Allocating fund assets is still a tricky balancing act
The balanced fund diversified across a range of asset classes has for decades been a staple choice of long-term savers.
Seeking to harvest the benefits of diversification and provide an attractive long-term return, balanced funds are likely to remain a popular choice for many individuals and institutions looking for a long-term home for their savings. In Ireland, the so-called managed fund offered by a range of domestic and international investment managers has traditionally fulfilled this role.
Notwithstanding the growing range of investment funds on offer here, the managed fund is likely to continue to fulfil this role.
While there has been a tendency to broaden the asset classes in which managed funds invest, equities and sovereign bonds generally represent between 80 per cent and 90 per cent of the average fund. The key asset allocation decision, therefore, is that between equities and sovereign bonds.
Ben Graham, widely acknowledged as the father of value investing, summarised his deceptively simple approach to this challenge more than 80 years ago.
“A fundamental guiding rule is that the investor should never have less than 25 per cent or more than 75 per cent in common stocks, with a consequent inverse range of between 75 per cent and 25 per cent in bonds,” he said.
“There is an implication here that the standard division should be an equal one, or 50-50 between the two major investment mediums.
“However, the only [investment] principle that has ever worked well consistently is to buy common stocks at such times as they are cheap by analysis, and to sell them at such times as they are dear by analysis. That sounds like timing; but it is not really timing at all but rather the purchase and sale of securities by the method of valuation.”
The extraordinary monetary policy response to the global financial and economic crisis of recent years continues to have a major impact on the valuation of asset classes.
The valuation of cash and bonds relative to equities and to their longer-term history looks unattractive at the moment, while the valuation of equities relative to cash and bonds looks correspondingly attractive. But this is considerably less so when compared to their longer-term history.
For Graham, this would likely suggest an asset allocation at or near the upper end of his maximum exposure to equities of 75 per cent.
However, before the modern managed fund manager hastens to replicate this allocation, some thought as to the differences in context from the time of Graham is warranted.
In particular, the markedly different monetary regime and the markedly more active policy environment have introduced uncertainties never faced by the father of value investing.
It may be little wonder that one of his most famous successors, Seth Klarman of Baupost, recently decided to return money to his investors.
“Investing today may well be harder than it has been at any time in our three decades of existence, not because markets are falling but because they are rising; not because governments have failed to act but because they chronically overreact; not because we lack acumen or analytical tools but because the range of possible outcomes remains enormously wide; and not because there are no opportunities but because the underpinnings of our economy and financial system are so precarious that the unabating risks of collapse dwarf all other factors,” Klarman wrote recently.
Valuation must remain central to the decision about equities versus bonds. But even with this insight from Ben Graham the challenge of asset allocation for the managed fund manager has arguably never been as difficult.
If you have invested in a managed fund, or if your pension scheme has invested in one, it might be worth asking the manager how he or she is addressing this challenge.
John Looby is an investment manager at Setanta Asset Management, a global value manager based in Dublin. The views expressed are personal and do not necessarily reflect the views of his employer.