A portfolio to withstand any financial crisis
One of the big questions investors face right now is: are we facing inflation or deflation? It's not an easy one to answer. So you should build a diversified portfolio that offers plenty of upside, but which hedges against a worst-case scenario. Here, Cris Sholto Heaton picks a basket of assets for a balanced portfolio, and explains how Asia fits into that.
I get many thought-provoking emails from readers. Recently, a number of you have asked how my views on Asia fit into a wider investment context. Are we facing deflation or inflation? Could there be another big crisis, perhaps caused by the break-up of the euro?
These questions aren't easy to answer so much depends on the action taken by governments and central banks across the world. So investors should try to build a diversified portfolio. One that offers plenty of upside, but which also hedges for the worst-case scenario.
So this week I'll outline some of the assets that could go into a balanced portfolio, and how Asia fits into that. I've just read the latest issue of Marc Faber's Gloom, Boom & Doom Report, which has an excellent section on the same subject. So I'm including some of Faber's thoughts too.
Of course, the ideal portfolio is different for each individual, depending on your age, risk tolerance, tax status, and many other things. So this is just a very rough outline, not a blueprint. With that caveat in mind, let's get started
A foundation of high-quality shares
Low-debt, dividend-paying stocks with stable earnings should be a cornerstone of most portfolios. Shares like these are often called 'defensive'. But 'quality' is a better term, because they tend to outperform other investments over the long term.
In deflation, these stocks should be able survive and keep paying an income. High inflation will probably hurt them temporarily. But they should retain their real value in the long run. They should also survive almost any financial crisis.
I'd have around 30-50% of a portfolio in equities, split among different countries and different currencies. Most advisers would suggest having around 10-20% of your equity allocation in emerging markets (EMs), based on their share of the MSCI World index. But I think this is too low for many investors.
EMs already account for 35% of world GDP. As their economies grow and their markets develop, they should overtake the developed world in both GDP and market capitalisation within two to three decades. So you should invest with this in mind.
How aggressive you are will depend on your risk appetite. Allocating up to 50% of your equity money to EMs could make sense for a younger investor. But don't allocate blindly based on geography. Keep valuation in mind. Many EM stocks are low-quality firms or have poor governance, so be picky.
For developed markets, I'd focus on large caps, particularly sectors such as consumer staples and healthcare. Many of these stocks offer attractive yields, stable earnings and exposure to EMs. European firms are often more attractively valued than US peers.
For EMs, you should include stocks within growing sectors such as financial services, which are less attractive in the West. Consumer goods, healthcare, education and infrastructure are also good bets. I make an effort to look for promising small and mid-cap stocks, which are often under-owned and under-researched by institutions.
Faber suggests having 20-30% in equities. That's less than I favour for reasons we'll see below. He also suggests allocating around half to EM stocks.
Treasuries could be a terrible investment
Most developed world government bonds are unattractive. The ten-year US Treasury has a yield to maturity of just 2.94% just now. Of course, it's possible that might still deliver an acceptable return. Market yields could fall further (thus pushing up the price of bonds and delivering capital gains). After all, Japanese bond yields spent a decade sliding to new lows, as the chart below shows.
But this is a one-way bet on very low inflation or deflation. If we get higher inflation instead, a portfolio of bonds at these yields would be devastated. That's a very unequal, unattractive pay-off.
Faber suggests allocating 20-30% to corporate bonds of varying maturities. Yields on developed world corporate bonds are certainly better than on government debt. They should do well if deflation emerges. But if inflation takes hold and I believe it will eventually it will make returns on corporate bonds look poor too. So if you have a large corporate bond weighting, be ready to sell if inflation shows signs of picking up.
For most investors, direct investment in bonds isn't viable due to the costs and minimum deal sizes. Instead, if you're looking for a corporate bond fund, I'd suggest the M&G Corporate Bond Fund. This has returned around 15% since I mentioned it a year ago. The fund invests mostly in investment-grade developed-world bonds.
I'm more optimistic on Asian local-currency government bonds. I expect this market to grow substantially and attract more foreign buying for two reasons.
First, Asian economies have better balance sheets than most of the West. As this becomes more widely accepted, the lower credit risk means their bond yields should trade closer to Western government bond levels. Second, Western investors should also see gains from the likely long-term rise in the value of these currencies against developed world ones.
