accepted by shareholders.

The policy board seems to be very common. One of the difficulties that corporations sometimes experience is when a strong board tries to compensate for a weak CEO by meddling in management. Governance does not mean managing the company, it means supporting, helping and challenging the CEO, helping her to perform to her full capacity on behalf of owners. A policy board will formalize this distinction by clarifying desired outcomes, setting boundaries outside of which the CEO must not act, then leaving the CEO free to use her creativity and initiative to produce the outcomes.

While a policy board clearly delineates responsibility, it leaves the board at the mercy of the CEO for gathering information. The CEO may become a filter that only allows certain information and a particular perspective to bubble up to the board. Without meddling in management, a board needs to be curious and energetic, encouraged to “walk the shop floor” to gather insight and be able to help the CEO identify positive and negative situations and trends.

Corporate governance comes in many flavours. There isn’t a single right way to implement good governance, but the purpose of a board is to understand the corporations’ strengths and weakness, have insight on the environment within which it operates, and use this perspective to support and challenge the CEO to function optimally on behalf of owners.

Tactical asset allocation is less straightforward than strategic asset allocation. Instead of choosing target (strategic) levels for different asset classes within a portfolio, tactical asset allocation looks to alter the asset mix based on the current economic environment. There are a number of factors that produce a variety of approaches.

It is well known that markets move in waves. As an example, stocks seem to grow (and recede) in fits and starts. Bonds, too, have good years and bad years. This shouldn’t be surprising, since the human brain seems to be wired to identify trends. Investors make decisions based on the trends they see and magnify the effect. It makes sense that, if a person is attuned enough to spot the good and bad markets, they could allocate their funds to the more profitable asset.

The efficient market hypothesis (which may be on its last legs, following the 2008 market meltdown) would characterize it as impossible to time the market. That would be true if markets instantaneously adapted to new information. But not only to they react over time, they tend to overshoot. Because of the momentum of the market, it’s theoretically possible to get in front of a wave.

It remains extremely difficult to predict the beginning or end of a wave, market minimums and maximums. Any experienced value investor can relate an anecdote of cheap stocks getting cheaper. The same difficulty applies to entire markets. The stock market appears cheap. Will it get cheaper or will valuations rise? Bonds appear expensive, with yields that are low relative to the past 10 years. Will yields rise and prices fall? The questions are rhetorical because the timing of a change in momentum is unpredictable.

When tactical asset allocation is left up to an investment manager, usually at a pension fund or a mutual fund, they look at macroeconomic indicators, relative value and investor sentiment. (Unless they are superstitious and use technical analysis.) They apply their knowledge, their experience and their discipline to make a call. Generally, however, they don’t want to stray too far from the benchmark. If they’re wrong, they impose opportunity cost on the fund, in addition to the trading and tax costs that come from increased transactions. Most funds have flexibility to move up to 15% from the strategic asset allocation, but in practice this level is rarely reached.

Almost all tactical asset allocation mutual funds under perform their benchmark. But that doesn’t debunk the strategy, only the way it’s implemented by these mutual funds. I apply tactical asset allocation very differently. First, I use a relative strength formula. This system removes the guesswork and my own imperfect judgement. Because I invest in individual stocks, for income, I don’t use this approach in all my accounts. But within my non-taxable accounts, I invest 100% in a single asset class (index ETF). When the momentum of another asset class overtakes the one I own, I switch 100%. Because portfolio performance is augmented by asset class outperformance less costs, I want to capture all outperformance while minimizing trades. This all-or-nothing approach is markedly different from a mutual fund, where the trading costs (in practice) seem to outweigh any outperformance captured.

Tactical asset allocation is simple, but it’s not easy. Human nature causes us to want to be active at the wrong times, buying something that’s popular and selling after an investment has shown to be a dud (buy high, sell low). Tactical asset allocation requires a system that removes the emotion and simplifies the buy and sell signals. Because of the increased activity, the outperformance must outweigh the costs. In order to make bold trades, confidence must be very high.

Last week, I wrote about asset allocation. By far the most common approach is strategic asset allocation. By definition, this is the long-term strategy. How much of a portfolio should the investor allocation to cash, stock and bonds?

Much research has shown that most of the level of return is determined by the choice of asset allocation. The same is true of volatility (which I don’t believe approximates risk). If I choose all stocks, I’ll have stock-like returns (probably higher over a long period of time), whereas if I choose all bonds, I’ll have bond-like returns (probably lower, but more likely to be positive over the short and medium term). If I mix stocks and bonds, my portfolio will act partially like a stock and partially like a bond. This is neither difficult nor surprising.

