August 11, 2009
My Monte Carlo analyses confirm the views of Gross and El-Erian that emerging markets will have substantially higher long-term returns than domestic markets, but the risks associated with emerging markets also remain high. For years, emerging markets have had volatilities substantially greater than the S&P500 and Betas substantially greater than 100% relative to the S&P500 for years.
With PIMCO’s New Normal in mind, how might we modify some model asset allocations? By way of example, we will look at Ted Aronson’s model portfolio and how it might change under this world view.
Aronson’s Model Portfolio
This portfolio, with 20% in bonds, is spread between domestic and international equities, as well as between large-cap and small-cap equities. One striking feature of this portfolio is that it diversifies mainly by combining market-cap weighted equity indexes, not by including asset classes such as REIT’s, commodities, or sub-classes like infrastructure.
When I analyzed this portfolio in May 2008, the Monte Carlo projections estimated its expected annual return to be 9.1% with a standard deviation of 14.3%. This can be compared to the trailing three-year average annual return (arithmetic) of 13.5% with a standard deviation of 9.1%. Quantext Portfolio Planner (QPP) was projecting that this portfolio would have considerably lower return than it had enjoyed in recent years and significantly higher risk — there was a high potential for mean reversion (downwards) because the preceding years had substantially exceeded the expected long-term return. When I run the Aronson portfolio through QPP using data through the end of July 2009 with all baseline settings, I find that the expected annual return is 9.3% with a standard deviation of 16.6% — remarkably close to the projections in May 2008. The major difference today, of course, is that mean reversion is on our side, because the trailing three-year return for this portfolio is now 1.5%.
The baseline settings for QPP used in both May 2008 and now assume that the real return for the S&P500 is 5.3% with a standard deviation in total return (nominal) of 15%. Implied volatility (which is expressed in terms of annualized standard deviation in return) in options pricing is a useful sanity check to see where the markets expect volatility to go. The implied volatility for the S&P500 for options expiring in December of 2011 was 26% as of this writing. This is substantially lower than the very high values we saw late in 2008, but is still far above the long-term average of 15% that QPP uses as its baseline value.
The Aronson portfolio has a current Beta of 0.99, so the higher volatility in the S&P500 translates directly into higher volatility for this portfolio. If the S&P500 has volatility of 26%, the Aronson portfolio will see volatility of a little over 26%. Historically it is not typical for a portfolio with 20% bonds to have a Beta that is essentially 1.00. This is a result of the higher correlations between asset classes.
How might we modify this portfolio to align better with the New Normal world view? First, we will want more TIPS and fewer high-Beta equities. We will also want allocations to some low-volatility Dividend Aristocrats. There is also a lot of redundancy in the original Aronson portfolio—there are funds with so much correlation that they add no real value. The trailing three-year correlations between the portfolio and each fund are shown below:
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