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Why high-net worth investors need to rethink their asset allocation Add to ...

Summer is usually a time to relax and recharge the batteries. This summer, while you’re on the beach or at the cottage, I encourage you to use the downtime to reconsider a topic vitally important to your long-term financial health: your current, as well as “go forward” strategic asset allocation. You will find numerous studies about how your asset allocation drives 80 per cent to 90 per cent of your long-term returns, so it’s important to really think about yours.

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We receive asset allocation reports from dozens of major managers on a fairly regular basis. I’ve also had the pleasure of attending three separate meetings with one of the world’s top-rated and largest fixed income managers over the past month, as part of a regular schedule of learning sessions for Tiger 21 members. What I heard was nothing less than a wake-up call on asset allocation, on a “look ahead” basis.

I asked these managers a point-blank question: what kind of total returns including income/coupons are you telling your pension fund clients to expect on fixed-income portfolios over the next five years? Their answer: 0 per cent to 2 per cent returns on index-like portfolios (i.e., portfolios that aren’t actively managed). If they’re lucky.

This expectation of ultra-low returns has profound implications on asset allocations/projections. Based on what I see, those who continue to put their asset allocation on “autopilot” may be in for a very rough landing. That’s why I call it a wake up call. Many investors are not thinking nearly enough about the new reality – they are complacent, and they assume the old rules still apply. After a 30-plus year bull market in bonds, investors need to rethink their assumptions on the fixed income side of their portfolios.

Here are several things we’re currently doing with our high-net worth (HNW) client allocations.

Boosting equity and alternative exposure
The old saw in financial services was a 60/40 split between equities and fixed-income investments (primarily government bonds). Such an allocation represented the maximum amount of return for an ideal level of risk, and was the “go-to” allocation for 90 per cent of individuals 90 per cent of the time.

Over the past 30 years, this strategy would have done well. But going forward, this asset allocation model may be obsolete. Think about it: if 40 per cent of your portfolio in government bonds is earning 0-to 2 per cent a year, that contributes to 0-to .80 per cent for the portfolio as a whole, on a weighted return basis. That creates a significant burden on the rest of your portfolio simply to keep up with inflation, much less build wealth.

Going forward over the next 3 years or so, we’re recommending a more strategic 40/30/30 asset mix between long equities/fixed income (long and short credit strategies)/alternative investments (authentic hedge funds) as a more viable allocation for most of our HNW investors, those with lower return expectations. Investors with longer investment time frames may want an even higher equity allocation.

Thinking beyond government bonds
Speaking of bonds, now is a good idea to further diversify your bond portfolio. We’ve been investing in investment-grade corporates and high-yield bonds for some time now. Geographic diversification is also a good idea: emerging markets may be less of a credit risk than developed markets these days. With all bonds, we’re reducing duration to minimize interest rate risk. We expect rates/yields will rise at some point.

Putting “alternative strategies” in the portfolio
This is about putting more tools in your portfolio toolbox, which is always a good idea. I’m thinking particularly of “long-short” managers here, both on the equity and the fixed-income side. The idea being that in a range-bound market, investors who can make money on the downside as well as the upside will be at an advantage. Alternatives also include some private global real estate holdings as well as infrastructure MLPs.

Raising U.S. exposure
Currently, Canadian investors have a tremendous overweight in Canadian equities and bonds, largely because of Canadians having a natural “home-bias”. We’ve been allocating more to U.S. markets over the past several quarters, in large part because of the growth potential we see in the U.S. from this point on.

Raising cash
We’ve taken the opportunity to raise cash – primarily U.S. dollars, given the very recent Canadian dollar strength this last few weeks. Mostly by trimming profitable positions and getting some “powder” ready. While core positions are being maintained, this is not a time to go “all in” on anything.

Considering global opportunities
It never ceases to amaze me how many HNW individuals I meet who remain almost exclusively focused on North American opportunities. Now, with Europe and North America tipping into or crawling out of a recession, it makes sense to broaden the geography of your portfolio. Some European/Asian markets are very cheap now; Japan too. Equities can make a lot of sense here, but global convertible bonds are another possibility.

Aiming for tax-efficiency/tax alpha
Tax efficiency or “tax alpha” can potentially add an extra 1.25 per cent– to – 1.5 per cent to your returns annually. In this low-return environment, the extra boost can make a tremendous difference. Now more than ever, it makes sense to investigate the tax efficiency of your portfolio, and take advantage of “Return of Capital” (or ROC) structures, corporate class investments, dividends, etc. And please, make sure you’re maximizing your RRSPs and TFSAs – they’re one of the last remaining legitimate tax shelters available to Canadians.

I want to be clear here: I’m not saying everyone will need to make a change to their strategic asset allocation. You could end up with 60/40 split between equities/fixed income, just because that’s where your risk tolerance is. What I am saying is you need to think more about the subject of asset allocation. If you just assume things will take care of themselves, you could be paying for it. Moving into the next five years and beyond, the “40 per cent fixed income” portion of the standard “60/40” asset mix will surely be a drag on future portfolio returns. Historically, bonds have been great, but they are highly unlikely from here on to produce meaningful returns.

Thane Stenner is founder of Stenner Investment Partners within Richardson GMP Ltd., as well as portfolio manager and director, wealth management. Thane is also Managing Director for TIGER 21 Canada. He is the bestselling author of ´True Wealth: an expert guide for high-net-worth individuals (and their advisors)’. www.stennerinvestmentpartners.com (Thane.Stenner@RichardsonGMP.com). The opinions expressed in this article are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Ltd. or its affiliates. Richardson GMP Limited, Member Canadian Investor Protection Fund.

 

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