Do portfolio tilts make sense?

Investors focused on asset allocation need to think about what weightings to give different asset classes, and whether "tilts" make sense. What is the definition of a tilt and when should you consider tilts in your portfolio? The Index Investor's editor, Tom Coyne, provides some parameters to consider when you think about tilts for your portfolio. He writes:

We (The Index Investor) distinguish between investments in funds that track a broad market index (e.g., the Wilshire 5000, Russell 3000, DowJones Total Market Index, etc.) and those that track a subset of the broad market.  These subsets are based on different criteria -- for example, value or growth, small caps or large, or small cap value companies.  There are two theories about the potential risk/return impact of investing in a tilt rather than the broad market index. 

One theory believes that markets are reasonably efficient, most of the time.  This implies that any difference between the expected return on a tilt and the expected return on the broad market index is due to some difference in risk exposure.  A tilt should therefore be expected to produce either higher returns than the broad market index, but with higher risk, or lower returns with lower risk.

The second theory makes two critical assumptions.  First, that at least some investors make systematic trading errors.  These might be due to differences in the information they have available, the presence of irrational thinking, or their pursuit of a goal other than maximizing their risk adjusted return (e.g., as in the case of a Central Bank that is buying foreign currency bonds to hold down its exchange rate). 

The second critical assumption is that substantial obstacles exist that prevent other investors from trading against the first group, and arbitraging away any potential superior returns that result from their behavior.  If these assumptions are both true, then it is theoretically possible for a tilt to produce higher returns than the broad market index, but with lower risk.

Whether a tilt makes sense fundamentally depends on an investor's view about the validity of these two assumptions over the expected holding period of his or her investment.