MASECO’s Strategic Allocation

Equity Risk Premium

Dimson, Marsh and Staunton(1) have highlighted in their research on a number of occasions that investors in all developed countries have been compensated for taking equity market risk over a long period of time. Investors were compensated for taking equity risk in 2009. The S&P 500 appreciated 26.46% outperforming US Treasury Bills(2) which appreciated 0.09%. The MSCI World (ex-US) appreciated 35.35% outperforming US Treasury Bills by 35.26%.

Small Cap Premium

Fama and French discussed in their research of the ‘Three Factor Model’(3) that investors are compensated for taking small company and value risk. Investors were indeed compensated for taking small cap risk in 2009. In the US, small cap stocks(4) appreciated 39.07%, outperforming the S&P 500 by 12.61%. International small cap stocks appreciated 50.82% outperforming the MSCI World (ex-US) by 15.47%.

Value Premium

In the same paper, Fama and French also said that investors were compensated for taking value risk. 2009 was another year of underperformance for value in the US. The MSCI US Value Index appreciated only 19.18% compared to 26.46% for the S&P 500. For most of our investors, however, we were investing in an institutional asset class fund(5) which appreciated 31% as it deviates from the MSCI US Value Index in order to achieve a true value tilt (excludes utilities, REITs and some other traditional value stocks). Outside of the US, the MSCI World (ex-US) Value Index appreciated 38.33% marginally outperforming MSCI World (ex-US) by 2.98%.

Emerging Market Equity Risk Premium: +48.46%

MSCI started tracking equity returns in emerging market equities in 1988 and since then emerging markets have outperformed developed markets on a regular basis but with more risk. The IMF, in their annual research piece entitled ‘World Economic Outlook’, highlights the stock market capitalisation of different countries and their contribution to world GDP. Emerging markets contributed more than twice as much as the US to the world’s GDP, but their stock markets’ capitalisation is only about a quarter of the US. At the end of 2008, emerging markets represented 43.70% of the world’s GDP but only 10.90% of the world’s stock market capitalisation. Meanwhile the US represented only 21.30% of the world’s GDP but 43.40% of the world’s stock market capitalisation. Consequently we believe that emerging market equities are under-represented in most investors’ portfolios and that US equities are over-represented. MASECO’s strategic asset allocations are overweight emerging market equities. In 2009 the MSCI Emerging Market Index appreciated 78.29% compared to MSCI World which appreciated 29.83%.

Fixed Income Credit Premium (Investment Grade only): +21.08%

Investors are usually compensated over a long period of time for taking some credit risk when investing in bonds. Generally investors are not compensated for investing in bonds with significant credit risk (high yield bonds) as those bonds fluctuate significantly in price and the increase in return is not commensurate with the additional volatility. In general we would usually prefer to keep credit risk low in our bond allocation and take risk within our equity allocation. Investors were compensated for taking credit risk and we warned investors about risk in the Treasury markets in our Q1 Investment Quarterly when we wrote: ‘The largest bubble may currently be in US Treasuries. Yields are at their lowest level for 70 years, fearful of deflation and depression. The yield on the 30-year Treasury bond stands at 2.91% down from 4.35% in mid-November. If the 30-year Treasury bond yield rose back up to these levels its price would fall by almost 25%’ and prompted investors to switch into corporate bonds. Since the middle of January 2009, the price of the 30 year US Treasury bond has fallen by roughly 25% as yields have moved higher. During the year the Intermediate US Government Bond Index(6) fell 1.17% and the Intermediate Corporate Bond Index(7) appreciated 19.91%. Fixed income credit premium also appeared in most international bond markets.

Duration Risk Premium: -10.03% (8)

Investors are usually compensated over a long period of time for taking a small amount of duration (interest rate) risk when investing in bonds. Generally investors are not compensated for investing in bonds with very long maturities as those bonds fluctuate significantly in price and the increase in return is not commensurate with the additional volatility. In general we would usually prefer to keep duration risk low in our bond allocation and take risk within our equity allocation. In 2009 Investors were compensated more for spread compression than for rising intermediate rates. Long-Term US Government Bonds(9) fell by 8.89% while Short-Term US Government Bonds(10) appreciated by 1.14% over the year.

