The concept of a world allocation fund is a good one, although the “pickings are slim, so consider building your own,” Morningstar advises. Even if the menu was better, the case for designing and managing your own multi-asset class fund is still compelling. One reason is cost. You can probably build your own asset allocation strategy for less if you do it yourself. Another reason is that you can optimize the management of the asset classes according to the particulars of your financial profile. That’s sure to provide superior results compared with a one-size-fits-all strategy.
But where to begin? With the market, of course. From the 30,000-foot level, there are a dozen major asset classes, not including cash and its equivalent, such as Treasury bills. Minds will differ as to definitions of broadly defined asset classes, but our list is a good place to start:
The tricky part is deciding how to weight the major asset classes–now and in the months and years ahead. Unfortunately, there are no generic answers. Every investor’s asset allocation should be customized to reflect her specific set of circumstances. The good news is that there’s an obvious benchmark to start the analysis: Mr. Market’s asset allocation.
If we weight all the major asset classes above by their market values, the resulting portfolio is a passive benchmark for a global asset allocation strategy. It’s hard to find such an index, which is why I built my own–I call it the Global Market Index (GMI). As I explain in some detail in my book Dynamic Asset Allocation, the finance literature tells us that the value-weighted market portfolio is the optimal strategy for the average investor with an infinite time horizon.
In other words, over the long haul it’s probably going to be difficult to beat a passive mix that holds everything, or something approximating everything. Of course, there are no “average” investors per se, and we all have finite time horizons. Nonetheless, GMI has performed competitively over the last decade. For the 10 years through last month, GMI earned an annualized total return of 6.5%. That compares with roughly 4.1% for U.S. stocks, based on the Russell 3000. If you mindlessly rebalanced GMI’s mix every December 31 back to its allocation from the previous year, the benchmark’s annual return rises to around 7.4%. Not bad for a know-nothing strategy.
How does Mr. Market’s allocation stack up these days? Here’s GMI’s allocation at last month’s close:
Thanks to ETFs, you can replicate GMI for as little as 50 basis points. The tough part, however, is deciding how to customize Mr. Market’s asset allocation. The possibilities are endless, of course, as are the potential triumphs…and failures.
A review of the various multi-asset class mutual funds in Morningstar Principia’s database (there are more than 1,000 with track records of at least 10 years) shows that most of the associated strategies have come up short vs. GMI’s performance history. That’s not surprising. Indeed, that more or less describes the historical record within single asset classes, and no less appears to be true for broad-minded asset allocation. Why? The short answer: Excess returns are a zero sum game, and the winners are financed by the losers. After deducting trading costs and taxes, there are only two basic strategies for beating Mr. Market’s asset allocation: taking bigger risks or being smarter than the crowd. Well, maybe there’s a third… luck.
Meantime, it’s a relatively safe forecast that GMI will continue to deliver average to above-average results over the next 10 years. That inspires what is arguably the first question in designing asset allocation: Will Mr. Market’s strategy suffice relative to your expectations, financial needs and risk tolerance?