active: a heterogeneous portfolio built across asset classes can maximize returns for investors
The reason for this is that as globalization progressed, economies had become complex, increasing the correlation between stock markets across the world.
A heterogeneous portfolio can be created by diversifying capital across asset classes to maximize returns subject to an investor’s risk and cash flow constraints.
Exhibit 1: Performance by calendar year of asset class and sub-asset class
Exhibit 2: Table of the index and the vanilla hybrid fund
Tables 2A and 2B: Return and volatility of index and hybrid funds
Investors can deduce from Appendix 1 that no asset class consistently outperforms the other in the short term and that the 10-year CAGR interpreting investing over a longer horizon will compound wealth.
Exhibit 2 explains that even a vanilla hybrid fund can maximize returns and mitigate volatility for the risk taken. The reasons for this being the asset classes, with few exceptions, tend to be inconsistently influenced by macroeconomic events producing better risk-return trade-offs.
The appropriate proportion of capital to allocate to assets is crucial to building an optimal portfolio. Otherwise, investors expose themselves to undue risks. For example, if an investor invests 100% of the capital in the index as indicated above, he will be exposed to excessive volatility.
However, tactical asset allocation will incorporate capital market expectations of the investor’s desired level of risk and long-term oriented constraints, as exposures are targeted based on the quantifiable systemic risk of each asset class. assets, thereby generating maximum returns for the risk the investor can withstand.
The accelerating pace of change in the markets and changing sector terrain can prompt investors to time the markets and gain exposure to trending sectors. However, market timing remains an elusive concept to most and gaining a differential advantage is much more difficult than one is inclined to believe.
The Buffett & Yardeni patterns can serve as indicators of when prices break out of reasonable valuation ranges.
The buffet indicator model
The aggregate market capitalization of publicly traded stocks in a country divided by the gross domestic product or GDP of the country is a general way of indicating the relative position of the national stock market.
In general, if the indicator is above the long-term average, stocks are overvalued and vice versa.
The Yardeni model
A derivative of the commonly known Fed model is used to assess market positioning relative to valuation.
The Fed model indicates overvaluation if the earnings yield of a stock index is lower than the yield of 10-year G-secs. The Yardeni model improves on the shortcomings of the Fed model by incorporating the expected earnings growth rate. If the indicator is above the long-term average, it points to the overvaluation of the equity market and vice versa.
EY = PAR – (k*LTEG)
EY: Earnings Return
BY: Moody’s ‘A’ Rated Corporate Bond Yield
LTEG: long-term earnings growth of the index
K: Constant attributed to earnings growth
We believe that over 90% of the variance in returns can be narrowed down by asset allocation. A key element in times like this is to be disciplined and tough as the asset allocation that underpins the investment philosophy will prove effective as it has stood the test of time.
(The author is founder and fund manager – Right Horizons PMS)
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