I fully expect the markets to remain volatile over the next two to five years as the worldwide economy and financial markets work off the imbalances made apparent by the “great recession”. This heightened volatility, coupled with a domestic equity market that is, in my view, pushing the upper limits of its valuation range (Shiller P/E of 23.4; 87% percentile), affords the need for passive investors to become a little less so.
Two strategies these “passive investors” can use to protect themselves and enhance returns are diversification – true diversification, not just stock and bonds – and portfolio balancing. Diversification is important as one asset class may outperform one year and another the next. Re-balancing is key as you hope that selling a portion of your winning asset classes and buying the underperforming ones, which will later become the over performing assets. According to Ed Easterling at Crestmont Research, (pdf) the impact of re-balancing annually versus bi-annually (every other year) is a 1.3% benefit annually during bear markets and a 0.3% loss during bull markets.
With these two concepts in mind, let’s take a look at some data. Drawing roughly from the ‘Model ETF’ Portfolio at CNBC, I have created what I feel is a well diversified portfolio in terms of asset classes and geography. Using an equal weight portfolio yields the results seen below. I used 9/20/2006 as the start date as this is the beginning date for the DBV fund.
All data is from Yahoo finance using the Adjusted close price which adjusts for dividends and splits.
click to enlarge
As you can see, the diversified portfolio resulted in an annual return of 3.3% versus 0.7% for the SPY, and 2.4% for a 60/40 Equity/Bond portfolio. When factoring in once a year re-balancing on the portfolio, annual returns increase to 4.4%. What is more, the standard deviation on the portfolio is lower than that of the S&P 500 index making risk adjusted returns even more favorable. Risk adjusted returns are calculated using the Modigliani-Modigliani, or M-squared, method. An investor in the annually rebalanced, diversified portfolio would end up with 16.7% more assets over the period someone that simply held the S&P 500.
In all market environments, but especially in choppy, range bound markets where the benefits provided by diversification and re-balancing are most needed, ETFs are a relatively easy way for the “passive” investor to add diversification and potentially increase returns.