TDI Podcast: Modern Disciplines (#942)

28:33So you're diversified across equities and fixed income on a global portfolio. It's different regions and countries and sectors and styles. And ultimately, that diversification across the asset classes and sub-asset classes and geographies is, while there's no free lunch, It's kind of as close as you can get by smoothing return streams, investing in different asset classes that aren't perfectly correlated, i.e. they don't go up and down at the same time and to the same level without really sacrificing expected returns. And so you can lower risk without sacrificing returns. And to your point about where a lot of that return has come from, yeah, it's absolutely come from outside the U.S.

29:27And some of that has to do with the weakness in the U.S. dollar, right? And so when you invest in European equities and Japanese equities and emerging market equities, etc., you are receiving the returns to those markets. But when you are bringing your investments back into dollar terms, as the U.S. dollar is down, call it 10 %-ish so far in 2025 relative to key developed market peers, that depreciation of the dollar, which is very much a 180 from what we've seen over the last 10 plus years, has also been additive to portfolio returns in that 60-40 portfolio. As long, right, conceptually, as long as people know that they may have investments that are outside the U.S.

30:22that actually could be dollar hedged, and there are times when you want that and times when you don't want that. Yeah, and the rule of thumb is generally, and this can obviously varied, but without any views on currencies whatsoever, we would generally not hedge currency exposure in equities. And so you'll have some dollar versus foreign currency risk there and potential return. And in fixed income, we would hedge that currency exposure. And the reason being is that because currencies are more volatile than bonds, and generally similarly to lower volatility than equities, what you don't necessarily want is that currency to be the primary driver of risk and return.

31:13And therefore, you are hedging out or you're basically eliminating any currency impacts in your fixed income investing outside of your home currency. But you're leaving that for equities because it's just not necessarily the prominent driver of risk and return there. Right. So going back to the dollar for a second, rationales, reasonings, why the dollar is fading. I mean, 10 % on a currency in a year, and that's the basket we're talking about. There are other currencies around the world where we're either a little bit above that or below that. But usually a dollar that's soft is a recognition of concern about something about that country, right?

31:58It could be also that there is an idea that the Fed is going to be lowering rates. There's a lot of things that go on here. But it seems to me that the chaotic rhythm of what goes on here in the U.S. these days is creating a little bit of an exodus. And that's also creating a buy into things like gold, silver, and hard assets, which I want to pick up on. And by the dollar being down, it's also a tailwind to those assets. so is this something that we need to be concerned of and i'm going to mention one other thing and let you answer because a few weeks ago i had peter chiffon and let's just say that he hasn't strayed from his idea that the dollar is going to collapse you know the word collapse is used a lot uh dollar is going to collapse and the only thing you really should have is a big bucket of gold yeah and and gold is uh well you can come back to gold in a second but yeah completely agree on the dollar.

32:56It has been weak. It is certainly stabilized. And so a lot of that weakness comes back to a couple of different things. Traditionally, when there's kind of geopolitical risks and concerns, the dollar tends to be a kind of a safe haven, if you will, and will do well in periods of kind of geopolitical turbulence. What is going on this year with all of the tariffs and the trade negotiations and things along those lines has led to, if you were to assume that a large majority of trade is done, you know, trades of goods and services is done in dollar terms, if the amount of trade is reduced, then there's less demand for those dollars to complete those transactions.

34:00There are some countries that have taken offense to the trade policies in the U.S., and many of those countries have large reserves of dollars. They also have large reserves of U.S. treasuries. And when there's concerns, and so if you're kind of unhappy with us potentially selling down your dollars in response to that is something that we've seen some evidence of, probably less than what people would have expected. And then to the point of treasuries, We have some pretty large fiscal deficits, which theoretically could be very problematic going forward. Pretty large? Pretty large? Is that what you just said?

