Rethinking Strategy to Increase Allocations to Asia

My last blog on Asian equities (represented here by the MSCI AC Asia Pacific ex Japan Index) discussed my bullish view on this region for 2013 because of relatively attractive valuations and an analysis of forward returns from similarly attractive price points. Of course, one must recognize that Asian equities typically display higher risk levels than U.S. equities (represented by the S&P 500 Index) or developed international equities (represented by the MSCI EAFE Index), and almost as much risk as Emerging Markets (EM) Equities (represented by the MSCI Emerging Markets Index) over the past decade. One traditional approach used to manage risk in asset allocation is combining higher-risk assets such as equities with lower-risk assets such as bonds in a multi-asset framework. In this piece, we look at such a portfolio combination of Asian equities with Asian bonds (represented by the HSBC Asian Local Bond Index (ALBI)) to evaluate potential mixes with various risk profiles. Targeting the Blend While we recognize that every situation is different, it is useful to start any asset allocation discussion with a goal in mind. In this case, we asked whether there was a particular combination of Asian equities and Asian bonds that, over the past 10 years, delivered approximately the same level of risk as U.S. equities. We start here because U.S. investors tend to overweight their portfolios toward domestic assets.   The 60/40 Framework—Similar Risk to U.S. Equities over the Past Decade (For definitions of terms in this chart, please see our Glossary.)   • Asian Debt: Delivered an average annual standard deviation that was approximately one-quarter that of Asian equities and less than half that of U.S. equities over the period. Asia’s debt—specifically its sovereign debt—registered a yield to maturity of 3.59% and a duration of 5.63 years—all while being 94% investment grade as of February 28, 2013. • 58% Asian Equities/42% Asian Bonds: The combination (very close to a 60%/40% equity/bond model) delivered approximately the same level of average annual standard deviation as did U.S. equities over the past 10 years. However, the 58/42 equity/bond combination exceeded the average annual return of U.S. equities by nearly 5.5%.   Of course, there is no way to know whether this combination will produce a level of risk comparable to U.S. equities over the next 10 years, but we believe it is a worthwhile illustration of how a multi-asset class approach could have the potential to lower the volatility experienced by Asian equities alone. Another Tool in the Search for Income Generation When considering the aforementioned blend of Asian equities and Asian bonds, we believe that another useful attribute could relate to the current low interest rate environment. The truth of the matter is that traditional income-producing assets—such as 10-Year U.S. Treasury Notes or high-quality fixed income (Barclays U.S. Aggregate Bond Index)—remain at very low levels. As of February 28, 2013, Asian equities exhibited a higher trailing 12-month dividend yield than U.S. equities, and Asian bonds exhibited a higher yield to maturity than both high-quality fixed income and 10-Year U.S. Treasury Notes. Further Potential Benefits with a Fundamental Focus WisdomTree focuses on Asia with strategies for both equities and debt markets. The main difference regards a separation of market capitalization from weighting, instead focusing on fundamentals.   In the coming years, Asian countries have the potential to be engines of global growth. We believe that multi-asset-class exposure as well as a fundamental focus could have strong potential.   For more information on the subject, read our research here.