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Table: How They're Calling It
In this tremulous age when a widely perceived "safe" investment can collapse in just a few screen blips, or a long-term laggard can suddenly break out, divvying up your assets has never required more thought. "You may choose the right asset class, but if you're in the wrong part of the church, you're going to miss the sermon," says David Darst, chief investment strategist at Morgan Stanley.
Darst's churchly analogy rather elegantly sums up the intense search for divine wisdom going on inside every one of the private banks, brokerage firms and family offices in our 2012 asset-allocation survey.
This year Penta surveyed 40 of the largest wealth-management firms to find how they are invested to produce the best risk-adjusted returns for high-net-worth investors with a moderate appetite for risk. All the firms approached provided us with snapshots of their current asset-allocation models (shown in the table here), which in practice are adjusted to suit clients' needs and asset levels.
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With a shaky global economy and market volatility, the expected backdrop right through 2012, most of the nation's top wealth managers are putting more money to work in dividend-paying stocks, high-yield bonds, master-limited partnerships and emerging-market debt—anything, in short, that is fairly sturdy and pays income.
This is a more defensive stance than was recommended this time last year, when the average stock allocation was 49%. Today it's been cut to 45%. Conversely, average fixed-income exposure has increased to 34% from 30%, while cash holdings have jumped to 4.3% from 1.6%.
A defensive crouch was almost universal in the second half of 2011, as the European debt crises went code red, inflation-rattled emerging nations slammed on the breaks and a double-dip recession in the U.S. seemed like a sure thing. Mackin Pulsifer, chief investment officer at Fiduciary Trust, discloses his firm's cash position was between 15% and 20% at the height of the anxiety, before he eased off in the last quarter of 2011 and again began buying high-yield investments.
He's not alone. On this issue, the entire congregation is bellowing from the same hymnal, if not always on-key. Income investments are not only likely to stabilize portfolios as economic and political uncertainties play out in 2012, but they also make sense from a total-return standpoint.
Atlantic Trust's basket of income strategies is, for example, producing a yield north of 5%. Stack that return up against a U.S. stock market that could possibly only deliver 5% this year, but with much higher risk. The succinct way Kevin Bannon, chief investment strategist at Highmount Capital, explains it: "It's nice to get paid to wait it out."
Trouble is, if all players are lusting after income-producing securities, prices will inevitably shoot up. Just two months ago, the dividend yield on the S&P 500 was 2.1%, while the yield on 10-year Treasuries was 1.8%. Huge demand for dividend-paying stocks has since narrowed that spread to a neck-and-neck 2% yield for both instruments. "The biggest challenge then, and now, has been building risk controls in portfolios without paying an arm and a leg," says Gordon Fowler, chief executive officer of Glenmede.
But let's back up a moment. Before choosing individual plays for 2012, asset pickers must first make calls on the state of the world economy. Most are figuring the U.S. will produce GDP growth of between 2% to 2.5% this year, coupled with continued stock-market volatility. Overseas, they're betting on a recession in Europe, while looking for signs that the EU-debt crisis is spreading.
A slowdown in emerging-market economies, particularly China, is expected to continue as the up-and-comers vacillate between anemic global growth and the risks of inflation building up within their respective borders. In short, not a lot of good news.
But that's the consensus from a lofty perch. When it comes to actually picking a pew, wealth managers soon reveal their doctrinal differences. The proportion of total assets invested in equities, for example, varies from GenSpring's 18% to T. Rowe Price's 63%.
Most managers—such as JPMorgan Chase, City National Bank, Key Bank, T. Rowe Price, Bank of NY Mellon, Bank of America Merrill Lynch, Constellation Wealth and Morgan Stanley—have hacked back their European stock exposure and are maintaining bigger-than-usual positions in U.S. dividend-paying companies with global reach.
Again, the problem here is that some dividend-rich sectors, such as utilities, energy master-limited partnerships and consumer staples that were among the top performers last year, are fast becoming uptown pricey. Traditionally boring utilities, for example, usually have low price-to-earnings ratios relative to the broad market, but the sector's current price-to-earnings ratio of 13.8 is within striking distance of the S&P 500's 14.2 ratio.
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Investors this year might find their best opportunities in technology and energy. Tim Leach, chief investment officer at U.S. Bank Wealth Management, notes that technology is "55% of its historical average valuation." Those bargain-basement Silicon Valley stocks look even flashier when you consider that cash-rich U.S. companies are likely to spend on technologies making the firms more efficient. Similarly, U.S. energy stocks, currently 68% of their historic valuation, will get a rush when emerging economies again fire up their furnaces. That's why Leach has raised his strategic weighting in U.S. equities from 28% to 32%.
Paul Chew, head of investments at Brown Advisory, says that with the improving U.S. economy, it's wise to build up holdings in some solid small-cap names. "As the economy stabilizes, you'll see mergers and acquisitions increase, and when there is a high rate of mergers and acquisitions, smaller companies tend to outperform large ones," he says.
The calls overseas are harder to make. By valuations, European stocks are now among the most attractive in the world, "but you're not paid well enough to double down by holding both the currency and the stock," says Seth Masters, chief investment officer at Alliance Bernstein.