34:51Enormous. Enormous is probably the more appropriate word, but yeah. And if you're concerned about owning treasuries, you sell them you don't need the dollars in order to support those assets. And so there's been a lot from that perspective. and so that has caused some weakness in the dollar. So let's talk about some, let's get into some nitty gritty about asset allocation. There was a study a number of years ago that was done. It was actually a preeminent study in the area of asset allocation. It was post-Harry Markowitz and it was all about, it was actually done for pensions, right? It was called the Determinants of, what was it called?

35:35Determinants of Portfolio, now I forgot the name of it. Oh, that's so bad. It tells my age, you know, the determinant. Let's see. I'm going to look it up live. Determinants of portfolio.

35:55I think it was Princeton B. Bauer and hood. Correct. Terminants of portfolio performance. That's what it was. I was thinking, I was thinking volatility. I had performance. Anyway, It was done in 1986. It was Brinson, B. Bauer, and Hood. I don't know. Did I ever tell you that I spent an evening with William Sharp and I had dinner at his table? And there was another time that a couple of these guys, I think it was Hood. No, it was B. Bauer. It was B. Bauer. And I went head-to-head with B. Bauer asking questions about stand deviation and utilizing downside deviation versus this. and, you know, the bastardization of how he felt about the bastardization of his study, which was not to be this whole thing about selling asset allocation like a lot of firms did, you know, back in the day.

36:44But let's talk about this and let's talk about the importance of this asset allocation. And with regard to this study, right, this whole thing that talked about the most significant factor that accounted for and determined the portfolio performance was the asset allocation. That didn't mean that asset allocation meant this blah, blah, blah, blah, blah. It meant that that was a big part of it saying that, let me say it a little differently, that if stocks, the biggest determinant of a stock is probably the general stock market itself. That's kind of the same discussion here. The biggest determinant of your portfolio's overall performance and therefore risk and things like that is where you asset allocate rather than the security selection or market timing.

37:38Correct. Yeah. So these days, though, when we have a bit of a difference, I'm not saying this time is different. I'm not saying that. Whereas the assets out there, the broad sectors and asset classes seem to be moving relatively in tandem a lot, risk on, risk off, versus we'll move into utilities for safety. We'll move into tech if we really want to ramp it. I mean, there's some of that going on, right? But generally speaking, bigger picture stocks, fixed income, real estate, they all have a bit of a rhythm. So is this as important anymore? I do think that it is. And correlations will, they will change over time, particularly over short periods, right?

38:34But on balance, you're still going to get some diversification between equities and fixed income. And we've gone through periods, even this year, when they moved in the same direction simultaneously. And we've been through periods, which is a little bit more normal, when they tend to move in different directions. But if you were to look over longer periods of time and generally asset allocation portfolios and to your point on the paper that we're referring to, that was for pension plans. And pension plans have very long time horizons, right? And I think that the number was over 90 % of returns.

39:26And importantly, the variation in returns was explained by the policy mix or that overall kind of asset allocation mix. And so over long periods of time, certain asset classes will kind of come in and out of favor in the interim. but it's how much you have of the major asset classes, how much equities, how much fixed income. We can potentially throw real estate in there and other assets. But that is going to be the primary determinant of your risk and return. And to your point earlier about if you were to look it's kind of the average stock, it does have certain attributes that are, of course, specific to that company.

40:14The industry group that it's in has some bearing on the overall performance, if you will, kind of rising tides, lifts all boats, you know, slightly differently in different industry groups. They could be leaning larger cap or smaller cap and there are indices that track those that could be a little bit different. But the primary determinant over the long term of any individual stock is going to be the market return or the primary risk contributor. And so through asset allocation and in these portfolios that were analyzed from a pension perspective and similar to the portfolios that we manage on behalf of a whole broad swath of different types of investors.

41:02It's how much you have in equities versus fixed income at a very high level. 60-40, we talked about, right, is going to give you a very different return and variation in returns than something that's 20 % equity and 80 % fixed income, which is also going to be very different from something that is more aggressively positioned that's 80 % equities and 20 % fixed income. And kind of what we did, And what we always do is we start and sit down with clients and try to get an understanding of what their objectives are, what the constraints that they have against that, right? And we want to make sure that we meet the return objectives, the risk tolerance, the time horizon, the liquidity needs, et cetera.

