Keep Calm And Choose Wisely

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Includes: CRF, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, LLSC, LLSP, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TALL, TNA, TQQQ, TWM, TWOK, TZA, UDOW, UDPIX, UPRO, URTY, USA, USSD, USWD, UWM, VFINX, VOO, VTWO, VV, ZLRG
by: Tony Ash

Summary

Over the most recent 17-year horizon, large cap equity-only (SPY) lagged diversified global stock/bond/cash portfolios.

The historical time horizon and investable universe chosen will impact asset allocation analysis.

Think twice before overweighting equity in favor of a more diversified portfolio.

The recent run-up in equity markets is prompting many to question their strategic equity targets. My recent article on asset allocation strategy, Which Line Do You Like Best?, focused on the 10-year performance of the S&P 500 (through SPY) and core bonds (through AGG) against diversified stock, bond and cash portfolios represented by the Conservative through Aggressive global Dow Jones Relative Risk Indices (DJ Indices). The global DJ Indices reflect portfolios from aggressive 100% equity weighting (and risk) to conservative 20% equity weighting (and risk). The results were as expected: The riskier S&P 500 "won" the contest, but trailed early on and performed with much more risk (standard deviation of return) than the diversified indices.

A few comments on this article and elsewhere prompted at least two issues worth addressing in more detail.

The idea of the "investable universe" is always a critical question in the asset allocation decision. One reader noted that mid-cap stocks actually outperformed the S&P 500 over the chosen 10-year horizon ended December 2016 that was used and should be declared the "winner" instead of the S&P 500. He was correct, but unless that mid-cap equity carve-out of the investable universe was identified in the long term strategic asset mix ahead of time, any benefit would be missed. Other asset classes and specific securities likely outperformed the S&P 500, too, over that horizon. Since no one can know ahead of time with certainty where outperformance is going to come from, a diversified portfolio is the best solution to capture some of that unidentified exposure of outperformance ahead of time.

Another reader and Seeking Alpha Contributor, Dale Roberts, took issue with the time frame chosen, indicating that a longer time horizon gave different results. He said, "…in the large and mid cap space taking on all-stock portfolios has not paid off with greater returns. Over the last 20 years a simple balanced growth model has matched or outperformed the all stock versions." We all know that analysis of different time frames will more often than not give different answers. So, I checked.

Based on an available 17-year data set that I had starting with January 2000, Dale was correct! As we can see below, the S&P 500 (NYSEARCA:SPY) lagged diversified portfolios over this longer time horizon! Certainly, this time horizon included the dot.com and Credit crisis, but it is still instructive in the context of a different time frame and "sequence of returns" risk.

Per Table 1 below, from December 31, 1999 through December 31, 2016, REITS (through VNQ) was the big winner with an average annual total return of 11.81% with a standard deviation of return of 11.46%. The diversified Conservative through Aggressive Dow Jones Relative Risk Indices produced annual total returns from 5% to 6%, easily beating the S&P 500 return of 4.55% over this time horizon; all with less risk, except for the Aggressive index. There are many interesting outliers in this sample, including small cap equities (IWM), gold (though GLD) and TIPS (through TIP). Maybe not unsurprisingly, the strong performance of the small cap equity (NYSEARCA:IWM) carve-out helps to perpetuate the small cap anomaly by producing a strong 7.38% annual total return over the horizon beating the S&P 500 and all the DJ Indices.

Table 1

ETF / DJ Indices

17-years 2000-2016

Annual Total Return

Annual Standard Deviation

Return/Risk

VNQ

11.81%

21.72%

0.54

GLD

8.37%

17.33%

0.48

IWM

7.38%

19.89%

0.37

TIP

6.04%

6.12%

0.99

DJ Global Aggressive

5.99%

16.40%

0.37

IEF

5.88%

6.42%

0.92

DJ Global Mod. Aggressive

5.84%

13.13%

0.44

VWO

5.70%

22.68%

0.25

JNK

5.70%

11.46%

0.50

DJ Global Moderate

5.69%

9.88%

0.58

DJ Global Mod. Conservative

5.33%

6.82%

0.78

DJ Global Conservative

5.06%

4.10%

1.23

AGG

5.03%

3.86%

1.30

SPY

4.55%

14.86%

0.31

EFA

2.15%

17.39%

0.12

SHV

1.72%

0.60%

2.87

DJP

0.78%

17.45%

0.04

Source: Morningstar.com

From Chart 1 below, it is even more telling to see graphically how the S&P 500 cumulative value of $10,000 progresses. Once the S&P 500 got crushed from the dot.com bust in 2000, and the subsequent credit crisis, it NEVER recovered through 2016 to overtake the diversified DJ Indices. The core bond AGG (light blue line) shows a steady upward slope from December 1999, whereas large cap SPY (the dark blue line) dives to the bottom in the early years and then trails along the bottom; never to intersect the DJ Indices or AGG! The DJ Indices mirror the volatility shown by SPY, but to a nicely muted extent.

Chart 1

As we all know and have heard, "Those who don't learn from history will surely repeat it." Two things are most striking about this chart. First, of course, are the two material drawdowns during 2001/2002 and 2008/2009. Second, is where we are in the current bull cycle since 2009. From 2009 we see a very nice upward slope of the large cap equity-only portfolio with some bumps along the way.

The record-breaking strong equity markets may be coaxing some to increase their equity allocations to grab some extra return; and certainly core bonds appear to be a losing bet. No one knows when (if?) the next drawdown will come and capital markets are fickle and can be highly correlated at the worst times. Also, and most significantly, the economic and capital market environment now is very different from what is was then with the current historic low interest rates, record deficits, and slow global growth; Trump presidency, notwithstanding. With history as a guide, however, the diversified portfolios provided a better return/risk profile with more ending value than the large cap equity-only portfolio throughout the ENTIRE identified 17-year horizon. The benefits of diversification, with a special focus on carefully selecting the investable universe, are clear and well-worth following.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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