September 11, 2009
LOOKING BACK: FROM PEAK TO PRESENT
It's been a long, strange trip in the nearly two years since October 2007, when the U.S. stock market peaked. The details of the journey have been dissected ad infinitum, on a tick-by-tick basis. But what of the big picture? How does a broad review of performance among the major asset classes stack up since October 2007?
We can start by considering total return indices for the usual suspects by setting benchmarks to 100 for everything as of the close of October 2007. The chart below shows how the major asset classes have performed since then through the end of August 2009. (For the underlying indices that represent the asset classes see our post here.)
Another view on the same history is presented in our second chart below, which ranks the total returns for October 2007 through August 2009.
We spend a lot of time analyzing the major asset classes on the pages of The Beta Investment Report. The primary goal is searching for some perspective in managing multi-asset class portfolios and squeezing out a bit more return without taking on more risk. That begins by considering the rebalancing opportunities related to comparing performance. That's the easy part. By that standard, foreign government bonds appear to need some trimming while buying REITs looks productive, for instance, relative to results from October 2007 through last month.
Our benchmark in our strategic travels is our proprietary Global Market Index, which is a passively allocated mix of all the major asset classes weighted by the respective market values. (GMI was initially launched on December 31, 1997 and its asset allocation among the major asset classes has fluctuated with the market tide, untouched by human hands, ever since.) This index is no panacea, but it does give us a sense of what an unmanaged, objective measure of everything dispensed in terms of risk and return. That's no silver bullet, but it's a productive way to start considering the investment options.
GMI is a proxy for the true market portfolio and forms the basis of our analysis in The Beta Investment Report. You can see how GMI has fared in the first chart above by looking at the bright green line in the middle. It's no accident that it's produced a middling run relative to its components since October 2007.
The burning question is (always) whether we can enhance the results of GMI? In theory, yes, although in practice it's difficult, at least over time. In the short term, however, the challenge looks tempting, perhaps even easy. For example, simply buying TIPS or foreign government bonds back in October 2007—and shunning everything else--would have done the trick. Of course, how many of us were that smart? For some perspective on this challenge, think about which asset class today is likely to be the leader (or at least beat GMI) over the next two years. Are you willing to bet the farm on your decision? Or, perhaps you might hedge your bet by owning a few other asset classes? If so, how big a hedge? And how should it be structured? And what parameters will determine how you'll manage the mix through time? Etc., etc.
Therein lies the enduring challenge in asset allocation: Figuring out what's hot, what's not and what looks likely to track the historical average is at the core of portfolio strategy. The markets drop some productive clues at times in this quest for above-average performance, as we discuss routinely in The Beta Investment Report and in greater detail in our upcoming book Dynamic Asset Allocation. But there's no guarantee of success. That's not to say that we shouldn't try to improve upon GMI's results. But we should be careful about straying too far or trading too much. That includes keeping our expectations under control and focusing on risk management. In general, we shouldn't think that success will come easy as a long-term proposition.
In the very long run, those who outperform GMI are likely to be matched in numbers by those who trail the benchmark. That's true for the full range of strategies and risk appetites in the world, ranging from aggressive hedge funds down to more conventional strategies. Most of what goes on in the world of money management involves trading some piece (or two or three) of GMI's primary components, either among the components of a given beta or among the betas writ large.
The choice of how to proceed therefore begins by considering owning everything, using ETFs and/or index mutual funds. Replicating GMI translates into doing nothing via holding a passive mix weighted of the major asset classes as defined by market value. In practice, virtually everybody tweaks this benchmark to fit their specific situation. Eventually, some wind up ahead the benchmark, some don't. The details of improving your odds for staying in the latter category are messy. But at least we know where to begin in terms of a truly objective benchmark.
Posted by jp at September 11, 2009 9:56 AM