41:51And all that kind of makes its way into that broad, high-level asset allocation. Beyond that, there is some value to be added from leaning into or leaning away from asset classes, from choosing the right managers. But at a very high level, it's going to be the broad asset allocation, the broad market exposure that is going to determine the risk and returns that you are likely to achieve over the long term. So one of the things you do is manage the asset allocation models and for Franklin Templeton inside the various, we'll call them targets. Is that the right word? Target funds, I guess. Target data, target risk funds, model portfolios.

42:35There's been, I'm not a, listen, for my clients, I'm not a big fan of that. But for those people who have a 401k plan, let's say, I think that's the perfect place for this is the 401k plans. You know, for people that really don't know, don't have the time to deal with this and really need to have somebody semi-watching over. I just helped a client recently with their 401k. We went right into their Fidelity 401k and we set up the allocation and put it on automatic rebalance on a semi-annual basis. The automatic rebalance part of it is something that, you know, people oftentimes rely on us to do for them.

43:16because we're doing a combination of not necessarily automated, called semi-automated. When it gets to a point that we want to move, it doesn't have to be every quarter or every semi. It doesn't have to be when something we want to move something, but then we could design the rest of the portfolio around it where most people don't have that ability. So the target date funds really take care of that, right? So it rebalances and then takes you from, let's say when you're young, from an 80-20 portfolio, maybe to a 40-60 portfolio by the time you're 75. Yeah. Or something like that. It will keep you in the market, right?

43:49So it'll keep you invested. And there's the old adage of time in the market is more important than timing the market. And so it keeps the discipline of staying invested, staying diversified. And based upon broadly someone's age and what their time horizon looks like, so as they get closer and closer to retirement, their time horizon is shorter, their ability to withstand potential losses is less, and the portfolios, these target date portfolios, will make allocation adjustments based upon where people are within their basically pre-retirement lifecycle. And it's kind of a great set it and forget it solution in terms of appropriateness and discipline.

44:42I had somebody I had a discussion with a few days ago and they talked about, listen, I'm going to be retiring and I just need to be making what I'm making now. I'm like, okay, so I'm not arguing with that. However, what happens five years from now when, in fact, it used to be that you get a raise every year? Is your money getting a raise? Your retirement fund? Well, I never thought of that. Well, the fact is that even if it's not, and you don't think about that, are your costs going to stay the same? Or the fact is that just a 2 % inflation is going to creep up in over 10 years. That's going to be, without compounding, 20 % more cost factor.

45:21And you didn't keep up with it because you felt, I'll just leave it in the CD because that's easy right now. Now, I'm not suggesting that people shouldn't have any safe investments. But if you think about it, we have to really look at the idea that an asset allocation model, whatever it is, whatever that number is, is not just until you retire, but it has to take you for the rest of your life. The worst thing that can happen is that your money is in a situation where you outlive it. Right. we want your money to outlive you. And a lot of people have to, I've seen it. I've seen it where people just live.

46:05They're like, you know, I don't know what happened. And, you know, they just, all of a sudden they're, they're constantly having to do things that unfortunately, there's just not enough money to do what they need to do. I'm not talking about the nursing home cares and all that stuff. I'm just talking about just money, you know, on their expense side. So the asset allocation model, How does one go about figuring that out, aside from going to a target date fund, aside from utilizing an investment advisor? Yeah, very good question. And on the target date side, they tend to be pre-retirement vehicles, if you will.

46:45Some of them will have an asset allocation that continues to evolve for X number of years post-retirement. but they're more saving for retirement and getting you to that point. Beyond that, there tend to be income-oriented portfolios because you're going from a scenario where you are trying to save and build a nest egg to one whereby you've got that nest egg built up, you want to basically retain it, but you also need it to be able to generate enough income to support you in those retirement years. And there are a number of income-oriented model portfolios that we manage, but retirement income type solutions or income portfolios that are designed to provide competitive levels of income.