Straying from the Global Government Bond Indices: +17.27%

The major global government bond indices are all market cap weighted and consequently ‘invest’ in the most heavily indebted countries in the world. Investing in these bond indices would be the equivalent of investing approximately a third of a fixed income portfolio into dollar denominated US Treasury Bonds, a third into Japanese yen denominated Government Bonds (JGBs) and a third into euro denominated government bonds(11). We do not think that this is a sensible strategy as why would an investor want to lend their money to the most heavily indebted countries in the world? Consequently, we allocate this piece of a client’s portfolio to an active manager who seeks to invest in government bonds which may benefit from credit rating upgrades, currency appreciation and interest rate opportunities. In 2009, the Global Bond fund(12) NAV appreciated 19.17% outperforming the JPM Global Government Bond index which appreciated only 1.90%.

REITS: +26.97
Commodities: +26.45%

We include these two asset classes in a portfolio in an attempt to reduce portfolio volatility and maintain the real value of the portfolio. In general, real estate and commodities have not been highly correlated with most of the other components of a diversified portfolio but have provided investors with returns greater than inflation. In 2009, investors were compensated for diversifying into both REITs and Commodities. The Rogers International Commodity Index (RICI), which we invest in for the commodity portion of clients’ portfolios, was the best performing of the three major commodity indices in 2009. The RICI appreciated (26.45%) more than either the Goldman Sachs Commodity Index (22.90%) or the Dow Jones AIG Commodity Index (20.09%). In 2009 the unleveraged Global REIT fund we invest in for our clients was up 32.59% and the leveraged Global REIT fund appreciated (79.68%) compared with the NAREIT 50 Index which appreciated 26.97%.(13)

Asset Class Funds: Outperformed

Morningstar recently announced the introduction of a new ‘Box Score’ report analysing the performance of actively managed US equity mutual fund managers. Morningstar finds that 41% of actively managed funds outperformed their respective indices for the three year period ending June 30th 2009, using a measure of Jensen’s alpha. But Morningstar notes that ‘once the Fama/French factors are taken into account, active managers’ outperformance relative to the indices falls materially.’ By the latter measure, only 37% of managers outperformed, and average alpha was negative in all nine style categories.

S&P SPIVA’s report suggests this is also the case internationally. S&P reports that only 31% of US large cap core funds for the five-year period ending June 30th 2009 outperformed the S&P 500 Index. Results were even less favourable for non-US markets, where 13% of international funds and 10% of emerging markets funds outperformed their respective benchmarks. We often hear that non-US stock markets exhibit greater pricing errors than the US, supposedly offering a target-rich environment for clever stock pickers. The numbers suggest this is wishful thinking.

Fixed income markets were no less challenging: for the same five-year period, Standard & Poor’s found that 22% of intermediate government funds were outperformers, and the number dropped to 11% for high-yield bond funds and only 2% for mortgage-backed securities funds.

NOTES: All of the performance numbers quoted above are in US dollars unless otherwise stated. Also, not all clients have exactly the same portfolios or the same investment vehicles. Depending on a client’s risk appetite, time frame, implementation strategy, currency reference or other reasons, their portfolio may differ from our Strategic Allocation. That being said, all of our Strategic Allocations do tilt and slant as described above and would have benefited from the outperformance of many of these slants last year. It is also important to note that there are often times when some investment vehicles mentioned above are not recommended to clients. The main reason is usually because the investment vehicle described is not tax efficient or may be deemed unsuitable for a client and an alternative is used.

• Elroy Dimson, Paul Marsh and Mike Staunton (2002). Credit Suisse Global Investment Returns Sourcebook 2009 and Triumph of the Optimists, Princeton University Press.
• US Treasury Bills, DFA (2010).
• Fama, Eugene F.; French, Kenneth R. (1992) “The cross-section of expected stock returns” Journal of Finance.
• MSCI US Small Cap Index.
• DFA Tax-Managed US Marketwide Value Fund.
• Morningstar Intermediate US Government Bond Index.
• Morningstar Intermediate Corp Bond Index.
• US Fixed Income Market.
• Morningstar Long-Term US Government Bond Index.
• Morningstar Short-Term US Government Bond Index.
• JPM Global Government Bond Index.
• Templeton Global Bond Fund.
• DFA Global Real Estate Fund and ING Clarion Global Real Estate Fund.
• USD Benchmark Composition: Citi Treasury Benchmark 5 Yr, JPM Global GBI, MSCI AC World, S&P Global REIT, Morningstar Long-Only Commodity.
• GBP Benchmark Composition: Citi UK GBI (3-7 Yr), JPM GBI Global (ex-UK), UK FTSE All-Share, FTSE World, S&P Global REIT, Morningstar Long-Only Commodity.
• EUR Benchmark Composition: Citi WBIG Govt, JPM GBI Global, Euro Stoxx 50, FSTE World, S&P Global REIT, Morningstar Long-Only Commodity.