The Asset Allocation Interactive tool allows investors to select a benchmark: the standard 60/40 allocation, a global market-cap-weighted portfolio, or a portfolio of long-term liabilities. Selecting one of these transforms the y-axis to expected excess returns (over the selected benchmark) and the x-axis to expected tracking error against that benchmark. The view here, using the 60/40 benchmark, shows the return potential for taking tracking error risk. Note that the first grey dot to the right of the 60/40 grey dot, located on the y-axis, represents the "Advisor Average" portfolio, which is priced to deliver a 1.0% expected excess return with a modest 2.2% expected tracking error. This portfolio is primarily composed of US stocks and bonds, with a smattering of alternative assets.
Several dots further to the right lies the 10%-volatility efficient portfolio. We expect this portfolio (as of August 31, 2017) to return 2.9% more than the 60/40 benchmark, with 5.3% tracking error. Taking on this risk creates the potential for significantly higher and more efficient returns, but only if the client can live through the discomfort of holding the portfolio over the long run. The 5.3% tracking error means that clients should expect this portfolio to underperform their 60/40 peers by more than 5.3% roughly once every 6 years, and by more than 10.6% once every 44 years or so.
Many have been stung by the “cost” of diversification in recent years. In 2015, a 60/40 portfolio returned 1.3% while a diversifying basket of 10 equally weighted alternative assets8 returned –5.3%. In 2013, the 60/40 benchmark delivered 17.6% while the alternative asset basket returned 1.1%. These shortfalls are undoubtedly painful and test conviction. But should they have been a tremendous surprise? Again, we see “shock” at outcomes well within the expected bounds of tracking error. Precisely this emotional pain, and the required resilience to hold onto the investment strategy producing such pain, is what gives rise to the opportunity. In The General Theory of Employment, Theory, and Money published in 1935, John Maynard Keynes summed up this dilemma well when referring to the long-term focused maverick investor:
If he is successful, that will only confirm the general belief in his rashness; and if in the short run he is unsuccessful, which is very likely, he will not receive much mercy. Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.
With risk comes opportunity and the potential for better investment outcomes. Today’s environment of low expected returns has driven many investors to seek higher and different sorts of risk in order to meet their return objectives. Compelling opportunities exist with a plethora of global assets priced to deliver returns above the anemic 2.7% long-term return we at Research Affiliates are expecting from the US 60/40 portfolio. But achieving this higher return requires exposure to higher volatility and significant tracking error risk. Investors who want to follow this path and the advisors who seek to map the path for them should have a full understanding of these risks and a plan in place for traversing the likely bumpy terrain ahead.
Exploring off the beaten path led me to my most memorable hiking experiences in the Chugach. I knew that popular trails nearest to town would deliver predictable experiences, and a steady stream of fellow hikers would help mitigate any risks. As I ventured farther back in the Chugach wilds, the mountains grew taller, fellow travelers fewer, and the risks greater. Sometimes these adventures resulted in a miserable slog along a moose trail through an alder-choked valley, or a fruitless scramble along a sheer mountain ridge, only to get turned back well short of the summit. These risks were known, and acceptable. Persevering through them led me to my best memories: finding a new route to the highest point of a seldom-explored peak, both exultant in the victory and humbled by the grandeur of wilderness from all sides, while soaking up the light of the midnight sun in a place few of my peers would ever reach.
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