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Herb Morgan (Efficient Market Advisors, LLC) submits: As one who embraces the Theory of Market Efficiency, I believe the majority of value created within portfolio management comes from the asset allocation decision. When constructing asset allocation models one must resist the temptation of vanity and assume the worst about their own talents. Gasp! I may be wrong.

The most popular model held by the clients of my firm is the 6 – 10 Moderate portfolio of Exchange Traded Funds. We start with optimization pursuant to Modern Portfolio Theory and finish with a Tactical Overlay. Firmly believing both in the market’s ability to create surprises, we “stress test” our asset allocation models to ascertain how they hypothetically would have performed through various historical periods of ugliness.

Using the 6-10 Moderate as an example we find that during the period from July 1978 through June 2006, assuming complete quarterly rebalancing, our portfolio would only contain two draw downs in excess of ten percent, compared to seven such periods or “dips” for the S&P 500 Index. August 1987 through November 1987 would have produced a decline of 12.27% and January 1980 through March 1980 would have produced a decline of 10.10%. Recovery periods were three months and two months respectively.

The two worst draw downs for the S&P500 over the same period were 44.73% from August 2000 to September 2002 and 29.58% from August 1987 through November 1987. The former has yet to fully recover (72 months later) and the latter recovered in eighteen months. The real focus of those who create asset allocation models should therefore be to minimize the propensity of a portfolio towards sustained declines and to further minimize the expected or average recovery time from said declines when they inevitably occur.

Sadly, loss avoidance remains a difficult concept for the purely tactical crowd to embrace. We spend so much time looking to maximize methods of capital gains that we expose ourselves to unnecessary risks which ultimately deliver bone shattering losses with recovery periods measured in years rather than months. To be successful in the business of asset allocation (the real value added in the investment business) one must assume that capitalism works. Accepting that the mutual gain from exchange, created everyday by the voluntary actions of profit maximizing individuals will in most years, over most periods, increase the value of stocks will lead one inevitably to the conclusion that ours is a business of loss avoidance.

Exchange Traded Index Funds are the optimal vehicle for creating investment portfolios with low propensities towards failure. Avoiding active management that focuses on security selection rather than asset allocation, and its high likelihood of periodic unintended failure, reduces exposure to draw downs of undesirable magnitude.

Source: ETFs Increase Portfolio Predictability