Prof. Craig Israelsen, a regular speaker at A4A webinars, answers 22 questions below that we did not have time to cover at his last session in which he reviewed attributes of asset classes and assocaitad behavioral issues.
Given that MLPs have outperformed substantially during 2000-2009, what is your opinion regarding the use of both hedged and unhedged emerging market bonds?
Among non-US developed fixed income both hedged and unhedged approaches are used. For example, the new Vanguard emerging markets bond fund (VGOVX) hedges currency risk. One solution is to use one fund that hedges and another that does not.
Did you ever research the preferability of value versus growth in your equity exposure in your 7Twelve portfolio?
I have found that a value tilt in US small cap stock tends to produce better results than small cap growth over the long haul. There is a value “premium” among US mid cap stock and US large cap, but not as distinct as in US small cap.
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How does this model work during a distribution phase or retirement?
I have designed several “age-based” 7Twelve models for the distribution phase. In general, the allocation to cash increases and the allocations to the other 11 asset classes decrease. But, importantly, the model stays diversified across all 12 asset classes over the entire life-cycle of the investor.
Not sure if any one mentioned municipal bonds. Where do they fit here?
I don’t have a specific slot for municipal bonds in the 7Twelve model. For investors in certain states, they could certainly be added as an “satellite” asset class around the 7Twelve “core”.
How is this similar to or what are the differences from the Fama & French research and their value and small-cap tilt?
The 7Twelve model is similar in that it fully weights small cap in the model. In other words, of the 12 funds used in the model, large cap US equity has an allocation of 8.33%, the mid cap US equity allocation is 8.33%, and the small cap US allocation is 8.33%. If I used a single total market US equity mutual fund that employs market cap weighting (which is typical), the allocation to large cap US equity would be 70%, mid cap 20%, and small cap 10%. In short, the 7Twelve model “respects” large cap, mid cap, and small cap US stock equally.
Craig's salsa analogy (for creating a diversified portfolio) works really well with clients. Does he have any other analogies like that for dealing with incorrect benchmarking or the importance of avoiding large losses?
Thank you. Some of the other analogies that seem to make sense to my students are the following:
Benchmarking is all about fair comparisons. Comparing the taste of a slice of pepperoni to the taste of the entire pizza is not a fair comparison—just like comparing the performance of an entire diversified portfolio to the performance of one of its ingredients is silly.
The large loss issue is best demonstrated by showing the sheer math of it. A 50% loss requires a 100% gain to break even. Whereas a 75% loss requires a 300% gain to break even. Motto: don’t go there.
With regard to your Fidelity, Vanguard, T. Rowe Price, active and passive portfolios, are the recommended funds seven in number or twelve in number? Also, you mentioned in an earlier webcast that for clients who are more conservative your portfolios are tweaked for reduce equity percentage. Do you provide alternative portfolios suitable for those more conservative clients?
All of the 7Twelve models I’ve built use 12 actual mutual funds and/or ETFs. Yes, the research reports that I have prepared outline in detail the “age-based” (that is, risk reduced) 7Twelve models that would suitable for more conservative clients.
Please elaborate on whether an advisor can use either the seven asset classes or the 12 asset classes. Your research in the slides showed seven asset classes over 43 years. Do you believe the 12 asset classes would result in similar findings?
An advisor can build a 7-asset portfolio and/or a 12-asset portfolio. All of the research reports that I have prepared utilize a 12-asset model. Generally speaking they perform similarly, but the 12-asset model is more broadly diversified.
What’s the cost of your book and also the cost of your research for advisors?
The 7Twelve book purchased from me is $23 and is written for a lay audience. The research reports that I sell range from $75 to $350. The $350 report is designed for financial advisors and outlines a variety of 7Twelve models that I have built (the Active model, the Passive model, a Vanguard model, a Fidelity model, a T. Rowe Price model, a DFA model, and a tax-efficient model).
Regarding slide 41, how to vary the 7Twelve portfolio for investors over 65?
For investors over age 65 cash would be over-weighted and the other 11 asset classes would have a reduced weighting. In the most extreme case cash could have a 63% allocation. But, only the advisor will know the correct cash allocation after considering a host of variables that will influence the overall portfolio allocation (age of client, amount of retirement assets accumulated, health of client, number of dependents, amount of debt, other sources of retirement income, etc.).
