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Objective:
The SMAART Choice Strategy is a
conservative program designed to grow assets over the long haul. Select
exposure to emerging market bonds and equities, in conjunction with
remaining invested in US and developed international stocks and bonds,
can produce attractive returns with less volatility than a US stock
portfolio. Our SMAART Choice strategy does not aim for blockbuster
returns; it looks for slow, steady compounding of assets. Those looking
for high annual returns without regard for risk may wish to investigate
our other Rydex based strategies.
The Theory:
This strategy’s origins can be
traced to Harold Markowitz’ Modern Portfolio Theory. Markowitz
reasoned we could make four assumptions about investors:
- Investors are risk-averse. Purchase of insurance is proof of this.
- Investors estimate the risk of a portfolio based on the variability of expected returns.
- Investors make decisions based solely upon expected return and risk.
- For a given level of risk, investors prefer higher returns to lower returns.
Can’t
argue with this logic, can we? Instead, scholars extended MPT from
their ivory towers. Capital Market Theory evolved, and is significant
for three reasons:
- Introduces the Risk-Free Rate of Return
- Introduces the Market Portfolio
- Market Portfolio includes all risky assets in proportion to their market value.
We use the MSCI All-Country World Index
as our global equity proxy, and the JP Morgan Global Government Bond
Index as our global fixed income proxy. Because
this portfolio includes all risky securities, it is completely
diversified - the unique risk (unsystematic variability) of any one
asset is offset by the unique variability of other assets in the
portfolio.
The Market Portfolio carries only systematic risk – the variability in all risky assets caused by macroeconomic events.
Why Might the Market Portfolio be Appealing?
So the Market Portfolio (consisting of
assets of all kinds from around the globe) introduced in Capital Market
Theory seems to be the lowest risk proposition for investors. What is
in this market portfolio, and what makes it so low risk?
First, one should be aware that the US
stock market accounts for less than 50% of the total world stock
market. According to Ibbotson Associates, at the end of 1994 the US
made up about 35% of the world’s $10T stock market
capitalization:
Second, world stock market capitalization
is smaller than the capitalization of publicly issued bonds. World bond
market capitalization stood at $16T at the end of 1994, again according
to Ibbotson Associates. US bonds accounted for roughly 45% of this
total.
We can see that an investor who is
focused only on US Large Cap stocks is ignoring the majority of the
world’s investable assets. This is akin to an investor in US
stocks ignoring every sector except financial stocks.
The world’s fastest-growing
economies lay outside of our borders. While the US is certainly the
largest cog in the global economic engine, it isn’t the only
source of growth. The high growth rates of less-developed nations lead
to the potential for higher stock market returns in those countries.
Although these markets may be more volatile over short time periods (in
1998, for example), their high growth rates are likely to persist over
time, as capital is infused into these areas.
Historical Argument for Asset Allocation
Over time, foreign equities have
outperformed US equities. In fact, the EAFE index outperformed the US
market from 1971-1994 with less volatility. Similarly, augmenting US
with international bonds improved returns, with minimal risk being
achieved at a 70 /30 mix. The global efficient asset allocation
portfolio with a return equal to that of the US stock market (13.3% per
annum) has a risk equal to only one-third that of the US stock market
according to Oldier and Solnik. Conversely, a global efficient
allocation with the same risk as the US stock market outperforms by 8%
per annum.
If a money manager has relative
forecasting ability, they will engage in active investment strategies
that reap the benefits of international risk diversification while
focusing on preferred markets. At LBS, we combine the power of expert
systems and genetic algorithms to analyze the global investing
landscape and select global efficient portfolios. Superior returns are
not the objective; rather, we seek to give superior returns for a given
level of risk. For our SMAART strategy, the level of risk ranges
between 1/3 – 2/3 of the US stock market.
LBS’ Take on Global Asset Allocation
This strategy is not for everyone. In
fact, we suggest completing our risk tolerance survey to help you
determine whether or not this strategy is for you or your client.
This is a conservative strategy designed
to grow assets over the long haul. Select exposure to emerging market
bonds and equities, in conjunction with remaining invested in US and
developed international stocks and bonds, can produce attractive
returns with less volatility than a US stock portfolio. Our SMAART
strategy does not aim for blockbuster returns; it looks for slow,
steady compounding of assets. Those looking for high annual returns
without regard for risk may wish to investigate our US sector
strategies.
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