FORSYTH PARTNERS ASSET ALLOCATION MODELS

By Forsyth Partners Limited

We feature a series of model portfolios with the intention of providing practical guidance for readers. It is updated and published quarterly.

The core portfolios are Global Equities, Global Bonds and Global Emerging Markets. In each of these we show the ‘FP Model Portfolios’ compared with major benchmark indices and an average of the positions of the leading fund managers.

Whilst we indicate specific percentage weightings, these should be used as broad guides and readers may wish to manage portfolios in a practical sense by considering exposure in terms of "ranges".

We divide the world into two broad groupings:

1. Developed Markets include North America, Japan, Continental Europe and the UK
2. Emerging Markets are featured on a regional basis to include South East Asia, Latin America and Emerging Europe, Africa & Middle East.

We also specify a number of portfolio variations based upon the core portfolios noted above. These include a series of Balanced Portfolios, a Positive Growth Portfolio and Currency Tilted Portfolios for Sterling, US Dollar and European investors who wish to retain a heavy proportion of their assets in their base currency. These portfolios are described from pure equity and balanced portfolio perspectives.

Last but not least we also feature performance information showing the results achieved. Please note, however, that the performance information is usually updated 1 month after release/publication of the asset allocation models.

Links to sections:
Global Overview, Market Commentaries - United States,  Japan, Continental Europe, United Kingdom, Emerging Markets - South East Asia, Latin America, Emerging Europe, Africa and the Middle East, Lessons from History.

GLOBAL EQUITY PORTFOLIO

Comment:

We have decided to make only a modest change to the content of our Global Equity Portfolio this quarter. The main emphasis continues to be towards the US market which we see as being the prime driver of world equity market fortunes. The 50% weighting is broadly in line with that of the MSCI World Index.

Following the introduction of the Euro we have decided to increase the European weighting by a modest 2.5% on the grounds that the Euro will be strong and that European bourses will benefit from the new confidence factor. We are reducing our UK weighting by 2.5% to compensate.

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A Revised Approach

To date, our Asset Allocation module has featured the FP Global Bond Portfolio setting out a single strategy for global bond investors with the model weightings being determined in relation to the Salomon World Government Bond Index and the weightings of a group of leading global bond funds. Specific fund recommendations were also included. The use of a single model took into account the views of fund managers about the relative attractions of bond instruments and currencies. However, with the advent of the Euro, we believe it is more appropriate to set out a series of bond strategies which can reflect the currency profiles of investors and which also recognise the divergent views amongst commentators about the potential strength/weakness of the Euro in the new world order.

We have set out a series of model portfolios established from a US Dollar, Euro and Sterling perspective. The combined value of markets in the Euro bloc is now larger than that of the US bloc and, therefore, a strategy for this market is clearly required. Sterling has to some degree been sidelined but we include a Sterling model simply because many of our subscribers have clients whose returns are managed against a Sterling base currency. In each case, a recommended portfolio is set out to reflect scenarios which the base currency of the client model will be strong or weak.

Constructing the Model Portfolios

We have noted in the past that the performance of single country bond funds has generally left something to be desired largely because expense levels can severely impact the level of returns. The successful bond managers are those who have managed global or regional mandates. As well as having the opportunity to structure portfolios to take into account the attractions of instruments with different maturities, there has been the opportunity of being able to add value by applying a currency overlay. Indeed, many of the funds with global or regional mandates could attribute a large part of their returns over the years to the contribution from currency management. In Europe, at least, the scope for currency gains has largely disappeared. There is now no scope for the fringe market plays against the Deutschemark and the other core European markets.

The focus of our model portfolios will, therefore, be more towards global and regional funds. Those funds featured in the model portfolios are all Rated Funds and details are set out in the Bond Funds section of the Fund Selections module in the Manual. We are aware that the major bond fund managers are rapidly expanding their choice of global and regional vehicles. A whole host of Euro denominated funds have already emerged and we see "Euro Pricing" being offered on a number of existing funds. As our new approach features models referenced to a base currency it becomes most important that we understand the currency strategies which the fund managers will be adopting. For example, the attitude towards hedging will not always be obvious, even though a fund is priced or denominated in a particular currency.

Our Preferred Scenario

Our discussions with global fund managers lead us to take the view that the most likely outcome for at least the next three months will be one in which the Euro will remain firm. Hence, in calculating the performance of our model portfolios we shall use the "strong Euro" model.

GLOBAL BOND PORTFOLIO

Comment:

As noted later in our Global Review, we strongly prefer bonds over equities at present. With hindsight, our overweight position in emerging market bonds did us no favours in the last quarter. Going forward, particularly after the sell off and with yield spreads having widened significantly, we still retain a weighting although a more cautious one. As the prospects of reducing interest rates on a global basis are good, we have boosted our weightings in the core areas of the US, the UK and Continental Europe. Favoured currencies are found in countries with current accounts surpluses. We note that the global bond managers are actively managing currency exposure at present with the Deutschemark bloc currently being favoured.

