Investment Strategy Desing: Investor's profile - Asset Allocation & Security Selection

2. Investor’s profile. Objectives

Investing is not for everyone and not all forms of investing are suitable for every investor. Our task is to develop an investing strategy that adjust to the following factors: previous investment activities, general knowledge of investment products, personal situation, risk aversion levels and objectives.

The investment strategy that we will propose will be designed for a retail investor, without previous experience trading in the stock market and with a relatively small, accumulated wealth. The ideal investment horizon is between 3-5 years, and we will refrain from doing intraday trading which is likely to undermine the performance of our algorithms and be subjected to emotions.

In terms of behavioral biases towards risk, the investor should be generally comfortable managing risks. However, we aim at taking the minimum short/leveraged position which entail greater risks. Our strategy will be mainly constructed around long positions in assets we expect to appreciate. We will also consider some common knowledge advice such as: younger investors should invest more in stock relative to bonds, and retail investors should not follow active investment strategies.

When it comes to asset distribution and given that our investor is expected to own most of his assets (education, labor, housing, etc.) in Spain, we will prioritize investments in other geographic regions.

2.                                      3. Investment Strategy.

We will construct a diversified portfolio that is resilient to changes in the market via uncorrelated assets and will use ETFs to invest in sectors in which our specific knowledge is more limited profiting from their liquidity, diversification, and low transaction costs.

As stated earlier, we will follow a passive investment strategy as much as possible with the aim of minimizing buy/sell commissions. We will pay close attention to those assets that have suffered important corrections in 2022 and that now offer more attractive valuations.

We will carefully select those assets with risk factors that make them unappealing to other investors, that are being priced with relatively low multiples and that we consider to be undervalued relative to their potential growth. In addition, we will also do technical analysis to determine potential entry levels.

3.1. Asset Allocation.

The next step when constructing our investment strategy is determining how much to allocate to risky assets (stocks, commodities, crypto, etc.) and how to much to risk-free assets.

At almost any other point in time, given the characteristics of our objective investor, we would recommend investing little to nothing in risk-free assets due to the low risk-return ratio. However, things have changed after 2022 and the outlook for this type of asset is very promising in 2023.

In a context like todays, with high volatility and inflation, there is almost no asset which could be classified as risk-free. Inflation makes cash lose purchasing power and only now are we starting to see some banks offers positive returns on deposits (even though in real terms it they are still negative). For us, the most convenient “risk-free” asset is going to be US government bonds. Before giving exact weights, we would like to review why we consider there is a promising future ahead of these securities.

Fixed-income securities: a promising future ahead.

In 2022, high inflation pushed the FED to undertake the greatest increase in interest rates since the 70s and 80s. To remain competitive, the US Treasury must pay higher coupons on its newly issued debt to the point where it begins to be very attractive for investors to acquire fixed-income assets from the biggest economy of the world.

The biggest threat is the possibility that inflation hasn’t peaked yet and all that we are experiencing is a downward trend that will be followed by yet a higher maximum. However, as we have seen in the Macroeconomic Analysis, we do not see this as the most likely scenario. Altogether, we shall not forget than even in the worst case, we will see a depreciation of our bonds, but we will keep receiving the promised coupons and our money will be secure if we maintain the bond until maturity. In addition, in this situation stocks will also suffer and will do so relatively more than bonds.

Another risk is the decision of the FED to carry on Quantitative Tightening (the FED is planning to cancel the repurchase programs and let the issued bonds mature) which will increase the supply of bonds. However, we expect many investors to start taking long positions in bonds and thus absorb a significant volume of the bonds that were previously purchased by the central bank.

What we really expect is investors to shift their focus from inflation to tackling the economic recession what has traditionally been a favorable environment for bonds. In addition, were the US economy to fall into a recession in 2023, it is also likely that the FED will pursue some kind of expansive monetary policy putting downward pressure on the yield and thus increasing the price of our bonds.

We want to purchase bonds from the US and not any other country in the world because we do not want exposure to default risk. It is true that other less developed nations are offering higher yields on their bonds. However, tightening financial conditions and increase interest rate makes also more likely that a government runs into a default. In the future, once the ECB stops purchasing bonds from peripheric countries (Spain, Portugal, Italy, etc.) and starts doing QT, we will see a normalization of the risk premiums and we could start considering the opportunity of investing into these countries because the risk-return ratio will be more adjusted.

Finally, contrary to stocks where we capitulation is yet to be seen, we have seen net outflows from bonds, certifying this negative investor sentiment that is common to all market reverses.

Now the question is how much of the portfolio to allocate to fixed-income assets. One alternative could be to follow the traditional 60/40 strategy which by the “law of contrarian sentiment” should perform well this 2023 after the catastrophic 2022. Even though, we have outlaid a positive outlook for US bonds, we understand that our strategy shall be comfortable assuming greater risks. What we are going to do is move onto the construction of the risky portfolio, calculate historic returns and volatilities, and then use traditional AA formulas to calculate the optimum weights.