That's why half of the 40 wealth managers surveyed cut their exposure to developed economies overseas by 20%, compared with this time last year. Some major players—Brown Advisory, Highmount, Harris Private Bank, Morgan Stanley, Constellation Partners, Atlantic Trust and Northern Trust—have scaled back by 50% or more.
Stock pickers sitting on the other side of the nave are, in contrast, seeing opportunities in Europe, particularly in Germany and France. "A lot of these stocks have been tarnished with a broad brush. You can buy some very good companies at about eight times earnings, with dividends of 5%," says Marc Stern, Bessemer Trust's chief investment officer. "If it's got strong management, a good balance sheet and good competitive position, we're interested."
Others buying European value stocks: Alliance Bernstein, William Blair, SunTrust, Glenmede and Barclays Wealth Management. The risk that the euro itself might blow up is hedged via the currency-forward market. "The euro is facing an existential threat: It's likely it will survive, but it could fall apart or partially unravel," Alliance Bernstein's Masters says. "If that happened, someone who had not hedged would experience a loss on currency and, without a shadow of a doubt, a decline in the value of the stock."
Emerging-market equities posted a 20% decline last year. Such economies are dependent on the buying power of the developed world, which is why most wealth firms reduced their emerging-market holdings in mid-2011. But understand that any scaled-back exposure is purely temporary. Emerging-market companies generally have strong balance sheets, good earnings potential and as good or better margins as their developed-market peers.
On the fixed-income side, emerging-market debt is yielding about 6% and is the new must-have. PNC, GenSpring, BNY Mellon, Atlantic Trust, and Constellation Wealth built up positions in emerging-market debt in the fourth quarter of 2011, from little, if any, exposure earlier in the year.
Why the sudden appetite? Wealth managers have come around to the view that emerging-market governments are in better fiscal shape than those of developed nations: Their economies have stronger growth prospects, and they are often backed by large foreign-currency reserves. "The quality of the debt has changed so much. About 60% of emerging-market debt is now investment grade," says Derek Young, president of global-asset allocation at Fidelity Investments.
That's a pretty stunning development. In the early 1990s, 90% of emerging-market debt was viewed as the junk pile of sovereign bond issues. Furthermore, many asset managers today like the local-currency exposure that comes with the emerging-market debt, believing such currencies will out-samba the dollar over time.
In fixed-income back in the U.S., asset-allocation chiefs are nearly all in agreement: High-yield U.S. bonds, currently yielding 7.5%, are the sweet spot. The market is pricing in more doom and gloom than is warranted, says Archan Basu, JPMorgan's global head of portfolio construction. "Current spread levels imply default rates of 7%, versus the historical 4%, and the 1.5% to 2% we anticipate," he says.
With cash on corporate balance sheets slightly over 8% of assets, twice as much as usual, junk yields should narrow relative to Treasuries while the U.S. economic recovery continues. Neeti Bhalla, Goldman Sachs Private Wealth Management's head of tactical asset allocation, is figuring on a 6% return on the S&P 500 for 2012, with 15% volatility. In contrast, she's expecting a 10% to 12% return with about 10% volatility among high-yield U.S. bonds.
Wealth managers largely are—no surprise here—underweight Treasuries and core bonds in general; neither pay well enough on a risk-reward basis. Munis were bought heavily at the end of 2011 and still are finding appeal over taxable counterparts. Not so for Treasury Inflation Protected Securities (TIPS), which have been reduced to near nothing in portfolios, the natural fallout as inflation fears have retreated.
We added columns to our table this year, so it's clear which alternative investments are sucking in money. Going forward, we are asking the wealth managers to keep us informed throughout the year of any changes in their calls.
Commodities are currently negative to neutral, relative to their long-term strategic allocation. It's logical: Slow growth globally translates to reduced demand and prices for the raw materials of industrial production. Mysterious gold is, in contrast, mapping its own course. "Last year, the Dow Jones Commodity Index was down 13%, but gold was up 10.1%," says Bob Browne, chief investment officer of Northern Trust. "We still think there's more upside than downside in gold in 2012."
REIT valuations were driven up to unattractive levels last year, but allocations are remaining steady because wealth managers picking through the real-estate rubble are still finding opportunities here and there. Apartment complexes are the big draw. On the West Coast and in the Northeast they "have done unbelievably well, and it will be the same story this year," claims Sam Katzman, chief investment officer at Constellation Wealth Advisors.
There's been only minor dabbling in hedge-fund and private-equity exposures, mostly because the investments are so illiquid. But some new capital has been pulled into hedge-fund strategies likely to do well in today's highly correlated and volatile markets. A favorite: macro hedge funds, whose managers can benefit from directional and global bets across economies, markets and currencies. "They're best positioned to maneuver in a nimble fashion through volatile markets," says JPMorgan's Basu.
Lastly, managers are maintaining cash at more than twice their usual levels. Morgan Stanley is possibly the most bearish of wealth managers, preparing for markets to come in at negative single digits in the U.S. this year, which is why the bank is holding the most greenbacks. "We have 14% in cash and cash-like investments," Darst says.
But most of the others claim their large cash hoard isn't because they are bearish, but because they want to be able to pounce on deals as they arise in this year's expected market turbulence. As Fifth Third Bank's regional portfolio director told us, "If we've learned nothing else lately, it's that things can change very quickly."
Say Amen, somebody.
Comments? E-mail us at editors@barrons.com
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