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GLOBAL EMERGING MARKETS PORTFOLIO

The emerging markets of South East Asia have enjoyed a return to good fortune in the last 3 months. The upswing was much stronger than most commentators expected. The Latin American markets have suffered on the back of the problems in Brazil although there does appear to be an indication that the IMF action, with the support of the US, will succeed. Despite this, there are question marks over the fundamentals for the region. With the exception of Russia, the central and Eastern European markets have come back into favour slightly but the real opportunities do seem to arise in the Southern European emerging markets of Turkey, Greece and Portugal. Portugal was one of the first phase Euro currencies and is now included in the MSCI Europe Index (for developed markets) but several of the emerging Europe regional funds still feature an exposure.

Going forward, we believe that the momentum in Asia will continue during the first quarter on the back of a strong Wall Street. Hence our decision to overweight this market. We are making no change to the Latin America weighting and the boost to Asia has been financed by a cut in the EAME weighting.

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BALANCED PORTFOLIOS

Comment:

The Balanced Portfolios have been constructed under three scenarios – 70/30 equity/bond, 50/50 equity/bond and 30/70 equity/bond. The purpose of providing three scenarios is to enable readers to choose the most appropriate model to select specific client risk profiles. The composition of the models flows directly from the Global Equity Portfolio and the Global Bond Portfolio. The figures show Q3 1998 weightings in parenthesis.

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POSITIVE EQUITY GROWTH PORTFOLIO

Comment:

The Positive Equity Growth Portfolio is intended for investors who wish to take a long term (5+ years) view. Over this time horizon we believe that it is reasonable to expect that equities will outperform bonds and that emerging markets should outperform developed markets although higher volatility levels will feature in the former. The composition of the models flows directly from the Global Equity Portfolio and the Global Emerging Markets Portfolio. The figures show Q4 1998 weightings in parenthesis.

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CURRENCY TILTED PORTFOLIOS

Comment:

The currency tilted portfolios recognise that many investors prefer to have a substantial proportion of their assets held in their home currency or country. The "Equity Only" portfolio above is constructed from the Global Equity Model. However, the figures reflect a 50% weighting in the home equity market before the Global Equity Model is applied. For example, in the US Dollar tilted model, the 75% weighting in US equities comprises a core weighting of 50% together with 50% of the 50% US exposure in the Global Equity Model.

The same principles are applied in structuring the "Balanced 50:50" portfolio. The method of determining the equity element is the same as that on the "Equity Only" portfolio. The bond content also follows the same principle, but now uses the currency perspective model portfolios.

We are showing in parenthesis the figures for Q4 1998.

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1998 was one of the most turbulent years in recent stockmarket history. Indeed, for many market operators who had not seen the Crash of '87 the events during the Summer were a sanguine reminder of how a free market actually works. Towards the end of the year we saw a liquidity driven rally whilst, at the year end itself, markets were very subdued pending the introduction of the Euro. The purpose of this commentary is not to dwell on the events of the Summer. The reasons for the near melt down in capital markets and the rescue actions of the Federal Reserve have already been well expounded.

So what for the future? What does seem to be clear is that volatile stock and bond market conditions are likely to remain with us. The global movement of capital continues to increase strongly and shifts of preferences between asset classes will have a significant effect on the relative value of the asset classes themselves and, within the classes, on the markets themselves. Market timing will become increasingly more difficult. One further reason will relate to the argument between those who continue to worry about the sustainability of corporate earnings (how can high "P"s be justified with "E"s under pressure) and those who simply "go with the flow", riding on the back of a liquidity driven rally supported by merger activity and corporate reconstruction.

Unless the investor is very nimble and has a crystal ball with on-line access to some higher Being, then the safest route may be to hold to that asset class - equities - which has consistently delivered the best returns over time.

However, in the real world, where there are real clients who do not like losing money, this approach may not be acceptable. Even though we have seen better stockmarkets in the last three months, by historic standards valuations remain unduly high. Therefore, it is probably right to include some degree of balance in portfolios. There is still scope for further interest rate cuts and these will be necessary as the news on corporate earnings will disappoint investors. Bonds will deliver solid but unspectacular returns against this background.

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UNITED STATES

Despite the problems of 1998, the S&P 500 Index showed a return of over 20% during the year. Earnings expectations may be unrealistic but the US market continues to be supported by a wall of liquidity. In unnerving times, the market will also be favoured by international investors as part of the continued flight to quality assets. When Alan Greenspan slashed US interest rates in the Autumn in order to prevent a global credit crunch, he reinforced the confidence of the American investor but also the confidence of American consumers in general. It is this consumer confidence which is providing the support for the US and global markets.

