Most Popular ArticlesSeptember 1, 2009
The Merriman portfolio had a considerably higher exposure to financials than my proposed New Normal portfolio because of its higher Beta with respect to the S&P500 and the high weight of financials in the S&P500 prior to the crash. Mr. Katz suggests that individual stocks add too much risk. My example above suggests that being as highly correlated to the S&P500 as the Merriman portfolio adds more risk than even a substantial exposure to a big loser in 2008 like BAC. Oddly enough, Mr. Katz’s example serves to reinforce my point: a high Beta / high R-squared portfolio (like the original Merriman portfolio) was a riskier proposition in 2008-2009 than adding significant allocations to even an individual stock that sustained a major loss in 2008-2009.
The question of how much exposure to any single stock makes sense is very much a function of the characteristics of the stocks. The Vanguard Total World Stock Index has a 2% allocation to Exxon. The Vanguard Global Equity Fund has an allocation to 2.5% to Royal Dutch Shell, and almost 2% each to Pfizer and Altria. It is not meaningful to assert that a 2-3% allocation to any individual stocks is ‘too risky’ without some meaningful estimation of risk.
Exposure to Fama-French factors
An additional criticism leveled by Mr. Katz is that the original Merriman portfolio has a tilt towards smaller cap stocks and towards value stocks—which Fama and French suggested both add value—while my portfolio has a tilt towards large-cap stocks. What he ignores is that my portfolio also has a tilt towards lower Beta, which Fama and French have also noted as a significant source of performance: lower Beta portfolios out-perform. The Merriman portfolio has higher Beta, thereby sacrificing this benefit.
The tilt towards large-cap stocks in my portfolio is due to the emphasis on firms which are stable and pay dividends—one of the suggestions from Mr. Gross for coping with the New Normal.
Exposure to international equities
In the New Normal world view, the dollar will be weaker and growth will be concentrated in the emerging world. As such, exposure to developed international markets will be of limited value. This is already clear from the very high correlations between the EAFE index and the S&P500—and has been for years. Mr. Katz asserts that the strong tilt of my portfolio towards emerging markets “adds unnecessary risk” although he provides no quantitative support for this assertion—and the historical volatility measures do not support this.
Conclusions
Mr. Katz concludes that “Mr. Considine’s suggested portfolio makes several questionable bets and in so doing he arrives at a portfolio that is riskier than it needs to be.” Mr. Katz’s conclusions about the relative risk of my proposed New Normal portfolio vs. the Merriman portfolio are not, however, supported by any quantitative estimates of risk. To the contrary, he bases his arguments on his qualitative judgments using heuristics that are not justified based on academic research. I am surprised that Mr. Katz entirely discounts quantitative measures of risk in his analysis.
The PIMCO New Normal may or may not play out. Regardless, there is substantial evidence that attempting to diversify simply by combining market-cap weighted indexes and judging diversification based on ‘how many’ stocks are represented in the portfolio has not been an effective strategy in recent years, nor is there any evidence to suggest that it will be in the future. Mr. Katz asserts that correlations will come down and that this will increase the diversification benefits among market-cap weighted indexes. This may be true, but there is no support given for such a bet—and Mr. Katz even notes that these correlations have increased considerably through time. He may be correct, but this is just as much a forecast (perhaps a “questionable bet”) of specific future outcomes as those in the New Normal scenario.
If the elements of the New Normal come to pass—low growth, higher inflation, and increased importance of emerging markets—my analysis suggests that a portfolio structured like the one described in my original article will out-perform.
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