3.2. Security Selection.

In this section we are going to analyze specific products, the characteristics that motivate our investment and the potential risks that could undermine the performance of our portfolio.

Position #1: iShares 7-10 Year Treasury Bond ETF (IEF) (USD)

Both the motives and the risks for this investment have been outlined before. This ETF is a collection of US bonds with maturities in between 7 and 10 years and the coupons are incorporated to the ETF’s price. It has suffered a 20% decline from its peak in 2020 and is now fighting with a historic resistance level at $99 (which coincides with the 23.6 Fibonacci retracement from the historic maximums).

The ETF is priced in USD and thus it is subject to exchange rate risk. We will seek to hedge our position in USD afterwards by combining all the positions in USD.

 

Position #2: iShares China Large-Cap ETF (FXI) (USD)

China’s reopening is offering a promising outlook for the second biggest economy in the world. FXI offers exposure to the biggest companies in China and lost more than 60% of its value since its peak in 2021. Chinese companies are trading at very low multiples and many sectors are back at 1990s levels which offers lots of room for appreciation.

China is also one of the very few economies which has positive real interest rates which gives its central bank the possibility to conduct expansionary monetary policy if needed to combat a contraction of consumption. They also have relatively low levels of Debt to GDP ratio. Finally, many scholars are coming up with the idea that China will surpass the United States as the biggest economy in the world. They own most part of US debt due to their trade surplus and are investing a big percentage of this money in gold to protect themselves from any possible credit crisis.

When it comes to the risk factors, we can include the following:

-        Covid-Zero policy return. In January, President Xi announced the end of the program aimed at restricting mobility and preventing the spread of the virus. This was very much celebrated by the markets hoping for a recovery of Chinese consumption. However, as we experienced in western countries, the sudden reopening of the economy leads to higher rates of infections (with very low death rates). We have to rely on the Chinese government not backing up due to this initial and temporal effect.

-        Real State bubble. Real state is China’s biggest sector. It occupies a large percentage of the population and has already experienced extreme situations in the past (Evergrande). Our fear is the potential damage to other sectors due to the high interconnection.

-        Credit risk. In China, private debt is very high (Figure 3) and we shall not forget that interest rates are positive in real term in the country. However, given that the main banks in the country are nationalized, we expect the Chinese government to block any possible damage to its financial sector.

We have chosen the ETF called FXI because it is very liquid, has a relatively low P/E ratio (9.48) and expense ratio (0.74%). The aspect that worries us the most is the high percentage assigned to companies in the Consumer Discretionary sector (33.36%) which will suffer as a consequence of a global economic downturn. However, internal demand should be great enough to compensate for this effect.

 

Figure 3. China’s Private Sector Debt.

 

Position #3. iShares Russel 2000 Value ETF (IWN) (USD)

With this second position on stocks, we aim at having exposure to the US. Even though, we believe other regions to outperform, it is important to have in our portfolio the current biggest economy in the world.

Another factor behind our decision, is the undervaluation compared to large companies (Figure 4). This could also give us opportunities to implement a strategy using relative indexes: Long Russell 2000 and short the S&P500.

Figure 4. P/E of Small minus Large-Caps. Data retrieved from S&P, Russell Fact Sheet. Credit Suisse.

We also believe that small companies will be the biggest benefiters of cutting interest rates because most of them run on promising future payoffs that are very sensitive to interest rates.

The ETF IWN selects those small companies within the Russell 2000 that correspond to the category “Value”. As commented before, we would also expect Value to do better than Growth in this context of high interest rates and economic contraction. That is why we would focus on well-established business, with a long tradition of dividend payment, low debt ratios and strong competitive advantages.

Position #4. SPDR Gold shares ETF (GLD)

While many analysts consider that gold has not lived up to the expectations in 2022, we see gold as one of the few assets that has had positive nominal returns during last year. Although one would have expected gold to perform better in a context of high inflation, the strong negative relationship between gold and the US Dollar has been very detrimental for this commodity.

However, during this period many central banks around the world have continuously accumulated gold in their vaults. Increasing demand for gold is not met by supply and this should push the price up. The risks when investing in gold come from the great market price manipulation done by institutional investors which sell “paper gold” to keep its price down. We believe this strategy cannot be carried out indefinitely and sooner or later the price of gold will reflect is true value. In addition, economic uncertainty brought by unprecedented levels of debt can redirect investors into gold.

GLD is the most popular commodity ETF in the world. The investment objective of the Trust is for the GLD to reflect the performance of the price of gold bullion, less the Trust’s expenses. Its gross expense ratio is 0.4% and the Gold Custodian is HSBC Bank plc.