From a fund perspective, the out-and-out growth funds have been the star performers. Apart from a short period in the early Autumn, the value managers have continued to struggle. Small cap funds have underperformed the big caps. An exception, perhaps, lies in the technology sector where there was a surge in the prices of Internet related stocks in thin markets.

Is next year to be any different? Many commentators talk about the conditions in 1999 beginning to favour the stockpickers. They argue that indiscriminate buying will no longer suffice and that selectivity will become more important. They will be right if the US economy does show any significant signs of slow down.

Our analysis of global equity managers shows that in the last quarter the US portfolio content of global equity funds has increased to 39.5% (37.8% three months ago). Global bond managers have maintained their Dollar bloc weighting at 45.3% (45.2%) and weightings lie well above the benchmark neutral position of 34.0% on the Salomon World Government Bond Benchmark.

JAPAN

We have decided to maintain a modest 5% weighting in Japanese equities in the global equity model. We find the market difficult to call and believe that it is too risky not to be a participant. Over the last quarter, whilst the market has disappointed, the strength of the Yen has bolstered up Dollar returns. The main worry continues to be the banking system and the speed at which financial reforms will be introduced.

Our analysis of global equity managers shows that in the last quarter the Japanese portfolio content of global equity funds has increased slightly to 9.3% (from 8.7% three months ago). Global bond managers have further decreased their Yen bond weighting to 3.0% (2.2%) but weightings lie well beneath the benchmark neutral position on the Salomon World Government Bond Benchmark. Our discussions indicate that the managers remain distinctly negative about the prospects for Japanese bonds with yields likely to rise .

Recommended Weightings:

Equities in Global Equity Portfolio 5.0% (5.0%)

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European equities were badly damaged in the summer but have made a sound recovery since then. There are major worries about the sustainability of a recovery on the grounds that the European economies are struggling to avoid recession. The introduction of the Euro has in some sense meant that investment managers have not always had their eyes on the ball. In December, for example, volumes were very thin as the level of trading activity, or the lack of it, was dictated by administrators. Volumes in the European stock market fell particularly sharply but there was some activity amongst the core currencies, particularly the Deutschemark, which many investors had viewed as being effectively the same as the Euro.

Our analysis of global equity managers shows that in the last quarter the European portfolio content of global equity funds has declined slightly to 28.2% (29.0% three months ago). Global bond managers have increased their European bond weightings yet again to 37.7% (34.5%). Weightings remain slightly under the benchmark neutral position.

Recommended Weightings:

Equities in Global Equity Portfolio 27.5% (25.0%)

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UNITED KINGDOM

As noted above, we are increasing our European equity weighting and this increase is being financed by a reduction in the UK exposure. At the revised 12.5% level, exposure lies more in line with the MSCI benchmark neutral position. The chart shows the performance of the European markets against the FTSE All Share Index. Despite the heavy sell off in European markets in the summer, the markets on the continent have significantly outperformed the All Share over the last year. We expect this trend about performance to continue but, perhaps, not to the same degree.

Our analysis of global equity managers shows that in the last quarter the UK portfolio content of global equity funds has declined to 11.4% from 14.1% three months ago. Global bond managers have reduced their UK bond weighting to 9.7% (10.5%). Weightings still lie well above the benchmark neutral position.

Recommended Weightings:

Equities in Global Equity Portfolio 12.5% (15.0%)

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General Comments

Despite the fact that the risk reward scenario leaves emerging markets relatively unattractive compared with the developed markets of the US and Europe, the environment for emerging markets as an asset class has steadily been improving over the past weeks. Managers are increasingly focusing on macro risks such as the level of debt and currency risk, and there is currently much greater discrimination between the different markets on the realisation that certain markets are more developed than others.

We expect interest to increase towards EU convergence plays such as Hungary and Poland, in the same way that Greece attracted enormous interest. Investors are likely to seek higher returns as interest rates fall in the developed countries and Poland, which continues to have relatively high real interest rates, may well attract increased foreign investment. Additionally, the view that the downside risk is lower than the upside potential seems to be leading investors to want to take advantage of the value currently to be found and on a longer term view. Improving corporate governance and more sophisticated management in selected markets is another factor that is likely to result in increased interest in emerging markets on a selective basis.

 As emerging markets have become governed to a greater extent by global events, we are noting that managers are making a play on global themes such as technology. Thus, India, although a minor market in global terms, features more than one would expect as a play on information technology where it has a global competitive advantage.