Of course, this depends somewhat on inflation in emerging Asia being lower than in developed markets in the future (at least relative to bond yields in each region). In the past, it's been the opposite way round. But I believe that as Western governments try to inflate away their debts, while Asian ones remain prudent, this relationship will reverse.
The best route for investing in Asian government bonds that I've found is the ABF Pan Asia Bond Index Fund. This Hong-Kong listed exchange-traded fund (ETF) holds debt from eight regional governments (see chart below for a breakdown). It's a low-cost tracker managed by State Street.
Tim Price, who writes The Price Report newsletter, is keen on the New Capital Wealthy Nations Bond Fund. Managed by Stratton Street Capital, this invests in debt from smaller countries with strong balance sheets, in Asia and elsewhere.
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For adventurous investors, I think convertible bonds offer up some interesting opportunities. This is a somewhat niche idea, but please see here for a bit more detail.
Overall, my typical bond allocation would be lower than Faber's suggestion, at 10-20%. I just don't see enough ideas that look attractive. Instead, I'd rather focus on 'bond-like' stocks such as those mentioned above: very high-quality businesses offering decent yields.
A solid income from good real estate
In the long run, good quality property in the right areas, and bought without excessive debt, should deliver good returns. Faber suggests an allocation of 20-30%, which I'd agree with. For many investors, direct investment in real estate is too risky. The size of the investment means you have to put a significant chunk of your portfolio into a single asset. But real estate investment trusts (Reits) and property funds with good portfolios, capable management and responsible levels of leverage, offer an excellent option.
The first place to look is Singapore, which is becoming the Reit centre of Asia. There are a number of high-quality Reits that offer attractive yields. I have long liked Ascendas Reit, Ascot Residence Trust, Suntec Reit and First Reit among others. They're no longer as stunningly cheap as when I first recommended them, but they're still attractive.
Gold the investment you hope will lose you money
I don't like gold. It's not an income-producing asset, so it's impossible to price it in any real sense. Indeed, it actually has a negative yield, because it costs money to warehouse.
But it's stupid to ignore the fact that it has historically served as a store of value, and many people still regard it in that light. So in the event of very high inflation, gold is likely to rise sharply in value. That means it makes sense to hold some in a portfolio as an inflation hedge. It should also do well in a crisis.
Faber suggests allocating 10-20% to precious metals. I'd regard the lower end of this as a maximum and think that 5% could well be enough. That's because gold's performance in high inflation is unlikely to be linear relative to the rest of the portfolio. Very high inflation could well send gold to $5,000/oz or so.
So a relatively small weighting to gold should be enough to keep some purchasing power during the worst of the inflation. Other assets would be hit. But most other than bonds should regain their value in the long run. At the same time, a small weighting limits the downside risks to the gold price should inflation remain muted. You should hold the gold at the very least through physically-backed funds. It would be much easier for derivative-based ones to default in a crisis.
For other inflation hedges, investors could consider investing in producers of commodities with tight supply outlooks, in farmland and plantations, and in timber. The latter is an especially interesting asset class with a long history of good returns. It's not the easiest to invest in, but there are a couple of London-listed vehicles: Cambium Global Timber Fund and Phaunos Timber (see this recent piece by Merryn Somerset Webb for more). Any allocation here should come out of the equity and real estate sections of the portfolio.
Don't hold too much cash
Faber suggests that around 20-30% of assets could be kept in cash for now, across several currencies. Rates on cash are poor. But the high volatility we're experiencing means that investors may get a chance to invest at a much lower level, he reckons.
My problem with cash is that you won't necessarily get a chance to invest at significantly lower nominal prices. And with deposit interest rates very low, it's a struggle to ensure that your money is not being eroded by inflation (in many countries, it's impossible if you want instant access). If you focus instead on shares, bonds and Reits that throw off a steady stream of cash for reinvestment, the need to hold cash for opportunistic investments can be minimised.
Finally, consider holding your assets with brokers and custodians in more than one country. Some credible analysts, such as Russell Napier of CLSA, have suggested that Western governments' efforts to sort out their public debt problems could well lead to capital controls. And we should never forget that the US government expropriated its citizens' private gold reserves in the 1930s.
I don't think this is the most probable outcome, but it's possible. If we're trying to protect our portfolio, we should allow for this.
But do please remember that by opening accounts outside the UK, you lose the protection of the Financial Services Authority and Financial Services Compensation Scheme. Make sure you know what the local investor protection rules are. And spread your holdings around more than one firm and make sure you use firms with a good reputation, rather than the cheapest deal on offer.
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