Asset Allocation, Risk Premia and Sharpe Ratios

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Includes: DIA, QQQ, SPY
by: James Picerno

The big shift in the mix for the Global Market Index (a proprietary benchmark that uses a passive weighting of all the major asset classes) over the past year has been a drop of nearly three percentage points for U.S. bonds and the same for foreign developed-market government fixed income. Meantime, the leading increase in relative terms for the 12 months through this past May has been a rise in the weighting for foreign-developed market stocks. As the table below shows, equities in mature markets added more than two percentage points to their collective allocation in GMI for the year through last month.

In close second for the biggest relative increase in GMI’s asset mix: foreign corporate bonds, which also gained over two percentage points in their asset allocation. (You can find the proxy indices for all the major asset classes and recent total return performance here.)

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Meanwhile, the second table below updates risk premiums for the major asset classes and GMI through the end of May. Remember, the risk premiums below are defined as the annualized total return less 3-month T-bills, which are used as a “risk-free” benchmark. In a future post (hopefully within a week or so), I’ll post my estimates for long-run risk premia.

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Finally, here’s a look at how trailing Sharpe ratios (risk premium divided by return volatility) stack up for the trailing 3- and 10-year periods through May 31, 2011. Higher Sharpe ratios reflect higher realized risk premiums relative to volatility (annualized standard deviation of return). For example, the best-performing asset class over the past decade in terms of its return-to-risk ratio: emerging-market debt, which boasts a Sharpe ratio of 0.93. By comparison, U.S. equities suffered an extraordinarily low Sharpe ratio of just 0.08. Yes, here's one more piece of statistical support for saying that it’s been a very tough decade for stocks. Ouch!

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