August 11, 2009
VEURX and VTSMX add no net value to this portfolio under current projections. High correlations between a range of asset categories that diminish the diversification benefits of combining these assets classes are a key part of the New Normal, and this idea has been emphasized as a long-term theme by El-Erian. Corporate bonds and TIPS have low correlations, with returns above nominal bonds.
Now let’s apply the New Normal world view. I have thrown out asset classes that were so highly correlated that they did not add anything, I have selected a series of low-volatility, high-quality stocks from the Dividend Aristocrats, and I have emphasized emerging markets for my broad equity exposure. Further, I have added exposure to commodities, REIT’s, and a tilt towards infrastructure in the form of utilities. Consider the following portfolio:
The New Normal Alternative to Aronson’s Portfolio
The Monte Carlo simulation (QPP) projects that this portfolio will have 9.3% in expected return, with 12.3% in standard deviation under baseline conditions. This is the same expected return as for the Aronson portfolio, but with substantially lower risk. Part of what makes this portfolio attractive is the low correlation between the individual stocks:
Correlations to New Normal Portfolio
In a world in which market-cap weighted indexes have very high correlations, individual stocks provide one of the last refuges for those seeking to combine assets with low correlations.
A standard critique of this kind of analysis is that this portfolio, with significant allocations to individual stocks, is too risky because it is undiversified. There are several ways to respond to this. First, this approach could be implemented with a larger number of properly selected individual stocks. Second, I have previously analyzed the issue of increased default risk with individual stocks, and I found that this is quite well captured in QPP. Third, QPP agrees with the Charlie Munger world view that it is possible to own a small number of stocks and still have a well-diversified portfolio. Our proposed New Normal portfolio has a Beta of 66% and, of course, carries significant non-systematic risk by virtue of its small number of concentrated positions. Recent research by Burton Malkiel shows that non-systematic risk is, in fact, rewarded by the market, and Eugene Fama and Ken French have shown that low-Beta portfolios out-perform. Both QPP and Bill Gross share a preference for “stable dividend-paying equities,” which implies a careful selection from the universe of stocks, rather than just buying market-cap weighted indexes.
Finally, owning individual equities helps to provide an additional benefit: In an era of low expected returns, it becomes ever more important to minimize the drag expenses exert on returns. Owning individual stocks over extended periods of time can yield a portfolio with the absolute minimum in expense drag (transaction costs only). It can also confer tax benefits. One of Gross’ points with regard to the New Normal is that expenses that that seemed small in the context of 10%-plus annual returns will loom large in an era of lower returns.
As a second example — and with the core concepts in mind — let’s look at a portfolio with 40% fixed income designed by Paul Merriman of FundAdvice.com:
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