Peter Bernstein has been shocking his clients. The investment guru and best-selling author says it no longer makes sense to put most assets in equities. With dividend yields puny, stock returns should be anemic for years. Instead of buying and holding stocks, investors should make opportunistic purchases, emphasizing bonds or whatever assets seem relatively cheap, Bernstein says.
To critics, that sounds like market timing, heresy for most professional investors. But after three years of declining markets, money managers are looking for ways to deliver positive returns. Bernstein is not alone in advocating strategies that focus on stocks only at opportune times.
The advocates include some of the most successful investors around. A top performer is Sheldon Jacobs, a money manager and editor of The No-load Fund Investor, a newsletter whose picks outpaced the S&P 500 during the past decade. Convinced that we are due for a long period of choppy markets, Jacobs emphasizes stocks only when prices look favorable.
One of the most notable converts to timing is Ralph Wanger, founder of Liberty Acorn. Since it started in 1970, the fund has outdone the S&P 500 by more than 3 percentage points annually. A longtime champion of buy-and-hold investing, Wanger now believes that the market will churn up and down, failing to reach a new high for at least the next 10 years. To help investors cope, he has launched Columbia Thermostat, a fund that increases its stock allocation only when the S&P drops. “In a market like this, the rules of investing shift,” says Wanger. “You don't want to be fully invested in equities all the time.”
So far, financial advisors show little interest in embracing market timing. Instead, they are clinging to traditional approaches, setting asset allocation targets and sticking to them. “It is a fool's game to think that you can do well by shifting all to cash or all to stocks,” says Pran Tiku, a principal with Peak Financial Management, a registered investment advisor in Wellesley, Mass.
Market timing is not easy, Bernstein concedes. But he says that top managers can succeed with the approach. Some research supports this thinking. Studying timing efforts by investment newsletters, Mark Hulbert, editor of Hulbert Financial Digest, found that 80 percent failed, but 20 percent added value through their asset allocation moves. Many of the winners succeeded over long periods. “By relying on the 20 percent that beat the market in the past, you increase the chances of succeeding in the future,” says Hulbert.
The Hybrid Route
Financial advisors who are wary of timing on their own might consider using asset allocation funds, which shift between stocks and bonds. While most funds in the group have delivered spotty returns, a few managers boast stellar records for being in the right place at the right time. The best performers protected their shareholders from the worst of the bear market. Because top asset allocators have low risk scores, they can serve as core holdings, accounting for a third or more of a total portfolio.
Financial advisors who prefer setting their own allocations might consider putting a small percentage of assets into a market-timer, which could help to diversify a portfolio that emphasizes aggressive growth funds or other risky choices. One low-risk choice is UBS Global Allocation A. During the past three years, the fund has returned 1.1 percent annually, outdoing four-fifths of international hybrid competitors while besting the S&P 500 by more than 17 percentage points.
The UBS managers invest in a full range of assets, including stocks and bonds from the U.S. and abroad. Seeking undervalued assets, the fund reduced its equity holdings to 20 percent of the portfolio in 1999 — in time to shelter shareholders from the collapse of 2000. This year UBS has raised equity holdings to 75 percent of the portfolio, enabling the fund to benefit from the rising markets. The managers now consider stocks somewhat undervalued, while bonds appear pricey. “With interest rates so low, fixed income isn't likely to provide a competitive return for some time,” says Derek Sasveld, UBS director of strategy analysis.
Taking the Edge Off
While UBS seeks the best individual stocks, Vanguard Asset Allocation places its bets with index funds, shifting between portfolios that track the S&P 500, the Lehman Brothers Long U.S. Treasury index and cash. Last July, portfolio manager Thomas Loeb moved to 100 percent in stocks, the first time since the late 1980s that he had taken such an extreme position. The fund still has nearly all its assets in the S&P 500. The shift to equities proved premature until recently, but that doesn't bother Loeb, who has out-returned 83 percent of domestic hybrid funds during the past decade. “We often move early into an asset because we begin buying just as others are becoming fearful and starting to sell,” he says.
To set his allocations, Loeb forecasts returns of stocks by projecting future cash flows. Then he compares that figure to the forecasted returns on bonds and cash. When no category seems to be a bargain, he holds 60 percent in stocks, 35 percent in bonds and 5 percent in cash. In 1999, the Vanguard fund had 80 percent in stocks, but it deftly reduced the figure to 40 percent by March 2000.
Another strong performer that relies on index funds is Wells Fargo Asset Allocation A, which shifts between the S&P 500 and a portfolio that tracks the Lehman bond index. Portfolio manager Galen Blomster currently has 85 percent of assets in stocks, his maximum position. He made the move last summer after concerns about terrorist attacks and corporate scandals took the market down sharply. “We tend to make shifts during emotional periods, and last summer was a prime opportunity to buy stocks,” he says.
One of the top-performing asset allocators is Leuthold Core Investment, which puts a premium on controlling risk. Worried about high valuations in the late 1990s, the fund lowered its equity position below 20 percent, a position that held down returns in the bull market. But that caution has helped Leuthold outdo the S&P 500 by 16 percentage points over the past three years. “We are not the right choice for someone who wants to shoot the lights out in a bull market,” says portfolio manager Jim Floyd. “We give up a little of the upside returns in order to avoid big losses on the downside.”
Convinced that the economy is poised to improve while interest rates rise, Leuthold now has 70 percent of its assets in equities. To pick stocks, the Leuthold portfolio managers examine the 140 industry groups in the S&P 500. Researchers look for groups with the best combination of traits, including relatively low price/earnings ratios and high earnings growth. Once they identify a promising group, the managers buy a representative basket of several names, not necessarily trying to identify the best stocks. Holding a big group of undervalued stocks helps Leuthold — and other top asset allocators — deliver healthy returns while keeping a tight lid on risk.