The Thrill of Victory, The Agony of Defeat

Morningstar reminds that there are lots of fund choices for diversifying across asset classes these days, perhaps too many. “Not only has the number of mutual funds expanded by the thousands over the past decade, but numerous exchange-traded and closed-end funds, many of them with very specialized, even exotic, mandates, have also popped onto the scene,” writes Gregg Wolper,

It’s easy to become overwhelmed with the possibilities. Fund companies are constantly rolling out new products, and increasingly that includes funds that claim to be all-in-one solutions. Most of the choices are, at best, redundant (relative to the existing lineup) or just plain misguided. That inspires stepping back from the sea of possibilities and refocusing on the strategic choices and the basic tools for managing portfolios. The good news is that much of the heavy lifting that delivers reasonable outcomes arises from relatively simple designs and management techniques with diversified investment strategies.
Most diversified portfolios share two common threads. First is the act of diversifying across some defined set of assets. The next step is managing the mix of assets. The possibilities are endless, of course, but the opportunity for earning higher return without taking on materially higher risk becomes increasingly marginal as you move beyond the basics. Generally speaking, you’ll need either higher inputs of skill, luck, or both, to engineer superior risk-adjusted results through time vs. what’s available from a simple diversification strategy.
In broad terms, the standard choices for diversification add up to a dozen major asset classes. That number can differ, depending on how we define “asset class.” But as a starting point, the 12 broadly defined markets in the table below (13 if you included cash) are a reasonable starting point. In short, these asset classes represent the opportunity set for most investors. And if we own everything (except cash) in its market-value weights and simply let it ride, we have a robust benchmark for risky assets writ large, as defined by the Global Market Index (GMI).
For the five years through the end of last month, GMI’s annualized total return is 4.6%. That’s roughly average relative to the individual asset classes. In fact, history shows that GMI and similarly designed indices tend to deliver average to slightly above-average results in the long run. No surprise there. But what can we do to improve results?
There are many possibilities, of course, but some simple, forecast-free strategies are worth considering as a benchmark for asset allocation management. Rebalancing GMI every December 31 back to its market weights as of the close of 1997 (the date of the index’s launch) juices performance a bit. Instead of earning 4.6% a year since 2006 with a buy-and-hold strategy, systematically rebalancing GMI earns 5.7%. Equal weighting the portfolio and resetting it to equilibrium at the end of every year does even better, delivering 6.7% a year.
But those are merely the opening bids in the sea of choices for elevating returns further. Of course, things get increasingly complicated and risky as we move beyond broad asset class diversification and simple asset management strategies. If we want to earn something different than the market, we have to move away from the market portfolio. For example, we could overweight one or more of the asset classes, perhaps radically so, relative to the market weight. We might sidestep several asset classes entirely. We could also engage in a more opportunistic form of rebalancing by adjusting the portfolio when volatility strikes vs. waiting for a pre-set date.
Another route is to own a more granular definition of a given asset class. For instance, instead of holding one fund as a proxy for a broad mix of U.S. stocks, we could break the asset class up into multiple pieces via style, capitalization and/or industry groups. This increases the rebalancing opportunities.
Yet another alternative is to incorporate return forecasts into the management process and tilt the asset allocation to those areas where the future looks brightest and cutting back on markets where the performance appears unattractive.
Moving further out on the limb of risk, we might add leverage or short exposure to the portfolio. We could use actively managed funds to populate one or more of the asset class categories. There are also alternatively weighted index funds to consider as well, offering the option of replacing the standard market-cap indexing products with something intent on earning better results. There are also hedge funds and other exotic realms to explore.
Even with all these additional choices, we’ve only scratched the surface. But while there’s no shortage of potential for beating the unmanaged portfolio that holds everything (GMI), there’s a limit on benchmark-beating results. There’s a ceiling on how much alpha can be minted relative to GMI’s beta for the simple reason that alpha must sum to zero. Winners are financed by the losers. That doesn’t mean we should ignore the possibilities for moving beyond a broadly defined, unmanaged portfolio, but it should keep us somewhat humble about what’s required to beat GMI over the long run.
History suggests as much. Crunching the numbers on 900-plus multi-asset class funds in Morningstar Principia’s database shows that GMI’s results are slightly above average relative to the actively managed competition. That’s no surprise. The zero-sum-game rule is alive and kicking… always.