The Enduring Power Of Passive Asset Allocation

 |  Includes: ACWI, VT
by: James Picerno

The dominant theme in the financial economics literature is that most relationships are dynamic. Everything from asset valuations to correlation and volatility fluctuate through time. This empirical fact applies within and across asset classes. Change, in other words, is a constant and it is the primary source of risk and opportunity. But there's always an exception to the rule. Perhaps the leading example in finance is the persistence of average results by a representative index for an asset class or an asset allocation strategy.

One instructive example can be found in my semi-regular updates of how the Global Market Index (GMI) fares against 1,000-plus multi-asset class mutual funds and ETFs through time. In the previous update last September, GMI proved itself competitive in a varied field of actively managed strategies. History continues to repeat on this score. Indeed, GMI—a passive, unmanaged mix of all the major asset classes weighted by market values—has outperformed nearly 90% of more than 1,200 funds for the 10 years through December 31, 2011. It's surprising that GMI's record is so strong against the bulk of actively managed competitors. I doubt that this level of strength will continue for GMI. Nonetheless, I have a high degree of confidence that a decade hence, a broad, unmanaged mix of the major asset classes will remain in the above-average category, if only modestly.

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As for the hard numbers from the past decade, GMI returned a 6.0% annualized total return for the 10 years through 2011's close. That puts GMI in the 89th percentile relative to the roughly 1,200 multi-asset class funds with at least 10 years of history. GMI's rebalanced and equal-weighted counterparts did even better, suggesting that there's a case for some forecast-free tweaking.

None of this comes as a surprise. Indeed, similar results are found within asset classes. No wonder that indexing is so popular. On the one hand there's a choice of capturing average to moderately above-average results with a passive strategy—a choice that comes with a relatively high degree of confidence for achieving the expected result. The alternative is opting for an actively managed strategy that, in theory, will beat the average. The critical issue for deciding whether to go with an active strategy boils down to confidence, namely: How confident are you that the manager will deliver superior results relative to an appropriate index? The chart above suggests that the odds for success may be lower than we think. But if you do use an active manager, then by all means do your homework and figure out why the fund has outperformed. Was it really skill instead of luck or just plain beta exposure?

Does this mean that asset allocation should always be passive in design and management? Not necessarily. But GMI's results remind that we should be cautious in expecting to perform miracles. It's hard to beat the markets over time. If your investment horizon is a decade or longer, history suggests that it's going to be difficult to add value over a diversified benchmark without taking a large dose of risk.