If global volatility is tying your stomach in knots, maybe you should let someone else do your worrying for you.
Where in the world?
By James M. Clash
DURING THE SUMMER stock market tumble, when the S&P 500 index lost 19% in six weeks, shareholders of the Vanguard Horizon Global Asset Allocation Portfolio had reason to be ecstatic. Their fund slid only 5%.
The performance was something of a vindication for fund manager Michael Duffy, who had shown great patience following his instincts about world market overvaluations. On the eve of the tumble he had 24% of his fund's $87 million in assets in cash and 44% in bonds. Most important, he had only 4% in U.S. stocks.
Duffy, 43, is a bit of a wordsmith for a quant with a Ph.D. in economics from the University of Chicago. In a May letter to shareholders he reported on his "calculation of animal spirits, or market exuberance," and went on to suggest that those mischievous spirits may have created "a bubble phase reminiscent of Asia in the late 1980s and the U.S. in the late 1920s."
That's pessimistic, even as bears go. "Our defensive stance saved us," says Duffy, who runs the three-year-old fund from the Arlington, Va. offices of Strategic Investment Management, the fund's adviser.
Conservatism has its price. While the U.S. market plowed ahead an average of 19% per year for the last three years, Horizon Global Asset Allocation—one of the four Horizon-series funds that Vanguard created in 1995 to help counter its too conservative reputation—gained 10% per year. Still, that's a point ahead of the median return among global asset allocation funds.
These funds are a species of balanced fund (one holding both stocks and bonds) and suffer from the same drawback—namely, that in blending different funds into a single one you lose the ability to take tax losses selectively on individual sectors. But the global funds are terrific for investors who don't have the self-confidence or the time to attend to a portfolio of narrowly focused funds. And there's nothing wrong with hodgepodge funds in a tax-exempt account, where you can't take tax losses anyway. Indeed, the high 150% turnover on Duffy's fund makes it unsuitable for a taxable account.
Duffy says he fine-tunes his asset allocations to a host of variables—interest rates, commodity prices, market volatility, inflation, earnings forecasts, discounted cash flows. In Europe, for example, Duffy thinks interest rates have fallen far enough that stocks, even near historically high multiples of earnings, are attractive. "The investor faces an even more stark choice in Europe than in the U.S.," he says, pointing to ten-year bond yields of 4% in Germany and 4.2% in France. With a P/E of 26, the average German stock has an earnings yield of 3.8%—which doesn't account for the growth potential. The average French stock has an earnings yield of 5.1%.
Instead of buying stocks directly, Duffy finds it more efficient to use index futures, like those pegged to the German DAX or the French CAC-40, and closed-end country funds selling at heavy discounts (see "Countries at a discount"). He's been buying the DAX, making it his second-largest holding at 8% of the portfolio. Among the closed-ends he likes is the Mexico Fund, with an annual expense ratio of 0.8% and a discount to net asset value of 30%.
Duffy's largest single-country bet is in Asia, where he's put 9% of the fund into the Nikkei 300 index. "Long bonds in Japan are yielding less than 1%—essentially what stock yields are," he explains. "And the price-to-book there is 1.5, versus 6 in the U.S."
Duffy is also bullish on the Aussie All-Ordinaries and the Canadian TSE-30 indexes, both rich with natural-resource stocks that have sunk to 12-year lows. "Many commodities are now trading near or below replacement costs," he says. "As an industrial buyer recently told me, the solution to low prices is low prices. The marginal guys are going out of business, moving the supply curve back, and prices will eventually go up."
Starting in July and before late August's three-day 8% stock rout, Duffy used stockpiled cash to buy U.S. Treasurys, increasing his exposure there from 30% of assets to 40%. He has taken profits in the Treasurys, perhaps a little too early, cutting the allocation back to 27%. Abroad, he has added to bonds from the United Kingdom and Canada, raising his total fixed-income stake to 47% from 44% pre-crash. He buys mostly government bonds and hedges much of his foreign currency exposure.
As for U.S. equities, Duffy thinks S&P 500 futures have started to look attractive as rates in the U.S. have fallen; he's upped his stake to 7% from 4% pre-crash.
Duffy's bargain hunting since the August slide has cut cash down to 9% of the portfolio.
As with all Vanguard funds, shareholders don't pay much for management. Horizon Global Asset Allocation is a no-load with an annual expense ratio of 0.6%, a third that of the average global stock fund.
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