The SEC is “looking into” model ETF portfolios offered by financial advisors, Investment News reports. “The practice has come to the attention of the staff and they are looking at various aspects,” an SEC spokesman wrote in an email to the publication. The article suggests that the catalyst for the inquiry is the abuse of promoting model portfolios. As the story notes “some industry experts worry… that many of the advisers offering these model portfolios aren’t sophisticated enough to do the proper due diligence on the underlying exchange-traded funds. In the long run, they say, investors could get hurt.”
So what constitutes a reasonable model portfolio vs. a crummy one? There are no easy answers without knowing who the intended investor is. A model portfolio that looks reasonable for one type of investor may be egregiously inappropriate for another. Blanket statements about rules, then, aren’t all that helpful here.
Of course, if we’re talking about most individual investors saving for retirement, etc., then it’s easy to spot abuses in the model portfolio game. Relatively undiversified portfolios are usually a warning sign on this front, for instance.
More generally, 50 years of financial economics suggest that we start the analysis of any model portfolio by looking to a strong benchmark for perspective. At the top of this list is the broadly defined market portfolio, which holds all the major asset classes on a global basis, with the constituent parts weighted by market value.
There are a number of advantages for using this broad measure of assets as a benchmark, as I explain in Dynamic Asset Allocation. One is that everyone can own this portfolio without moving the market. The broad market portfolio, in other words, can’t be manipulated. No matter how much money flows in, or out, of this benchmark, its value as a neutral measure of global markets remains intact. That makes this a robust yardstick for analysis in portfolio research.
Another plus is that a broad measure of the world’s market weighted by market values is simple and transparent. The underlying strategy is the essence of clarity and minimalism: 1) buy all the major asset classes, 2) weight each one by its relative market value, and 3) leave it alone. That’s a strong attribute for a benchmark. Indeed, keeping it simple generally is a powerful force for designing and managing investment portfolios. As Jonathan Burton advised earlier this month in The Wall Street Journal, simple is often better when it comes to investing.
Although a broadly diversified portfolio is a compelling benchmark for assessing model portfolios and many other investment recommendations that come down the pike, this approach to financial analytics is widely overlooked. That’s a mistake, in my view, but it’s understandable. Finding related analysis on broad multi-asset class benchmarks is difficult. In an effort to help fill the gap, I created a proxy for a broadly defined market portfolio—I call it the Global Market Index (GMI).
I routinely analyze and track GMI in The Beta Investment Report as a starting point for developing strategic intuition about how to manage asset allocation. I also track a real-world version of the Global Market Index using index funds. How has the benchmark done? For the 10 years through last month, GMI has generated a 3.4% annualized total return. That’s not great, but it’s been a rough 10 years. In any case, 3.4% looks pretty good vs. the 1.3% annualized loss in the U.S. stock market (Russell 3000). Meanwhile, a number of asset classes have done better, much better in some cases. Bonds in particular have had a good 10 years. In fact, by historical standards, fixed-income returns over the past decade have been at or near the best on record in some corners of bond land. No wonder, then, that a benchmark that holds everything did okay.
Should everyone run out and build their own Global Market Index portfolio? Probably not. In theory, this benchmark is the optimal investment for the average investor over the very long run. That describes almost no single investor, although it may come pretty close to describing some institutional investors. In any case, the point is that we should recognize that we’re all different, which reminds that the main challenge in portfolio design and management is deciding how we’re different. But different relative to what?
The Global Market Index is a good start for considering this critical question. Why? Because GMI makes no assumptions about what’s going to be hot, or not. Instead, it’s passive by holding everything, in weights determined by Mr. Market’s valuation process. GMI, then, represents the opportunity set and accepts it at face value. That’s one sign of good benchmark.
Is Mr. Market right? No, at least not always. Pricing securities today based on expectations of tomorrow’s risks is fraught with any number of problems. Of course, that’s why you expect to earn a premium over “safe” investments. More generally, there’s a case for second guessing the benchmark, at least to some degree. Expected returns vary, with some degree of predictability. Exploiting this opportunity takes work, however, and relatively few are up to the task. No wonder that in the long run it’s hard to add value over the broadly defined market portfolio, which is another reason why it’s such a strong benchmark—or model portfolio, if you will. That’s simply a statement that recognizes how markets work. Alpha, to invoke the academic term, sums to zero. For every investor who beats the benchmark, someone must trail it. And after we factor in trading costs, taxes and other frictions, it’s easy to see that there’s a natural headwind blowing on those who try to beat the market. Yes, some beat the odds, but just as many (if not more) lose. That calculus is a constant in the market, much as the house has the edge in the long run in a casino.
Keep in mind too that some who manage to beat the broad market do so by taking high risks—a factor that isn’t necessarily a sign of superior portfolio design/management skill. To use an extreme example to illustrate the point, if you owned only emerging market stocks over the past decade, you’d have beaten the market portfolio. Yes, it worked–that time. But that was a high risk strategy. The problem is that you might have chosen wrong, and some certainly did. If you bet the farm instead on U.S. stocks a decade ago (a popular idea at the time, by the way), you’d be sitting on losses today.
The key point: It’s easy to generate a high tracking error vs. a benchmark. But high tracking error isn’t always a sign of intelligent investing, even if the results are impressive.
The goal of prudent asset allocation is generating the required returns to satisfy your future liabilities with as little risk as possible. That’s hard to do. Once you adjust returns for risk, the population of investment wizards drops sharply.
In fact, relatively few investors end up winning in the long run. Why? Investing is a loser’s game, as Charlie Ellis famously counseled. By that he means that the priority for most investors (the Warren Buffetts of the world excepted) is focusing on not losing rather than on winning. It’s a subtle distinction, but an important one.
There are many aspects to learning how to win the loser’s game, most of which are widely recognized. Keeping expenses low, minimizing trading, diversifying broadly, rebalancing, and so on. Monitoring the right benchmark deserves a spot at this table too. It’s also a piece of the strategic plan that’s widely overlooked. Maybe the SEC’s focus on model portfolios will shine a light on this otherwise dark corner of investment strategy.