Reviewing The Ivy Portfolio by Mebane Faber - For Those Who No Longer Buy 'Buy & Hold'

by: Nick Gogerty

Meb Faber has written an interesting book, The Ivy Portfolio about asset allocation, Endowment approaches and asset class risk.

Mentioning asset allocation in polite conversation is akin to discussing plumbing. Everyone has an idea of what it is, they understand its importance, but it is a topic best avoided in polite conversation at all cost.

Like plumbing, asset allocation becomes "interesting" only when things get stopped up. Many investors believe their portfolio flow isn't quite working properly and are looking for a way to fix it. Plumbers are over-priced, dreary and generally smell like carnies. Luckily Meb knows a thing or two about asset allocation, isn't a dreary fellow at all and puts on a good read. He is sharp and has written a focused book on thinking about an interesting method of Asset allocation.

One of the most important papers in asset allocation is the seminal work of Brinson, Hood and Beebower determinants of portfolio performance which I read in the Jardin du Luxembourg while temporarily taking up smoking as a grad student in Paris. It describes the principal determinants driving portfolio returns. Surprisingly, at the portfolio level, security selection becomes far less important in most instances. (Hint: most managers are bad at security selection so the expected or derived positive contribution variance is de-minimus at the portfolio level).

The general gist of looking at asset allocation is that in the long run it matters more at the portfolio level which is driving terminal wealth maximization, the end goal. The dispersion and drivers of portfolio returns are driven more at the asset allocation level, than the security level in the vast majority of portfolios, with the exception of Buffett and a few people who know what they are doing.

Long term Asset allocation involves thinking outside of one's own time and geography. Looking solely at the U.S. equity market even back to 1871 for a doctored S&P index has come into vogue in the last year. This is bad research and sloppy thinking. It is akin to looking at a whale and saying it represents all the animals in the ocean.

Many equity markets have not only declined greater than 80%, but died all together, the same with bond markets. History is not kind in the long run to paper assets unless they are still growing in the form of timber. Be wary of the prognosticator with an imperious tone, sense of history and a sample size of one.

Meb's simple solution to this asset allocation exposure "buy and hold" dilemma is to get out of an asset class when it looks iffy. The trick of course is defining iffy. In this case it is a moving average of 200 days. I am usually against advocating the use of a single moving average or any "technical" as most people don't understand what they do, how they work or most importantly why. Meb has some good counter arguments for why one could consider this 200 day variable a nearly "naive" or non-optimized approach.

This 200 day number is still an area for further research, which will hopefully be taken up by an econometrician as the drivers of any allocation process should be understood. It would be interesting to see how the approach fared against the multitudes of examples of bubbles in assets ranging from farmland to tulips over hundreds of years and markets mentioned in Kindleberger's excellent work Manias, Panics and Crashes. The inherent question being; is there something in the Hobbesian leviathan of human bubble behaviour that has a shared time element or profile, Karl Popper would of course argue yes.

The Ivy Portfolio shows that across many periods of time and asset classes the risk using this 200 day long/cash approach is reduced and the returns increased for a portfolio using the respective asset classes. As an allocation exercise Meb provides multiple examples and potential justifiers for why this approach may work. The approach is always long the asset class as indicated by an index [ETF] or flat cash. More importantly at the portfolio level the allocation is modeled equally across asset classes. This is important as discussed here,as a priori optimization can be sub-optimal post fact.

The examples in The Ivy Portfolio are shown with Index and suggested ETFs. A website is available showing highlights to the approach. The Ivy Portfolio is a lot cheaper from a cost perspective than managed mutual funds and provides higher levels of diversification.

There are a few nice additions to the traditional Stock, Bond, Equity assets classes. One of these is a proxy for managed futures, ie. commodity exposure. As a former participant in the Chicago pits and teenage futures trader I appreciate these market's efficiencies. I wrote my masters thesis on quant approaches to hedge funds and found the low-correlated positive skew in commodities whether trend following with an MLM type index or passive like the GSCI to be a useful complement to many portfolios. The passive commodity indices are over oil weighted, Dollar denominated etc. and did horribly in 2008. I have exchanged a few e-mails with Jim Rogers about this, he of course recommends the Rogers commodity index.

The naive approach to weighted asset classes and adding commodities was good in The Ivy Portfolio's approach. Most people will realize this in 2-4 years post priori when the current stimulus works its magic on the purchasing power of the U.S. dollar.

Another nice asset class addition mentioned on page 116 is currencies. Having lived in 8 countries and worked in 6, and having sat on a quant currency prop desk in London building index strategies, I am a big fan. For those interested, Here is a crude Forex product I put together based on some work by Pierre Lequex and Emmanual Accar when I worked on unsuccessfully launching a money market forex product in 1997. Go figure, everybody wanted the +100% returns of and co., they weren't interested in 15% returns or a nice cash proxy yielding 200bps over t-bills and no leverage.

Timing counts in fund marketing just like comedy and juggling. The product had low correlations to traditional assets, it is similar to some Deutsche Bank momentum products available today.

The Ivy Portfolio if nothing else will get you thinking at the portfolio level. The returns show a risk reward ratio (sharpe) of roughly 2X the S&P 500. And yes the approach was out of equities in most of 2008. So take a look at Meb's book, as Bill Cosby used to say on Fat Albert, "...If your not careful you might learn something before its done."

If you really want to get deep into alternatives, study for the CAIA (Chartered Alternative Investment Analyst) certification and pick up a copy of Anson's Handbook of Alternative Investments or read Gibson's book on allocation, just don't bring it up at cocktail parties or first dates.

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