How best to ride the gloom and doom...

Now that most of the world is experiencing the effects of an economic contraction and considering that most of the more recent economic data are strongly suggesting that the recession will probably last beyond 2009, the question that comes to mind is how best to structure one's portfolio in order to most effectively ride the gloomy patch?

Taking a portfolio structured along three core asset classes (fixed income, equities and alternatives) and beginning with fixed income, my first suggestion would be to make sure that the exposure is diversified. This is in sharp contrast to last year's risk laden environment of "across the board" market corrections where the most effective strategy for fixed income turned out to be concentration in a single subset of the asset class, namely "treasury" type securities. The dramatic increase in risk averseness last year effectively punished all fixed income instruments outside those issued by governments. This means that today we observe spreads in other categories such as corporates, high yields and emerging market debt that are at levels comparable to those seen couple of years ago. Add to this that treasury type debt are probably not only overpriced (reflecting the acute risk averseness) but that we need to factor in all the additional supply that is likely to hit the markets in order to pay for the present and future "bailouts" and it quickly becomes clearer why maintaining a concentrated portfolio would be perceived as a highly risky proposition.
For equities a "sector rotation" approach is in order. Whereas a "defensive" play was most suitable for last year's "we are entering a recession" environment, and is probably still the case for at least part of this year, an eventual rotation back to "cyclicals" probably towards the end of the year would seem logical. Obviously this would depend on how the economy unfolds but we have to remember and factor in the "forward looking" nature of stock markets (a market rebound typically precedes that of the economy sometimes by several quarters).
As for alternatives, lots of caution would be advised in the hedge fund space. This is a segment that is likely to experience a high degree of consolidation as the less talented players are squeezed out, and as it becomes increasingly difficult for event the better ones to secure operating income. Private equity may also experience consolidation for similar reasons. The real estate market could, on the other hand, become attractive again, albeit in a highly selective way. Let us not forget commodities (a cyclical play) which should continue to provide excellent long term opportunities, especially after the huge correction.
Finally, we need to consider the aftermath repercussions of the stimulus plans that are being implemented pretty much across the globe. At this stage it is difficult to say whether they are potent enough to eventually trigger inflation. It will depend on many factors such as if the monetary authorities will react early enough or how much further housing prices need to drop before we reach a bottom. It is nevertheless prudent to provide some sort of hedge against the risk of both inflation and deflation. Exposure into such things as Treasury Inflation Protected Securities (TIPS) or gold (gold also being a good hedge against a weakening dollar) would help on the inflation side. Maintaining some exposure into treasuries would ensure at least some protection in the event of deflation.
One last word of advice would be to avoid looking too frequently at the markets, there is so much noise out there that it would serve no other purpose than to confuse and that is the last thing you need right now!

A hazy outlook...

The equity market hemorrhage, it seems, has spilled over into the new year with losses observed pretty much across the board. Sector wise, the hardest hit continues to be financials, followed by industrials as a distant second. Amongst the least affected are the traditional defensive sectors including healthcare and consumer staples but other cyclical sectors such as consumer discretionary are not too far behind! In other words sector rotation doesn't seem to be paying off in this instance as markets seem to be giving mixed signals about the extent and severity of the recession. In all fairness, the period (less than a month) is just too short to give a clear indication. If we add this years performances to those of last year, things look very different, with a clear demarcation between defensive and cyclical.

                                    

What about the bailout scheme? With the amount of money that has been pumped into the system we should be anticipating an eventual rebound, and the "forward looking" nature of the stock market should make it amongst the frontrunners in signaling a change in the cycle. But nothing like that is happening, at least for now because the money that is being thrown to banks is not it seems being used for lending purposes but rather to improve their sickly balance sheets. The TED spread, or the spread between LIBOR and U.S. Treasuries, although having narrowed significantly since right after Lehman's bankruptcy still remains too high to factor in a recovery. Just as in previous cycles, the downturn was driven by a financial sector that lost control of the complex derivative instruments that it unleashed into the markets, and just like in previous recoveries, a change in the business cycle will take place once the banks find themselves in a more solid footing, financially speaking. We don't see that happening anytime soon as it requires that banks fix their balance sheet problem (forget earnings) which will take a tad more than just receiving money from the government. 

Managing bonds...

A couple of blogs back I mentioned that treasuries as a subset of the fixed income asset class was one of the rare investments to generate a positive return in 2008. With the crisis in full swing, correlations among asset classes shot up, dragging almost all investments into deep negative territory. The unprecedented rally in treasuries was a sort of a knee jerk reaction to the perception of greater risk in the markets. Panicked and distraught investors sought the safety of the federal government to protect what was left of their rapidly diminishing wealth.
As mentioned in our recent Review & Outlook publication, our fixed income strategy, which was implemented in mid 2007 involved overweighting treasuries and other government securities at the expense of others such as corporates, emerging market, high yield etc. This decision resulted from the observation at the time that spreads in other fixed income markets were just too tight to justify the "greater" risk. Corporate bonds, for example, although generating higher yields, were just not worth the additional risk. This strategy of ours remained pretty much intact throughout 2008, with the exception of a few minor changes such as shortening durations and reducing corporate bond exposure further.
As a result of this strategy, the fixed income segment of our portfolio generated a stellar total return of 7.7% for 2008. This return is adjusted for costs including currency hedging operations. With hindsight, the positive return provided yet another example of the importance of diversification, helping to absorb some of the losses in the other asset classes. It also showed how a sound strategy combined with a disciplined approach can pay off over time.
What we didn't really expect, however, was how much better our fixed income strategy performance would turn out to be when compared to a peer group. We tapped into Bloomberg's database to generate a peer group of funds with the same characteristics and constraints as our bond strategy. The filter generated a list of 8 funds by various institutions with performances that ranged from -5.94 to 4.62%. These results put our bond strategy performance at the 100 percentile, with a 308 basis points outperformance to the best performer in the peer group.
The results also highlights an important point that was made by El-Erian, CEO and Co-CIO of PIMCO, which was that 2008 has shown us that product selection may be as important, if not more important, then the weight attributed to the asset class. Food for thought!

What to expect in 2009?

Stabilizing the economy will be the main priority of government policy in the first half of 2009. Both monetary and fiscal tools will continue to be employed aiming at restoring a sense of normalcy. New and effective strategies will have to be devised to replace those such as interest rate policy that have run their course as the Fed takes on a more “activist” role. Jumpstarting the economy will also require careful maneuvering given the unprecedented and uncertain nature of the crisis. Irrespective of the attempts towards stabilization, certain key factors such as the decline in housing prices will need to show signs of bottoming out before improvements can be hoped for.
2009 will be a challenging year for government institutions as they sort out a strategy to deal with the structural changes in their balance sheets and the quasi nationalization of the banking sector (risk taking has effectively been transferred from the investment community to government institutions). They will have to keep a close eye and tackle further disruption in the system as the crisis spreads to other areas such as commercial mortgages, auto and credit card loans and sectors that have yet to manifest themselves.
Confidence having suffered the most during this downturn will take plenty of time to heal as the full extent of the damage becomes apparent and government policy works its way through the system. Although there is still a long way to go, there are signs that confidence may be returning as mortgage yields begin to decline and the TED spread narrows.
A global recession which begun last year is likely to last throughout this year and possibly beyond as households cut back on consumption and business postpone capital expenditures. On the other hand, 2009 could turn out to be a transformational year, as a new administration with a penchant towards increased regulation takes over the helm of the U.S. government. Regulation in itself should not be viewed negatively (we have certainly witnessed the effects of the opposite extreme) as long as it is carried out in a manner that doesn’t hinder productivity or growth.
In this context, with the combined effects of having all the “bad news” out in the open, signs of bottoming out for various key indicators, the prospects of a large stimulus package passing through and continued vigorous government attempts to turn things round, we may see a strong rebound in the stock market sometime towards the second half of the year. The vigorous attempts to jump start the economy will, however, bring new threats in the form of inflationary pressure which means that governments will have to be extra careful not to miss the early warning signs and react before it is too late.
We expect 2009 to be a challenging year but for different reasons than those that defined 2008.

and the winner is....

Back in early October I posted a blog in which I argued that treasury type securities had taken over the role of hedge funds as an asset class that was almost totally de-correlated from the rest of the market. I also remarked that it was still too early to jump to any conclusions given that there still remained roughly 3 months before the end of the year and that anything could happen until then. 

Well, here we are again, roughly a week before the year ends, to asses the performance of the various asset classes. The graph in this blog is more comprehensive as it includes a larger number of asset classes and other instruments (commodities and hedge funds are technically not considered to be asset classes).

My first observation would be to highlight treasuries that have produced the only positive performance for the year. All the remaining asset classes which include global stocks, commodities, global real estate and hedge funds have been overwhelmingly negative. Hedge funds have lost somewhat less than the other asset classes but still a whopping 25% of their value (an average figure) has vanished into thin air, making it one of the worst years in hedge fund history.

What is even more astonishing to note is that the performance of treasuries are almost a mirror image of hedge funds. A cursory glance would suggest that the correlation is almost perfectly negative although in reality hedge funds have lost significantly more than the amount that treasuries have gained!

Notice also how commodities have shed all the massive gains it had accumulated up until the middle of the year. The monumental losses have brought the performance of commodities in line with the worst performers in the list (stocks and real estate).

This has been a year full of surprises (I mean who would have thought that treasuries would have been hoarded and that commodities would have posted records both on the upside and downside?). One can be confident that the performance picture for next year will probably look very different from those of 2008!

A system-wide failure...

The investment profession has taken a significant setback over the past couple of months, losing practically all the credibility it had garnered over the years. One has to look no further than 10 year treasury yields (currently approaching a record low of 2%) or the spread between 3 month libor and 3 month treasuries (still at record levels) to get a feel of the extent of damage and distrust in the system. What is disturbing in the current environment is not only the sheer monetary scale of losses involved but also its scope. Never mind that Madoff, a master illusionist successfully conned a large number of investors (including banks) for years when the whole financial system itself resembles a giant ponzi scheme. From the unscrupulous lenders who began selling mortgages to individuals that could ill afford them, to the banks that repackaged those same mortgages into so called "quality" tranches before dumping them on unsuspecting investors, to the rating agencies that issued bogus ratings on products that they did not even understand, to Greenspan, the "oracle" that did everything in his power to suppress any form of regulation, particularly with regards to the over the counter derivatives market, to Chief Executives at major banks that continued to claim that everything was under control when the truth was otherwise and to the SEC that preferred to ignore credible warning signs regarding Madoff.

The whole system it seems was rife with incompetence, greed, deceptiveness and other unethical behavior. No wonder then that confidence has sunk to record lows and shows complete indifference to the incessant government actions and pledges to fix the problem. It will take a lot more than plain rhetoric to restore trust that is so critical to the proper functioning of an economy.

More gloom and doom before the boom?

Taking a casual look at a few key indicators suggests that we should be embracing for further market turmoil in the coming year.The credit crunch which sprouted amid a severe housing recession shows no signs of abating despite significant efforts by policymakers to reassure investors that the crisis is "under control". Confidence is far from being restored and as a result, businesses and households are having trouble obtaining credit (just when they need it most) which means that we can expect large cutbacks on investments and consumption respectively, contributing in worsening the recession.
Both the 2 year breakeven spread (which measures the differential between 2 year nominal treasury yields and that of inflation protected securities) and the freefall in commodity prices corroborate with the expectations of a deepening recession through a deflationary cycle that is likely to dominate over the next two years.
If we add to this the loss in effectiveness of the Federal Reserve's key monetary policy tool (the result of a liquidity trap that forms as nominal interest rates approach 0 percent) and a Tobin's Q ratio (a well known ratio that compares the market value of a firm to that of its replacement or book value), signaling further downside for global stock markets, there frankly is not much out there to cheer about.
But then again, the forecasting profession is more notorious for having a dismal track record which means that the extreme bearishness that is being suggested at present may be nothing more than a giant smokescreen.

To rebalance or not to rebalance?

Rebalancing a portfolio (bringing the asset class weights to or close to their neutral weights) serves two essential purposes:
1. Preserving the defined risk profile of the portfolio over time
2. Increasing the probability of locking in market related performance gains by cashing in on outperforming investments (reducing the impact of a subsequent selloff in the investment) and buying more of underperforming investments (enabling the portfolio to capture greater returns from a subsequent rebound).
Rebalancing, together with diversification are amongst the core pillars of modern portfolio theory.
There is a caveat, however, that should be regarded carefully by those that employ rebalancing techniques when managing portfolios. It is that the effectiveness of rebalancing techniques depend largely on market conditions. In periods of market turmoil, rebalancing can prove to be counterproductive. Just like in the event of an earthquake, we are less likely to go about our daily chores, rebalancing is not necessarily the right thing to when market conditions are extraordinary.
The best way to illustrate this would be by taking an example of a "balanced" risk profile portfolio with an even split exposure to equities and bonds. Say, for example, that $1000 dollars is invested into equities and the remaining $1000 into bonds for a total portfolio value of
$2000 at the beginning of the year. Suppose that a financial crisis occurs and that by mid year, equities are down 30% whilst bonds remain flat (I know, its not very difficult to imagine such things these days). The portfolio value will be as follows:
Equities: $700
Bonds: $1000
Total: $1700
Suppose that right after the drop, the portfolio manager decides to rebalance with a final result of:
Equities: $850
Bonds: $850
Total: $1700
Suppose, also, that for the rest of the year, equity markets drop another 30% and bonds remain at the same level. Our portfolio at the end of the year will look as follows:
Equities: $595
Bonds: $850
Total: $1445
Now suppose that the manager did not rebalance at any time during the year. Our portfolio would end up as follows:
Equities: $490
Bonds: $1000
Total: $1490

We find ourselves with a portfolio that has a smaller exposure into equities but also with a better performance relative to the rebalanced portfolio. The non rebalanced portfolio total value stands at $1490 versus $1445 for the rebalanced portfolio. The difference (3.11%) may not seem like much but that is mainly becuase the total portfolio value is small!

Although this example illustrates the performance advantage of not rebalancing when markets are in turmoil (such as what we are experiencing at present), what it doesn’t show us as clearly is the increased risk of shifting the risk profile that not rebalancing results in. It is easy to imagine what would happen to the performances of the two portfolio examples in the event of a subsequent market rebound of similar scale to that of the drop.

Moral of the story: Rebalancing doesnt work well in times of extreme volatility but you have to weigh in the increased probability of a shift in risk profile if you decide to ignore rebalancing.