August 11, 2009
Merriman’s Model Portfolio
When I first analyzed this portfolio, I found that it was not very well diversified. This outcome is amplified when the analysis incorporates data through July 2009 because of the increase in correlations across asset classes during 2008-2009. If we look at the correlations of the non-fixed-income asset classes to the portfolio and to one another, it is clear that the correlations are so high as to be of very limited diversification value:
Correlations Among Elements of Merriman’s Portfolio
In particular, the correlation between the S&P500 (VFINX) and the large-cap value index fund (VIVAX) is 98.4%. There is nothing wrong with adding a value tilt to a portfolio, but holding both these funds certainly does not add much in the way of diversification. Similarly, the correlation between the small-cap index, NAESX, and the small-cap value index, VISVX, is 98.5%. The correlation between the developed international index fund, VDMIX, and the international value index, VTRIX, is even higher at 99.6%.
My Monte Carlo projections for this portfolio yield an average annual return of 7.5% with a standard deviation of 12.4%. This portfolio also has a Beta of 0.74 and R-squared of 92% (vs. the S&P500). Although this portfolio has 40% in bonds, the vast majority of its performance is driven by the S&P500.
After some experimentation with the Monte Carlo projections, I arrived at the following alternative to Merriman’s allocations:
The New Normal Alternative to Merriman’s Portfolio
As in the previous case, I have thrown out asset classes that added no real diversification value, I have emphasized emerging markets, and I have added significant allocations to Dividend Aristocrats. I have also added explicit commodities exposure (DJP) as well as exposure to infrastructure in the form of utilities (IDU). This portfolio has higher historical return and lower historical risk than the Merriman portfolio (trailing three years through July 2009). The Monte Carlo projected return for this portfolio is 8.8% with a standard deviation of 12.2% (as compared to a projected annual average return of 7.5% and a standard deviation of 12.4%). The Beta of this portfolio is 0.66 (vs. 0.74 for the Merriman portfolio), despite the fact that this portfolio holds only 30% in bonds vs. 40% in the Merriman portfolio. This portfolio also has much higher exposure to emerging markets (VEIEX) than the original. The projected improvement in return of 1.3% per year (with slightly less risk) may appear minor for those who still think in terms of double-digit equity returns. Under the New Normal paradigm of lowered expectations, however, this improvement is substantial.
Discussion
The types of portfolios shown in these examples challenge the conventional wisdom of asset allocation — they are very different from what most advisors espouse and practice. But there is increasing evidence that the traditional models are not working. It is hard to argue, for example, that investing in broad index funds is ”safer” than owning individual stocks after a year like 2008. The S&P500 lost 37% last year, and emerging markets lost more than 50%. The substantial increase in correlations among the major market-cap weighted equity indexes means that simply buying domestic and foreign equities provides very little diversification benefit. When we incorporate the additional New Normal themes described by Gross and El-Erian, there is increased focus on inflationary risks and on the notion that the emerging markets will be the engines of growth in coming years. These themes lead to heavier allocation to emerging markets, along with targeted exposure to stable dividend-paying companies for domestic exposure. Under this world view, commodities and infrastructure also look attractive.
The Monte Carlo analyses clearly suggest that a global market-cap weighted approach to equity exposure does not make a lot of sense. This conclusion is also a constant under-current in El-Erian’s When Markets Collide, in which he wrote:
Passive exposures typically track indexes that are backward looking—that is they reflect the world of yesterday rather than the world of tomorrow. (pp. 204)
If we see slower economic growth in the U.S. and other developed markets, accompanied by a progressive weakening of the dollar and its attendant consequences (such as higher inflation, higher commodity prices, and lower real yields on bonds), the best performing asset allocations will be very different than those that have worked in the past. The New Normal paradigm challenges fundamental assumptions about the effectiveness of markets in determining value and in predicting the future prospects of individual companies and, by extension, entire sectors (the financial sector being an obvious example). All of these factors tend to support the idea, espoused by Gross, that investors will need to minimize the drag on investment performance represented by intermediation and tax. Owning individual securities looks more attractive in such an environment.
The model portfolios presented here are not provided as ideals but rather as examples of what New Normal portfolios might look like. For those investors who prefer to have less exposure to individual stocks than is shown in these examples, the numbers of carefully-selected firms can easily be expanded.
An extended period of high volatility across asset classes is consistent with Minsky’s financial instability hypothesis, a model frequently cited in PIMCO publications. In Minksy’s model, investors take on more risk and leverage when markets are stable and exhibiting low volatility. As investors increasingly leverage up and demand less and less return for the risks they take on, they set the stage for financial crisis. Once a crisis starts, there is a period of active de-leveraging which corresponds to high volatility. Investors became complacent in the years up to 2007 in terms of taking on risk. Today, they have swung to the opposite extreme. In this environment, investors must take a critical look at traditional asset allocation models and consider how they should be adapted to better serve the demands of the New Normal.
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