Asset Allocation Outlook 2017

1. Roger Beutler, CAIA rogerbeutler@yahoo.com 858-205-4244
Asset Allocation Outlook 2017
Asset Allocations to Meet Your Spending Needs
Back in 1985, a 5% nominal return was easy to achieve, after all, the
Fed Funds Rate was plus 8%. Even asset allocations of
sophisticated investors looked simple. For example, the target asset
allocation of the Yale Endowment in 1985 was 65% U.S. Equity, 15%
U.S. Bonds, 10% Foreign Equity and 10% Real Assets
1
. The times
sure have changed as investors increasingly struggle to meet their
long term spending needs. While the lower future return environment
hits all investors, a case could be made that individual investors face
a bigger challenge as higher returning investments often are not as
easily accessible to them. Asset allocations for all investors have
certainly changed over the last decades, often adding more illiquid
strategies in an effort to meet return targets. Foundations with a
required distribution rate of 5% often end up targeting an expected
return of 7-8%. The accompanying risk as measured by standard
deviation, is more often than not a fallout of the required return target.
While simpler allocations were easily able to achieve required return
targets in the past, portfolios have become increasingly complex.
Today, a portfolio allocated 60% to global equity and 40% to global
fixed income is expected to return 5.2%
2
, just barely enough to meet
the minimum required distribution rate. Returns since the global
financial crisis “(GFC)” have been impressive, especially for U.S.
equity investors. However, these returns came off a lower base and
valuations have become increasingly rich in public as well as in
private markets. The U.S. economy has extended its expansion
streak to over 90 months, the 3rd longest since the early 1900 and
almost double the average at 47 months.
3
“In 2017 and beyond, we believe investors will need to do
more than simply rely on passive market exposures.”
PIMCO, Asset Allocation Outlook 2017
Redefinition of Risk
Investors have many ways to define and measure the risks in their
portfolios. At the total fund level, the often used standard deviation is
useful but only to a certain degree. Knowing your exposure to
sectors, industries or tenants of your core real estate portfolio help
shaping the risk picture and ask the right questions. But what is the
real risk for investors today? It’s not the next market crash. As the
GFC showed, even the best models fall apart during severe market
stress and tail risk remains very real. The biggest risk for foundations
and endowments, not unlike individual investors saving for retirement,
is the shortfall risk. The risk of not being able to meet your spending
needs or worse, start eroding your principal and ultimately running
out of money or being forced to significantly reduce your spending.
1
2002 The Yale Endowment Report.
2
Expected return based on a 60% equity allocation (54% US, 11% EM, 35% global
developed), 40% global fixed income allocation (40% US, 60% international). Expected
return assumptions by Roger Beutler, 2017 JPM Long-Term Capital Market
Assumptions, AQR, PineBridge, Principal Financial, GMO, Voya Financial.
3
J.P. Morgan, Guide to Markets U.S. 1Q2017 4
The expected return has been calculated based on the following allocation: US Large
Cap 12%, US Small Cap 13%, Int. Dev. Equity 17%, EM Equity 8%, US Core Fixed
Income 10%, International Fixed Income 5%, EMD 5%, US TIPS 3%, Cash 2%, US
Of course, grant making foundations have more flexibility than
operating foundations or endowments funding operational budgets
but the challenge remains the same. How do we carefully invest our
assets to ensure to meet spending needs and perpetuity of the fund?
The shortfall risk remains real, though investment returns in recent
years have provided some relief. That said, based on forward looking
return expectations, a typical, diversified portfolio of a foundation is
only expected to return 6.26%
4
over the next 5-10 years. The two
biggest expected return contributors are International Developed
Equity and Private Equity. While the probability of achieving the
required distribution rate of 5% in any given year is 54%, the
probability of a 7% or 8% return falls to 48% and 44%
5
, respectively.
In other words, you might as well flip a coin. On the upside however,
the probability of achieving an annualized return of at least 5% over
the next 25 years is 60%
6
. Managing the shortfall risk of achieving
the required minimum distribution rate or a fixed dollar contribution to
a budget is best managed by taking a long-term view. The long-term
view will also enable investors to allocate more to potentially higher
returning illiquid strategies.
“Across asset classes, the post-crisis regime where low-risk
asset classes and factors outperformed their higher risk
counterparts during a recovery is over.”
PineBridge Investments, Capital Market Line 31 Dec 2016
Expanding Your Asset Allocation to Meet Your Spending Needs
As expected returns of public equity and fixed income allocations
decrease
7
, the complexity of portfolios has increased in an attempt to
increase total fund returns. Despite that volatility over long-term
periods decreases, therefore making higher risk strategies more
manageable for investors, liquidity and short-term volatility need to be
managed and communicated to stakeholders accordingly.
Source: J.P. Morgan, Guide to Markets Europe 1Q2017
Core RE 3%, US Value-Added RE 2%, US Opportunistic RE 1%, European RE 2%,
Asian RE 2%, Private Equity 15%.
