April 13, 2015

Your asset allocation guide – April 2015

Knowing when to reduce the proportion of equities in a portfolio and when to increase exposure to other asset classes like property, cash and bonds, can be part science and part art. Valuations, fundamentals and sentiment all play a role.

Decisions to change asset allocation weightings are not always easy. Knowing when to reduce the proportion of equities in a portfolio and when to increase exposure to other asset classes such as property, cash and bonds, can be part science and part art.

To help with these decisions, it’s useful to consider three factors that apply to asset classes: valuations, fundamentals and sentiment.

Valuations: Are valuations in share, bond and property markets supportive or are prices trading above fair value?

Fundamentals: What are the current fundamentals of the asset class? For example, are corporate earnings growing strongly, are balance sheets in good shape, are credit defaults rising, is inflation under control, how large are rental vacancies?

Sentiment: Is investor sentiment supportive towards the asset class, is it weak or overly exuberant? For example if the proverbial shoe shine boy is handing out stock tips, it’s probably time to get out of the share market

Currently, most asset classes are displaying reasonable fundamentals. Governments are mostly in the process of reducing debt, corporate balance sheets are in good shape, earnings are growing modestly and rents are rising slowly in the property market. Sentiment is also generally good across most asset classes, investors are comfortable buying riskier growth assets and even bonds at zero interest rates, Initial Public Offers (IPOs) and corporate bond issues are being well supported. There is also significant investor demand for commercial property.

The valuation question is less clear cut. On the one hand, valuations appear expensive when compared with history, but reasonable when compared against the backdrop of near zero interest rates. So overall, there are no compelling reasons to change asset allocations this month.

Our asset allocation summary:

  • Cash: Hold an overweight position in cash to be able to take advantage of new opportunities when they arise, for example, a selloff in equities. We suggest shorter maturity term deposits over at call cash.
  • Fixed income: We suggest an overweight position. Developed world government bonds are very expensive and offer poor absolute value, so prefer products with limited interest rate risk. We suggest an equal split between Australian and (hedged) international bonds. Tactical income, absolute return fixed income strategies, floating rate corporate securities and short duration fixed income are all preferred over benchmark aware bond strategies.
  • Australian equities:Remain underweight. Growth outlook is lower than other markets and valuations are above fair value. Favour selected industrials (that is, offshore earners). Hold positions in quality smaller companies but do not add.
  • International equities: Given higher valuations in developed market shares, hold a neutral weighting. Maintain unhedged currency exposure. Emerging markets are cheaper than developed markets so maintain exposure.
  • Alternatives: Maintain a neutral allocation until opportunities emerge. Alternatives represent an important part of an overall strategy of building allocations to assets with a low/moderate correlation to equities.
  • Property: Hold a neutral allocation to commercial property. Demand for core property is robust as larger investors seek to buy real assets with attractive rental yields. At current pricing, Australian and international property appears fair value.

For further analysis, download the full report: