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How To Optimize Warren Buffett’s Asset Allocation Advice

In Berkshire Hathaway’s 2013 annual letter to shareholders, Warren Buffett gave some retirement savings advice to investors. The Oracle of Omaha wrote in his letter to shareholders that he had given the trustee designated to manage the bequest his wife will receive, the following advice: “What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit … My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.” Buffett’s advice sparked a debate in the financial community. Many market commentators asked if this really was the most sensible asset allocation approach for retirees, or indeed any investors at all. Javier Estrada at the IESE Business School, Department of Finance, Barcelona, Spain set out to answer this question in a paper titled, “Buffett’s Asset Allocation Advice: Take It … With a Twist”. In particular, the paper set out to answer the following question: “Is the asset allocation Buffett advised for his wife appropriate for other investors? If yes, why? If not, why not?” The study considers several different variations of Buffett’s recommendation. Eight static asset allocations with varying stock/bond proportions are evaluated, with particular attention to the 90/10 split suggested by Buffett. A further two minor dynamic strategies are also considered with valuation based twists. What’s more, the study is designed around the needs and skills of the average retiree. For example, the dynamic strategies are trivial to implement, and the person managing the portfolio will only need information about the performance of stocks, or that of stocks and bonds, over the previous year, which is publicly and widely available. Asset allocation: Data The data used for the study is based on the two asset classes suggest by Buffett, stocks, and short-term US Treasury bills. Returns are annual, adjusted for inflation and account for capital gains/losses and cash flows. Over the 114 year period considered, from 1900 to 2014, stocks and US T-bills had mean annual compound real returns of 6.5% and 0.9%, with annual volatility of 20.0% and 4.6%. The test portfolio was rebalanced once a year and the study assumes an annual withdrawal is made proportional to the asset allocation. The analysis is based on an initial capital balance of $1,000, an initial withdrawal of 4% of the capital and subsequent withdrawals annually adjusted for inflation over a 30-year period. Asset allocation: Results The chart below shows the results of the eight static portfolios over the period studied. (click to enlarge) Asset allocation results Figures indicated that strategies with equity holdings between 100% and 40% have similar failure rates, but when the allocation of stocks rises above 30% failure rates increase considerably; to above 10% in most cases. Although there are varied opinions regarding what is an acceptable failure rate, most practitioners seem to agree that failure rates below 5% should be viewed as acceptable by most retirees. Upside potential is measured by the mean, median, P90, P95, and P99. Downside protection is measured by both P5 and P10. The author concludes with test with the observation that: “…although the 60/40 strategy never failed, the 100/0 and 40/60 failed 3.5% of the time, and Buffett’s 90/10 failed 2.3% of the time, there does not seem to be a substantial difference in the failure rates of portfolios holding at least 40% in stocks.” “…as far as static strategies is concerned, Buffett’s suggested allocation has a very low (although not the lowest) failure rate; a very high (although not the highest) upside potential; and provides very good (but not the best) downside protection when tail risks strike. Put differently, Buffett’s suggested allocation seems to provide a middle ground between the best performing strategy (100/0) in terms of upside potential and the best performing strategies (60/40 and 70/30) in terms of downside protection.” Adapting Buffet’s advice Javier Estrada goes on to look at two different dynamic asset allocation strategies, which are based on the static strategy recommended by Buffett, but with a few changes. The first change [T1] relates to the annual withdrawal to the behavior of the stock market in the previous year. If stocks have gone up, the retiree takes the annual withdrawal from stocks and then rebalances the portfolio back to the 90/10 allocation. Conversely, if stocks have gone down, the retiree takes the annual withdrawal from bonds and does not rebalance the portfolio. The second change [T2] relates the annual withdrawal to the relative behavior of the stock and bond markets in the previous year. Just like adoption above, if stocks have gone up in the previous year, (more so than bonds) this change calls for the retiree to take the annual withdrawal from stocks and then rebalances. However, if the returns from bonds have exceeded those from stocks over the previous twelve months, the retiree takes the annual withdrawal from bonds but does not rebalance. (click to enlarge) Asset allocation results As the author observes, results of the two twists considered are very similar. T1 has a slightly higher overall upside potential, and T2 provides a slightly better overall downside protection. Both T1 and T2 outperform the 90/10 allocation. Although, the three strategies have the same failure rate (2.3%). T1 and T2 provide retirees with both a higher upside potential (as measured by the mean, median, P90, P95, and P99) and better downside protection (as measured by both P5 and P10) than the 90/10 allocation. Conclusion Overall then, Buffett’s asset allocation advice is sound and simple. However, for those retirees that are concerned about holding such an aggressive portfolio, the two aggressive strategies may offer better returns. The author of the paper concludes: “…the two simple twists considered here improve both the upside potential and the downside protection of the 90/10 allocation. These two twists require retirees neither to collect vast amounts of information nor to make any valuation judgments but only to observe the performance of the stock market, or the relative performance of the stock and bond markets.” “Either way, retirees can, with little effort, improve upon the results of the 90/10 allocation. In fact, because the performance of the two twists considered is so similar, retirees may want to lean towards the first one (T1) and simply adjust their asset allocation according to the observed performance of stocks.” “…those retirees that find a 90/10 portfolio acceptable are likely to find that with an insignificant additional effort, observing the performance of stocks and implementing the first twist discussed, they are likely to improve the performance of their portfolios.” Rupert may hold positions in one or more of the companies mentioned in this article. You can find a full list of Rupert’s positions on his blog. This should not be interpreted as investment advice, or a recommendation to buy or sell securities. You should make your own decisions and seek independent professional advice before doing so. Past performance is not a guide to future performance.

401(k) Fund Spotlight: Franklin High Income

Summary Franklin High Income has been the worst performing high yield bond fund over the last twelve months. The fund has suffered due to its heavy exposure to commodities via the debt of energy and materials companies. The fund sports a 7.14% yield, but investors should subtract 1% for the fallout that is to come to the coal debt the fund still holds. High yield debt will likely rebound in the short term, but I’d rather own small cap U.S. stocks instead. Introduction I select funds on behalf of my investment advisory clients in many different defined contribution plans, namely 401(k)s and 403(b)s. I have looked at a lot of different funds over the years. 401(k) Fund Spotlight is an article series that focuses on one particular fund at a time that is widely offered to Americans in their 401(k) plans. 401(k)s are now the foundational retirement savings vehicle for many Americans. They should be maximized to the fullest extent. A detailed understanding of fund options is a worthwhile endeavor. To get the most out of this article, it is helpful to understand my approach to investing in 401(k)s . I strive to write these articles for the benefit of the novice and professional. Please comment if you have a question. I always try to give substantive responses. Franklin High Income Fund The Franklin High Income Fund has the following share classes: If the fund is an option in your 401(k), it will likely come in the form of the R or R6 shares. The expense ratio for the R shares is 1.11% and for the R6 shares it is .47%. For the purposes of this article, I will assume the A shares are being discussed since that share class holds most of the fund’s assets. Some readers may also own the fund outside of a company retirement plan. The expense ratio of the A shares is .76%. The Franklin High Income Fund is a typical high yield bond fund investing in lower-rated, higher yielding corporate bonds. As of September 30, 2015, the fund’s holdings were most heavily weighted to the following six industries: Energy – 16% Health Care – 10% Finance – 8% Cable Satellite – 8% Metals & Mining – 7% Wireless – 7% Beaten Up By Energy Investors who have pay attention to the markets would be right to be concerned about the large exposure to Energy and Metals & Mining, which make up almost a quarter of the portfolio. Actually, 25% of the portfolio was in energy last November and this has clearly been a source of pain for the fund since. Here is a few places where some serious damage was done: Bond Principal Amount on November 30, 2014 Market Value as of November 30, 2014 Principal Amount on September 30, 2015 Market Value as of September 30, 2015 Alpha Natural Resources $25,000,000 $19,812,500 $25,000,000 $1,812,500 Chaparral Energy ( 3 different issues ) $31,700,000 $31,339,000 $31,700,000 $9,866,500 Peabody Energy ( 3 to 4 issues ) $64,400,000 $61,575,000 $58,445,000 $17,831,000 Quicksilver Resources $35,000,000 $27,925,000 $15,175,000 $5,690,625 Terrible Performance Recently, But Better Long-Term I suspect that this is the primary reason why the fund has been the worst performing high yield bond fund over the last year (at least it is using the Barron’s fund screener ). The following chart shows the vast underperformance of the fund over the last 12 months versus the iShares High Yield Corporate Bond ETF (NYSEARCA: HYG ), a good proxy for a high yield index. FHAIX Total Return Price data by YCharts However, to be fair, the fund’s longer term performance has been much better, as shown on the following chart: FHAIX Total Return Price data by YCharts Outlook It is likely that in the near term the worst is over for high yield bonds and the Franklin High Income fund. However, the fund’s 7.14% 30-day SEC yield is still not enough to tempt me. The fund continues to have a fair amount of exposure to the U.S. shale oil and gas industry. I am bullish on oil, but this may very well come at the expense of more bankruptcies in the U.S. shale industry. The fund continues to hold debt of coal companies Alpha Natural Resources ( OTCPK:ANRZQ ), CONSOL Energy (NYSE: CNX ), and Peabody Energy (NYSE: BTU ). I’ve done the research on coal and I remain bearish. As far as I’m concerned, you might as well subtract 1% off this fund’s yield to cover the fallout that is coming. I will give the fund an honorable mention though for holding a little over 1% of the portfolio in the 2022 debt of Fortescue Metals, a company whose debt I have touted several times on Seeking Alpha. The one advantage that this fund and the high yield universe, in general, currently has is that interest rates have yet to rise. There is less rollover risk for companies having to refinance their debt. Because of this, I would not be surprised to see high yield bonds stage a comeback in the short term. Strategic Positioning My view is that we are entering the latter stages of the economic cycle and high yield bonds have already felt the tremors of more trouble to come. At present, I prefer to hold U.S. equities-namely small caps where valuations have recently come down quite a bit-over high yield debt and also a lot of cash. Nevertheless, if the fund’s high yield is too much for you to pass up, given that short term rates are near zero, I would limit exposure to no more than 5% of your entire 401(k). Investing Disclosure 401(k) Spotlight articles focus on the specific attributes of mutual funds that are widely available to Americans within employer provided defined contribution plans. Fund recommendations are general in nature and not geared towards any specific reader. Fund positioning should be considered as part of a comprehensive asset allocation strategy, based upon the financial situation, investment objectives, and particular needs of the investor. Readers are encouraged to obtain experienced, professional advice. Important Regulatory Disclosures I am a Registered Investment Advisor in the State of Pennsylvania. I screen electronic communications from prospective clients in other states to ensure that I do not communicate directly with any prospect in another state where I have not met the registration requirements or do not have an applicable exemption. Positive comments made regarding this article should not be construed by readers to be an endorsement of my abilities to act as an investment adviser.

Multi-Alternative Funds: The Best And Worst Of September

By DailyAlts Staff Multi-alternative mutual funds offer varying exposures to different alternative strategies, often managed by separate underlying managers. Thus, it’s not surprising that the category has fairly wide dispersion between its best- and worst-performing funds on a monthly basis: In September, the funds in Morningstar’s Multi-alternative category returned an average of -1.15%, slightly outperforming a 60%/40% blend of the S&P 500 Index and the Barclays U.S. Aggregate Bond Index, which returned -1.31% for the month. The top fund in the category returned +5.57%, while the worst performer posted a monthly return of -5.08% – a difference of more than 1,000 basis points. Top Performing Funds in September AQR boasted the top two multialternative funds in September: the AQR Style Premia Alternative Fund (MUTF: QSPIX ) and the AQR Multi-Strategy Alternative Fund (MUTF: ASAIX ). The funds posted respective one-month gains of 5.57% and 4.19%, easily surpassing the 1.84% gains of #3-ranked Cornerstone Advisors Public Alternative Fund (MUTF: CAALX ). The AQR funds also significantly outclass the Cornerstone fund in terms of assets under management (“AUM”), and returns over the past three, nine, and twelve months. AQR’s QSPIX and ASAIX had respective AUM of $1.3 billion and $2.2 billion as of October 19, compared to the Cornerstone fund’s healthy $474.4 million in assets. QSPIX’s returns over the past three, nine, and twelve months through September 30 were +7.30%, +5.78%, and +13.56%; while ASAIX posted returns of +6.64%, +6.97%, and +12.38% for the given periods. The Cornerstone fund, by contrast, returned +1.74% over the three months ending September 30, and +2.83 and +5.87%, respectively, for the nine- and twelve-month periods ending on that date. Worst Performing Funds in September One month doesn’t make a year as we will see with the bottom performers in September, but does highlight potential risks in particular funds and the need to have a longer-term view. The following multi-alternative mutual funds were the worst performers for the month: Catalyst’s Macro Strategy fund may have had a bad September, losing 5.08% and ranking at the rock bottom of the category, but over the first nine months of 2015, the fund returned an astounding +28.86%! That total is far better than any of the nine-month returns for September’s top-performing multi-alternative mutual funds. The fund’s returns over the three- and twelve-months ending September 30 were +3.18% and +26.22%, respectively. The Quaker Event-Arbitrage and AIP Dynamic Alpha Capture funds lost 4.94% and 4.70%, respectively, in September. Unlike the Catalyst Macro Strategy Fund, the Quaker and AIP Dynamic funds had negative returns for the three- and nine-month periods ending September 30. Conclusion Multi-alternative funds cover a lot of ground – you can tell by a quick glimpse at their names. Terms like “style premia,” “macro strategy,” and “event-arbitrage” would seem to describe different styles, and these funds do have different emphases – which is why their returns can vary by such wide amounts. Not only was there a 1,065-basis point disparity between the best and worst multi-alternative funds in September, but those same funds had a more than 23% differential in the other direction for the first nine months of the year. Clearly, investors interested in adding multi-alternative exposure to their portfolios can’t make their decision based on one month’s worth of returns – this is especially driven home by the immense gulf between the Catalyst fund’s one-month and one-year performance. But beyond merely looking at returns, prospective multi-alternative investors need to conduct deeper due diligence to ensure they understand the exposures they’re adding to their portfolios. With effective fund selection, multi-alternative investing should improve portfolio diversification, and this could contribute to improved risk-adjusted portfolio returns. Past performance does not necessarily predict future results.