47:45And the investor kind of needs to figure out how much ultimately they need. But the portfolio does throw off a certain amount of income with the desire to, depending upon the strategy, maintain a certain amount of principle or have that principle last for a certain period of time and then ultimately be liquidated after X number of years. But ultimately, you want something that is going to generate you income and is not going to do so with an inordinate amount of risk that you could be exposed to potential losses should there be market drawdowns. And so they tend to be a little more conservatively oriented.

48:32So what's your expectations on like a 60-40 portfolio in the next 10 years? Now, one of the things, let me set the stage, is that a lot of people are talking about that maybe we're ahead of our skis with valuations. And usually when you see these kinds of incredible runs of markets for a number of years, I mean, the last five years has been like, oh my God, that's enough. That's good. I mean, you could package that up for a lifetime of returns right there if you did it right. But what are we talking about and the expectation that you're looking and modeling for the next 10 years? Yeah. So last 10 years, global equity, global fixed income, this includes emerging markets, has returned about eight and a quarter percent.

49:12That relative to the last 25 years is kind of 80th percentile. So it's pretty darn good. next 10 years. And this is using return expectations that we develop. There's a number of firms like ourselves that have return expectations. They are mostly valuation oriented. And kind of the high level idea behind that is when markets are very expensive, you can expect forward returns over the next 10 years or so to be less than average, right? And when markets are quite inexpensive, you can expect returns over the next 10 years or so to be higher than average, all else being equal. Sitting here today, markets are generally not cheap.

50:10U.S. equities are not cheap at all. The rest of the world relative to the U.S. is less expensive. But overall, that 60-40 portfolio 10-year return expectation is about 6.5%. Not exciting to anybody. Nobody's excited about that. And that's a little bit lower than the last 25-year averages. That's the important part, though, the reality. We may not be excited about it, but the reality is that's what the numbers are. Yeah. And getting back to your question about whether the U.S. is done or the rest of the world is taking over from a valuation perspective, the rest of the world is cheap. And therefore, our return expectations are modestly higher for developed and emerging markets outside of the U.S.

51:00over the next 10 years relative to the U.S. Yeah. One of the things that I've talked to you about a little bit, and I know there's something that we're going to kind of probably have to keep talking about over time because there's a big question mark in my mind about the quality of earnings. And what I mean by that is that we have companies that are ponying up all sorts of money to fund a variety of different build-outs or product purchases. And the question is, where is that money coming from and how is it working? So when I talk about like vendor financing or circular calculations when it comes to financing and income, One of the things that we saw this last few years is companies like a Microsoft or you take even a Google.

51:52There's a variety of them, right? And what they've done is they've taken chunks of money, invested that in startups and other companies. Those companies are turning around and buying platform space with Microsoft. So Microsoft takes$10 billion, gives it out to these companies, says, you know what? You're going to develop your stuff. We want you to develop on the Azure cloud. Okay, fine. and it comes back as, I'm just picking a number out of the blue here, $7 billion comes back to Microsoft. So essentially and effectively, what Microsoft did was they took money off their balance sheet and turned it into their income statement.

52:32Interesting. How long does that last? Well, there's a lot of balance sheet assets out there. And what happens is it's growing because the value of their stock is growing so much too, it doesn't really matter because they have that capital use for other things. Then what you have is vendor financing, companies like NVIDIA. NVIDIA, what they did was they said to various players out there, you know, we're going to do this. You're going to buy our chips from us, like with OpenAI, big numbers. OpenAI turns around and says to Oracle, you know what, we're going to probably fund somewhere in the, somewhere about, you know, $300 billion over the next five or six years.

53:09Meanwhile, OpenAI is losing money every year. Where are they coming up with the money? Well, maybe it's part of the deal that Microsoft's given them. So there's this big circle jerk and vendor financing going on. We've seen this before. This is back in the tech bubble, not trying to freak people out here. But my question is, when you have your fundamental guys on the job there at Franklin Templeton, is anybody asking them to understand more about the quality of earnings and where they're actually coming from? because I think that's something that we need to be aware of. It may, by the way, it may be fine.