The only reason to keep cash is to be able to take advantage of buying opportunities or to be able to produce income. Otherwise, cash will only reduce the portfolio return. In the two rare cases where cash might be valuable, it would probably not be best. If people lose faith in the financial system, you’d be better off owning gold (or canned food and a gun). In the case of deflation, you’d probably be better off owning government bonds.

The true decision then is between stocks and bonds. I can think of two reasons to own bonds, either if you require guarantees (like large pension funds) or if you have enough capital that you can afford the lower income bonds (currently) provide. Suppose you have $1 million, but only want $30,000 per year income. Why risk your capital investing in stocks, when you can produce your required income from bonds? In a very large portfolio, an investor may choose to have a certain amount of guaranteed income, perhaps $2000 or $3000 just to cover the very basic lifestyle costs. The rest could come from stocks, but at least if anything went wrong, the bond portion of the portfolio would continue to provide income.

Stocks provide dividend income and long-term capital gains. This combination produces (over a long enough timeframe) higher returns than cash or bonds. Because of my young age and the likelihood that I’ll return to work at some point, I prefer to keep my portfolio 100% in equity. This means I experience the ups and downs of the stock market, but I also earn the returns.

Let’s use an example of a portfolio that is balanced 60% stocks, 35% bonds, 5% cash. Over the course of time, stocks and bonds will perform better or worse. This leads to opportunities to rebalance. Rebalancing will actually reduce returns by selling winners as they continue to grow, while buying losers that are languishing. However, it imposes rigour by helping to buy low and sell high. For someone who is undisciplined, it might produce a sub-optimal return, but a far better return than what they would achieve by jumping in and out of the market.

I don’t believe that there’s much point to strategic asset allocation. I also believe that rebalance produces sub-optimal returns. That’s why I spend more time on tactical asset allocation, which I’ll explore next time.

This is the first in a three-part series about asset allocation. Today, I’ll grapple with what asset allocation is, how it works and why anyone would use it. Next week, I’ll discuss strategic asset allocation in more depth. Finally, I’ll tackle tactical asset allocation.

What is it?

Asset allocation, in its simplest form, means dividing a portfolio between different asset classes. Asset classes are meant to be investments that perform differently. Technically, an asset class should have a negative correlation (one zigs when the other zags) in order to complement each other. Initially, savers saved cash, investors bought bonds and speculators played stocks. Each of those categories are considered asset classes. Over time, investors realized that stocks aren’t purely speculative, and have added them to their portfolio. Investment managers, whether to add spice to their portfolios, or to offer the appearance of sophistication, have multiplied the number of categories of stocks and bonds that are considered unique asset classes. Some examples are: government bonds, emerging market bonds, corporate bonds, high-yield bonds; dividend stocks, growth stocks, value stocks, large cap stocks, small cap stocks, emerging market stocks, and probably others. Beyond these categories, commodities and real estate may be realistically considered additional asset classes.

How it works

Asset allocation, then, is choosing which classes of assets will be included in the portfolio. Different asset classes have different characteristics and are used to meet different needs. Bonds provide income, as well as guaranteed return of capital. They should be used for investors who need income or who want guarantees. Stocks may provide some income, as well as capital growth. They are suitable for investors who want growth and who have a longer time horizon. Cash is not an investment, and is only suitable for bridging short gaps in income or for making future investment purchases. Real estate is useful for current income, as well as a hedge against inflation. Commodities provide a hedge against inflation. Depending on the goals of the portfolio, then, asset classes should be chosen that reflect those needs. For example, a portfolio that is intended to produce income that keeps pace with inflation would likely invest in some bonds, dividend-paying stocks, real estate and possibly a small amount of commodities.

Why use asset allocation?

Besides matching portfolio characteristics to goals, pension funds and investment funds use asset allocation as a method of diversification to smooth investment returns. For example, given that stocks zig when bonds zag, owning 50% stocks and 50% bonds would create a portfolio that is less likely to experience wild swings in value than a portfolio that is 100% stocks with no bonds. Further, if an investment manager equates risk with volatility, he will tell you that he has reduced risk. Increasing the allocation to bonds (guarantees) will always reduce risk, but not because volatility is reduced. As an example, in a portfolio that is 100% bonds, increasing the allocation to stocks from 0% to 5% may reduce volatility (due to negative correlation), but it has reduced guarantees and increased the possibility of loss of capital.

Asset allocation is an accepted part of portfolio construction. However, because my goals include high income and the potential for capital gains, I have allocated 100% of my portfolio to equities (much of which represents real estate). I don’t mind big swings in value, because fluctuations don’t affect my income. I would only buy bonds if I needed guarantees, or if I had more money than I need for my stock portfolio.