Another key global theme is liquidity and over the course of 1998, investors have focused more on the most liquid blue chips across both developed and emerging markets and now seem more prepared to invest in the more liquid emerging markets such as Hungary.

We are retaining our 5% weighting in emerging markets in the global equity portfolio and continue to recommend exposure through a global fund given the modest weighting. As noted in the global emerging markets model, our preference on a regional basis lies with South East Asia. Our discussions with managers indicate that the risk/ reward scenario still leaves emerging markets relatively unattractive compared with the developed markets.

After a torrid 1997 followed by the downturn of the summer of 1998, the Asian markets have performed well and showed significant added value compared to those of Latin America where the Brazil problems still give rise to concern. We should also note that the events in Brazil can not be viewed in isolation and that any deterioration on the economic or political front will lead to a spill over into the US and other markets.

Recommended Weightings:

Equities in Global Equity Portfolio 5.0% (5.0%)

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SOUTH EAST ASIA

Our analysis of global equity managers shows that in the last quarter the South East Asia portfolio content of global equity funds has increased significantly to 4.4% (2.4% three months ago). Our analysis of global emerging market equity managers shows that South East Asian weightings have moved ahead strongly to 26.5% compared with 19.8% last quarter.

Recommended Weightings:

Equities in Global Emerging Markets Portfolio 40.0% (25.0%)                 

LATIN AMERICA

Despite improving investor sentiment towards Latin America, the region remains somewhat of a wild card as a number of issues still need to be addressed before investors can justify an overweight position. Recovery in Latin America swings on Brazil's ability to successfully implement Cardoso's reform package, improvements in commodity prices, particularly copper and oil and the overall performance of the US stockmarket.

From a value basis, investors would be unwise to ignore Latin America as distressed valuations, particularly in Brazil and Venezuela, are at attractive levels and most have already priced in an orderly devaluation over and above the annual 7% real devaluation. Although valuations in Argentina, Chile, Peru and Mexico are currently higher then those in Brazil and Venezuela, their economic outlook is superior. Undoubtedly, the Brazilian Government are walking a tight rope. Lowering interest rates too soon in the New Year will induce capital flight, whilst failure to reduce rates enough will increase the fiscal deficit.

Our analysis of global equity managers shows that in the last quarter the Latin American portfolio content of global equity funds has remained virtually unchanged at 1.6% (1.4%). Our analysis of global emerging market equity managers shows that the Latin American weighting has increased from 31.8% to 34.8% this time.

Recommended Weightings:

Equities in Global Emerging Markets Portfolio 25.0% (25.0%)

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Our analysis of global equity managers shows that in the last quarter the EAME portfolio content of global equity funds has hardly altered at 0.7% (from 0.6% three months ago). Our analysis of global emerging market equity managers shows that EAME still remains popular but there has been a strong move in favour of the Southern rather than Eastern European markets. The average weighting now stands at 29.8% compared with 33.5% three months ago.

Recommended Weightings:

Equities in Global Emerging Markets Portfolio 35.0% (50.0%)

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LESSONS FROM HISTORY

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PERFORMANCE REVIEW

This Performance Review for the Period Up to 31^st December 1998

Notes:

1. All figures calculated in US Dollars on a bid to bid basis with gross income reinvested.
2. Indices used are MSCI World, Salomon World Government Bond and MSCI Emerging World Index.
3. Performance data extracted for Hindsight; other calculations prepared by Forsyth Partners.
4. Figures calculated 1^st January 1998 to 31^st December 1998.
5. FP Model performance calculations are based on funds recommended for the first three months of 1998 on an equally weighted basis on specific recommendations by market as featured in this Asset Allocation Review.
6. Index performance calculations are based on: (i) in the case of equities, MSCI weightings adjusted for the performance of the domestic MSCI Index in the relevant market and (ii) in the case of bonds, Salomon World Government Bond Index performance.
7. Average Manager performance calculations are based on the Average Manager weightings at the beginning of each quarter, with the appropriate domestic MSCI or Salomon World Government Bond Index movement applied to these weightings (Source: Micropal).

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This document is issued by Forsyth Partners Limited, which is regulated in the conduct of investment business by IMRO. This extract from their research should be read in conjunction with the Methodology and Background Notes Module which forms part of the Research Manual which is published by Forsyth Partners Limited and is available on subscription and, in particular, attention is drawn to the emerging market risks warnings contained therein. The price of shares/units and the income from them can fall as well as rise and the value of an investment can vary upwards or downwards depending on exchange rate movements. © Forsyth Partners Limited – FORSYTH PARTNERS LTD, 18 BARCLAY ROAD, CROYDON, CRO 1JN UK.

Tel: +44 181 649 9440/Fax: + 44 181 649 9441