53:46It may be just, hey, that's good. Everything's good. Yeah. But is that something we're looking at? It's something that we, within my team, look at a little bit less because we're more asset allocators than folks that do this. I see more top down. Yeah, we're more top down. And so we'll leave that analysis to the fundamental stock picking folks amongst the other teams that we will then farm out money to. One of the themes that we have seen that we continue to keep a watchful eye on, and I think this is a very similar type of a scenario, is corporate buybacks. Right. And and the fact that the expectation for for the full year of 2025 and we're three quarters of the way through the year, those numbers are becoming much more clear.

54:47But somewhere in the vicinity of a trillion dollars of stocks is being bought by those companies that issue those stocks. And, you know, it's really a function of various uses of capital. And if you think that your stock has a better opportunity to deliver returns than opening a new plant somewhere or, you know, building out. Especially because you're the king of the stock return if you're buying it back and pushing the price up. Correct. And when you're buying it back, there are fewer shares outstanding. And under the same amount of earnings with fewer shares outstanding, which is the denominator of that equation, that will increase your earnings per share.

55:40To your point about quality, that might not be the greatest quality of earnings growth, but it is a big portion of earnings growth. And when they are buying back their stock, that is creating demand to buy that stock. And so if that were to go away, that would be a large net negative to the equity market. So Howard Silverblatt, who is the keeper of the keeping information and all of the data and all that for S &P 5, for the S &P indices, S &P Dow Jones Industries. I don't know if you know him, but he's been a friend of the show. He's been on for, I don't know, 12 years. He's been coming on the show regularly.

56:18He's actually down here in Florida, too. We should probably do a lunch. But the thing about Howard is I've talked to him before. I said, has anybody done an analysis that strips out and does a retroactive look at earnings without stock buybacks? And I can never get a really good answer. But don't you think that would be something to look at? Yes. Companies are very fond of saying, you know, we have here's our earnings on a constant dollar basis. or saying without extraordinary items or with this, or they give you all sorts of reasons and rationale, right? As long as it's in their favor. So why not look at some of these things to try to really get down on what the real earnings are?

57:08Wouldn't that be striking to see if companies are really adding that much to their earnings just from the financial engineering? Right. That was the word I was going to use. financial engineering is. And stripping out the financial engineering could be a very good way of understanding just the organic growth rates of the company. Yeah. And what's interesting is, listen, the stock buybacks, they call that shareholder-friendly types of transactions. I'm a shareholder. I like them to be friendly. I'm all happy about it. I'm not complaining. but you wonder when, you know, all of these things kind of slow down a little bit and then, you know, there's a big change that happens and all of a sudden, who knows what that pillar that is going to be the weak one that's holding this all up.

58:02That's something to think about. That's something to think about. All right, we talked about gold. We talked about Europe. We talked about EMs. We talked about 60-40, Brinson B. Bauerhood. We covered a lot of area with Tom Nelson. Tom Nelson from Franklin Templeton Funds. Always good to have you on. Thanks for joining me again. Appreciate it. Thank you, Andrew. Thanks. Well, that's going to wrap it up for another great show. We have so much coming up the next few months, all the way through, I think, January. We are booked with great guests. So make sure that you're here. We have Howard Lindzen coming up.

58:31We have Danielle DiMartino Booth with an insider's look at the Fed, Vitaly Katzenelson. And we have just a whole host of people that are coming up. So make sure to be there. Ross Gerber, Tim Knight, Howard Silverblatt. I mean, boy, the list is thick. Make sure you are a disciplined investor. Make sure you stay a disciplined investor. Make sure you go to thedisciplinedinvestor.com and see all the things that we have to offer you over there. Thanks for joining me. I'll see you again real soon. This podcast is intended for informational purposes only and does not constitute personalized investment advice.

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