Do you use any of the CRSP indices? If not, why not?
I currently do not use CRSP index data simply because I don’t have access to it. Vanguard has switched some of their equity benchmarks over to CRSP indexes. While interesting and probably relevant, in a multi-asset portfolio such as 7Twelve there is not enough differential between CRSP indexes and MSCI or S&P indexes to dramatically alter any of my fund selections.
Does your advisor research report include the JNL reports?
No, the JNL reports that cover the Elite Access platform and the Perspective II VA platform are sold as separate reports for $150 each.
Why do you not break out non-US small cap?
Good observation. I break out developed non-US equity and emerging non-US equity. One approach would be to sub-divide the non-US developed allocation of 8.33% across both large cap and mid/small cap. Large cap might have a 5% allocation and mid/small a 3.33% allocation—or something along that line.
Would you consider a glide path to change allocations from growth to conservative strategy?
Yes, that is essentially what is happening in the allocations in my various “age-based” 7Twelve models. The changes are not the smooth changes inherent in a glide-path, but accomplish the same objective—albeit in more dramatic shifts at certain ages.
For those needing Income (not total return), how does the 7Twelve compare?
The current yield of the Passive 7Twelve model is just under 2%. It could be enhance somewhat by selectively using high dividend equity funds where possible.
Have you researched optimization of allocations among asset classes versus equally-weighted allocations?
Yes, I’ve tinkered a lot – but in the end I never know how to optimize going forward. Because I don’t know which asset class will outperform in any given year I find that equal-weighting is the most rationale approach.
Please explain in more detail about choosing appropriate benchmarks.
An appropriate benchmark for the 7Twelve would need to have a 42% equity, 25% diversifier, 33% fixed income allocation to reasonably mimic the 7Twelve approach. If a benchmark is much different than that it becomes less relevant as a useful benchmark.
The other benchmark approach is to use cash as the benchmark for everything. When people exit the “market” they often go to cash—so cash is a benchmark in that sense.
How frequently do you rebalance 7Twelve portfolios?
I measure the performance of the 7Twelve models assuming monthly, quarterly, and annual rebalancing. Quarterly and annual rebalancing tend to produce the best results.
By allocating equal weights to your 7Twelve asset classes, do you not make judgments about expected returns. Can you tweak the allocations?
Certainly. The allocations are “tweak-able” according to the goals and constraints imposed by the advisor and client. What I have found is that to effect a material change in the performance of the 7Twelve model the allocations need to be tweaked quite a bit. Small changes, such as moving one asset class from 8.33% to 8.00%, have almost no impact in a broadly diversified portfolio such as 7Twelve.
What was the backwardation/contango environment in the 1970's?
I don’t recall, I’d have to dig around to find that. But, the link below is an article on the general topic of backwardation and contango.
What was the performance of the 7Twelve in Q2 2012, when bonds, especially TIPS, cratered?
The Active 7Twelve was down 1.82% in Q2 2013 (I assume you meant 2013, not 2012). The Passive model was down 2.63% in Q2 2013. A diversified model shines over time. The 15-year average annualized return of the Active 7Twelve was 8.74% (as of 6/30/2013) and 7.70% for the Passive 7Twelve.
Any comments on your thought process that led to your recent change in cash allocation to his multi-asset portfolios for those over the age of 50?
The performance of bonds has been spectacular for the past 30+ years (since 1982) when interest rates in the economy started their decline (aggregate US bonds have averaged nearly a 9% annual return since 1982 whereas from 1948-1981 aggregate US bonds averaged about a 4% annualized return).
Going forward, as rates begin to move upward, the performance of bonds will likely return to the levels experienced pre-1981. In a diversified portfolio the impact of lower bond returns isn't that big of a deal (which is why I didn't adjust any allocations in the "core" equally-weighted 7Twelve model).
However, I felt that in the age-based models the heavy TIPS allocation was not worth the risk at this point. Older investors simply cannot sustain large losses. Preservation of capital is more important. Hence, my shift to more cash and less TIPS.
Of course, each advisor and client must examine their own specific situation to determine the right “age-based” allocation. My suggested allocations are generic because I don’t the specific situation of any specific clients.