Monday’s article on the average to above-average results that usually describe a passive allocation to all the major asset classes brought charges of foul play from some quarters. A few critics said I was cherry picking the data; one claimed that I was intentionally manipulating the numbers so as to engineer a favorable result for a benchmark of broad asset allocation vs. the universe of its actively managed equivalent. How, they wondered, could a passive strategy that holds everything compare so favorably on a regular basis? In fact, it would be surprising—impossible, in fact—if the results were otherwise.
Professor Bill Sharpe made this point more than two decades ago in his short essay “The Arithmetic of Active Management,” which observes:
Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.
This doesn’t mean that passive management wins the horse race. That’s impossible too. The extremes always go to the actively managed accounts. As Sharpe notes:
It is perfectly possible for some active managers to beat their passive brethren, even after costs. Such managers must, of course, manage a minority share of the actively managed dollars within the market in question. It is also possible for an investor (such as a pension fund) to choose a set of active managers that, collectively, provides a total return better than that of a passive alternative, even after costs. Not all the managers in the set have to beat their passive counterparts, only those managing a majority of the investor’s actively managed funds.
Nonetheless, when you take a pool of assets, simple mathematics demonstrates that there can only be a small share of portfolio combinations that rise to the top of portfolio results for any given time period. This outcome, which is persistent through time, is obvious once you consider that there are two main strategies for engineering above-average results (for simplicity, let’s ignore leveraging and short sales, which can be thought of as two additional strategy choices). You can select a subset of assets and/or you can pick different weights for some or all the assets, relative to an appropriate benchmark for the asset pool under scrutiny. The investors who choose wisely on those fronts will always constitute a minority. The problem is that it’s really hard to choose wisely month after month, year after year.
In fact, the pool of active managers is actually smaller than simple math implies. After adjusting for trading costs, taxes and other real world frictions, the mistakes of active management further pares the pool of above average results, as Charlie Ellis has pointed out many times over the years.
Across relatively short time spans, the results can and do vary by a wider range, giving the impression at times that the analysis above is misguided. But performance eventually drifts back to the results implied by “The Arithmetic of Active Management.”
One way to think about why broad diversification generally leads competitive results is by looking at a performance chart of all the major asset classes for the past 250 trading days through yesterday’s close (May 14), based on ETF proxies. Note the wide array of price changes in the chart below, which sets all the funds to initial values of 100 as of May 14, 2012.
In order to deliver impressive above-average performance over the past year (roughly the trailing 250 trading days), it was necessary to favor the best performers. The top-three in our example above: foreign REITs (VNQI), foreign developed-market stocks (VEA), and US stocks (VTI). The challenge is that this type of ranking is an ever-evolving list. Today’s winners end up as tomorrow’s losers, which eventually rise to the top in the next period. In order to maintain an above-average record for any length of time, you’d have to identify the winners and losers in advance more often than not. History suggests this is devilishly difficult, which is why it’s so hard to outperform a relevant benchmark of the targeted asset pool for anything more than a short period of time. Yes, some talented (lucky?) managers beat the odds, but good luck deciding in advance who’s destined for that exclusive club. Anyone want to take a guess which asset allocation funds will be in the top 10% for the trailing 10-year period through May 2023? I didn’t think so.
Even during periods of extreme negative results, the persistence of average performance via broadly defined asset allocation persists. In October 2008, for instance, when red ink was everywhere, I pointed out that a portfolio of all the major asset classes remained near the middle of results. Granted, those results were negative, but the fact that they were also average is simply the flip side of the average to above-average results that accompany this strategy in the good times, which thankfully is the dominant state of affairs across time.
This hard rule applies within a given asset class and for multi-asset class strategies too. Does that mean you should slavishly hold a passive mix of all the asset classes? No, not really. But history does suggest that you should think twice before going off the deep end with second guessing Mr. Market’s asset allocation.
Rather, you should focus most of your attention on rebalancing the asset classes. It’s pretty clear that broad diversification across markets is essential. The question, then, is how to optimize the rebalancing process? The default strategy is simply rebalancing periodically—once a year, for instance. This basic methodology has done quite well, although it’s worth considering how to enhance the process further. But that’s a topic for another day.
For now, the lesson is clear: Diversification across asset classes is the foundation for reliably capturing the lion’s share of the global market’s beta. If that beta comes with a positive expected return, as it usually does, we have ia powerful bit of advice for considering how to customize Mr. Market’s allocation to match specific needs and goals. This is old news, of course, even if comes as a shock to some observers of the financial scene.