5
Based on an assumed expected return of 6.26% with a standard deviation of 11.89%.
Returns are assumed to be normally distributed.
6
Annualized return based on end value after a 25 year period with 500 trials and
annual rebalancing.
7
For example J.P. Morgan’s latest Long-Term expectations for U.S. Large Cap equities
is 6.25% and 3% for U.S. Aggregate Bonds, respectively. 2017 Long-Term Capital
Market Assumptions, 21
st
Annual Edition

2. Roger Beutler, CAIA rogerbeutler@yahoo.com 858-205-4244
Liquidity management becomes even more important in times of
market stress. Putting it in other words, long-term returns are the
nutrition a portfolio needs to survive in the long-term, liquidity is the
air it needs to survive in the short-term. In order to be able to manage
liquidity and market events, a strategic asset allocation needs to be
flexible enough, allowing for ranges around strategic targets. A cash
buffer can be helpful to avoid forced selling and a liquidity squeeze.
The search for higher returning, ideally uncorrelated investments has
become more important than ever. Water rights, shipping
investments, life settlements, fine art, wine, timber/agriculture or
litigation finance are investment opportunities that come to mind. To
what extent such investments are scalable and of institutional quality
is a different story though. On the public side, tactical allocations to
single countries can add significant value to a portfolio. The Brazil
Ibeovespa for example gained over 63% in 2016.
Asset Class: Expected
Return:
Asset Class: Expected
Return:
US Large Cap
Equity
6.40 Timber 7.00
US Small Cap
Equity
6.90 US Core RE 5.50
International
Developped
6.90 US Value
Added RE
7.00
Emerging Markets
Equity
9.75 US
Opportunistic
RE
8.50
US Bonds 2.60 European RE 6.25
International
Bonds
2.00 Asian RE 5.50
EMD 5.00 Hedge Funds 3.50
TIPS 3.50 Private Equity 8.40
Cash 2.00 Global
Infrastructure
6.25
Commodities 3.75
An allocation of just 0.5% would have contributed 31 basis points to
total fund performance. Whether the potential allocation would have
been trimmed to realize gains during the year is a completely different
story. Of course, beta exposure will remain an important part of a
total fund’s asset allocation. As long-only investment managers often
failed to beat their benchmark in the last years, investors have more
and more relied on beta exposure. Larger dispersion of stock returns
as the business cycle enters later stages will provide more
opportunities for active investment managers to add value. Active
niche long only managers certainly are worth taking a look at.
Manager selection can still add significant value in private equity but
average managers don’t cut it. If top quartile managers can not be
selected or gained access to, one might just be better off by buying a
levered basket of publicly traded PE stocks. Overall, dilution of
contribution can be an issue not just within the private equity
allocation but also with long only allocations. More concentration to
make manager selection count will lead to better access, better
information and better ability to monitor the total fund. The perceived
safety of an overly diversified portfolio is nothing but the disguised
increase in shortfall risk. More often than not, the returns of 50th
percentile managers are not competitive and will lead to nothing but
mediocrity and failure to meet your goals.
Source: J.P. Morgan, Guide to Markets Europe 1Q2017
Overdiversification not only leads to diluted return contribution but
also to misallocation of resources. The resources needed to conduct
due diligence are the same for a big as a small investment. If you are
already willing to spend the resources to conduct due diligence, you
might as well put conviction behind an allocation and make it count.
“Expected returns for a simple balanced 60/40 stock-bond
portfolio are down by around 75bps and reinforce our view that
static balanced allocation has run out of road; investors
seeking to boost returns will have to increasingly consider
alternative assets, new avenues of diversification and, above
all, an active approach to asset allocation.”
J.P. Morgan, 2017 Long-Term Capital Market Assumptions
Roger Beutler, CAIA has been working in the banking/investment industry since 1992, more recently at a $2 billion operating foundation where he was Director of
Investments responsible for the foundation’s private market investments. During his tenure at the foundation, Beutler built a global private equity program,
restructured a global real estate portfolio, helped establish the asset allocation to meet the long-term spending needs of the foundation and presented to and
educated the board of trustees about the investment program. Additionally, Beutler led an IT project to develop reporting capabilities to improve the communication
with the board of trustees and evaluated/hired/terminated outside consultants to support the investment team. Prior, Beutler led the sub-adviser selection for a
family of mutual funds where he was responsible for managing investment mandates based on specific risk profiles, led negotiations with vendors/investment
managers and oversaw the legal review and implementation of investment management agreements. Additionally, Beutler held positions in the investment
consulting and Swiss banking industry. Beutler graduated from the University of Applied Sciences in Berne, Switzerland, majoring in Banking and Finance.
This article is for informational purposes only and does not constitute an offering of investment services. This article in no way constitutes the provision of investment advice. Information
in the article is not an offer to buy or sell, or a solicitation of any offer(s) to buy or sell the securities mentioned herein. For further information, please contact me at 858-205-4244.