November 12, 2014

Your asset allocation guide – November 2014

While equity valuation measures imply US shares are about 60% overvalued versus long-term averages, returns could be as low at 0.2% per annum if valuations return to long-term averages. Therefore, as Nick Ryder explains, there’s a need to find additional sources of portfolio returns.

Equity valuation measures, such as Professor Robert Shiller’s Cyclically-Adjusted Price Earnings (CAPE) ratio, currently imply US shares are about 60% overvalued versus long-term averages. However, if the CAPE did return to long-term averages, US share returns could be as low as 0.2% per annum.

It’s a similar story for bonds, where the yield on 10-year US government bonds is only 2.4% per annum. Based on long-term averages, returns on a simple portfolio comprising 60% shares and 40% bonds doesn’t look attractive – particularly before the impact of fees, taxes and inflation.

Of course, Shiller’s CAPE is just one equity valuation measure and ignores the fact that revenue and earnings growth in the US remains relatively robust. It also fails to take into account the fact that short term interest rates are near zero, which is likely not reflected in long-term measures.

However, what this tool does highlight is the need to find additional sources of portfolio returns – especially since future returns from conventional assets, like shares and bonds, are expected to be lower.

So where does an investor turn to boost portfolio returns over long-term averages?

Investors can start with features such as fund manager skill or their manager’s ability to select stocks that will outperform broad equity markets. Credit returns from funding companies, as opposed to funding governments, can also improve expected portfolio returns. Other options include currency exposures, unlisted commercial property exposures and hedge fund strategies that invest in distressed debt, futures and so on.

The other way to boost returns is to correctly time different markets by underweighting and overweighting equities, cash, bonds and property in a portfolio. However, opportunities to reposition within asset classes are more common as themes, sectors and countries fall in and out of favour with more regularity.

Our asset allocation summary:

  • Cash: Hold a slight overweight position until better opportunities emerge. We suggest term deposits out to two years are preferred over at call cash.
  • Fixed income: We suggest an overweight position and an equal split between Australian and (hedged) international bonds. Developed world government bonds are expensive, so prefer products with limited interest rate risk. 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 remains lower than other markets. Favour selected industrials (I.e. offshore earners).
  • International equities: Given higher valuations in developed market shares, hold a neutral weighting. Maintain unhedged currency exposure. Emerging markets are relatively cheap so direct or indirect exposure is recommended.
  • Alternatives: Maintain a neutral allocation until opportunities emerge. Alternatives represent important diversifiers and as 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 and rental growth fundamentals should improve. At current pricing, Australian and international property appears fair value.

For further analysis, download the full report: