While October saved many investors from what would have otherwise been a dismal year in the S&P 500, the same cannot be said for anyone whose investments weren’t constrained to core U.S. equity and fixed income. Both foreign developed and emerging market equities finished the year down. Of the 16 high-income asset classes we track, eleven declined in 2015. Commodities were absolutely decimated with gold (GLD), agricultural (DBA), base metals (DBB), and energy (DBE) down 10.7%, 17.2%, 25.3%, and 35.9%, respectively.
And these weren’t just one or two percent losses. Of the 27 asset classes and sub-asset classes we analyzed, 11 lost more than 5% and 8 lost more than 10%.
While broad U.S. equities were one of the few refuges in 2015, they were by no means immune to malaise of 2015. Small-caps declined 2.1% and value ended the year 8.4% lower. Even the great Warren Buffett and his Berkshire A shares underperformed SPY by nearly 14%.
Unsurprisingly, when global assets have such a bad year, many asset allocation approaches will follow suit.
To illustrate this, we constructed simple ETF/mutual fund models for five of the more well-known allocation strategies. We looked at 60/40, risk parity, the Ivy Portfolio, the Permanent Portfolio, and tactical asset allocation. Of the five, only 60/40 finished the year positive.
For many advisors and their clients, this was a frustrating year, plain and simple. However, with this frustration, comes the opportunity to remember some key investing observations that can be forgotten in the strong bull market of 2009-14.
Observation #1: There is no holy grail.
Asset classes and strategies will always ebb and flow through periods of out and underperformance. There is no holy grail in investing. No strategy will beat the market year in and year out. It just won’t happen. The five asset allocation approaches listed above all outperformed the U.S. equity market on a risk-adjusted basis over the 19-year period we examined (1997 to 2015).
However, they also all suffered through shorter-term periods of underperformance.
On average, there was a 56% probability that a given strategy would underperform U.S. equities in a given year. And this underperformance was by no means limited to a percent or two. In fact, in the years where the strategies underperformed, the average magnitude of underperformance was almost 10%.
In this light, 2015 looks downright normal.
See Important Disclosures at the end of this document for more information regarding these investment strategies.
Observation #2: Successful investing is one part intelligence and one part discipline.
Recently, Clifford Asness, Antti Ilmanen, and Thomas Maloney of AQR wrote a piece forInstitutional Investor titled Market Timing Is Back in the Hunt for Investors.
In the introduction they attribute a quote to the late Paul Samuelson, who during the technology bubble of 1999-2000 said something along the lines of, “Market timing is an investing sin, and for once I recommend you sin a little.”
The rest of their article provides ample evidence for the use of value- and momentum-based market timing methodologies within a broader asset allocation framework.
We would add to this statement that if investors are going to sin, they should do so systematically.
One of our favorite examples of sinning with consistency is Warren Buffett. In an interview with Bloomberg TV, Cliff Asness had this to say regarding Warren Buffett and his phenomenal success:
“I used to think being great at investing long-term was about genius. Genius is still good, but more and more I think it’s about doing something reasonable, that makes sense, and then sticking to it with incredible fortitude through tough times.
Of course [AQR] found [Warren Buffet] was fantastic – but not quite as fantastic. His track record was phenomenal…but human phenomenal.
What was beyond human was him sticking with it for 35 years and rarely, if ever, really retreating from it.
That was a nice little lesson that you have to be good, even very good, but sticking with it and not getting distracted is much more the job.”
In 2015, Warren Buffett’s Berkshire Hathaway (BRK.A) A shares underperformed the S&P 500 by nearly 14%. Remember 2009 when the market rallied after its significant 2008 losses? Those same A shares underperformed the market by more than 20%.
Has Warren lost his magic touch? Probably not. He was up 27% in 2014 when the market was only up 13%.
His style, however, can sometimes be uncomfortably idiosyncratic. But that’s nothing new. Any time you go off benchmark, that’s going to be the result. To significantly out-perform, you have to be willing to be significantly different.
We can take a look at how different investment styles have performed throughout the years to see that they can go through short-term periods of significant under-performance.
See Important Disclosures at the end of this document for more information regarding the above investment styles.
Value is a striking example in 2015. Most investors believe that buying cheap stocks will help them out-perform the broad market over long horizons: but “cheap” significantly under-performed the market this year. We doubt this will cause broad investor sentiment to change from the belief that value will still out-perform in the long run, but it may cause some investors to take some value exposure off the table.
And this is a problem, because investing is a team sport. A manager needs to have the conviction to stick with his approach, but it is equally important that the client has the discipline to stick with the manager.
Continuing with the Buffett theme, consider that an investor that sold Berkshire every time it underperformed the U.S. equity market for a year would have only captured about a quarter of Buffett’s gains.
The same is true for almost any of the broad factor approaches above. While each of the five factors outperformed domestic equities over the full period, an investor who constantly rotated to the approach with the best 3- or 5- year track record would have eroded most, if not all, the benefit.
See Important Disclosures at the end of this document for more information regarding these investment strategies/styles. The above chart reflects Sharpe Ratio for these different investment strategies/styles from 1997 through 2015.
Instead of trying to figure out which style was the best, simply equally diversifying across all of them helped achieve their long-term out-performance while limiting exposure to short-term relative volatility.
This same concept holds for asset allocation styles as well, which brings us to observation #3.
Observation #3: Don’t put all your eggs in one strategy basket.
While picking a thoughtful asset allocation approach and sticking to it is a huge step in the right direction, picking a set of complementary asset allocation strategies is even better.
An extreme example would be to allocate 20% of a portfolio to each of our five example allocation models. This approach would have hypothetically generated a Sharpe ratio of 0.52. A Sharpe of 0.52 is better than four of the five individual models, only 0.01 less than the best performing of the five, and more than 2.5x higher than the broad U.S. equity market over the 1997 to 2015 period.
The benefits of strategy diversification are so strong that it is nearly equivalent to being able to choose the best performing strategy with perfect foresight. Strategy diversification is so powerful because each strategy, if driven by sufficiently different investment processes, will cycle through periods of out and underperformance independently. Their ebbs and flows should at least partially cancel out, creating a more consistent return profile.
Practically speaking, having five separate asset allocation approaches in one portfolio may not be operationally feasible. However, using two or three is very possible for the average investor, especially given the continued explosion of the ETF market. One example would be pairing a strategic allocation tailored to a client’s risk tolerance with a tactical model.
See Important Disclosures at the end of this document for additional information regarding the above investment styles. The above chart reflects Sharpe Ratio for these different investment styles from 1997 through 2015.
2015 was a tough market for almost any allocation approach that wasn’t solely invested in U.S. equities. That said, long-term evidence still suggests that there are many active approaches that can be used by investors to achieve superior risk-adjusted returns.
The key, of course, is having the discipline to stick with those approaches when they under-perform in the short-run. At the very least, investors must not be tempted to chase what has been working well recently, as this consistently erodes any performance benefit from the active strategy.
Finally, diversification once again proves to be one of the simplest techniques investors can apply to tilt odds in their favor. Whether across equity styles or asset allocation methods, diversification can help investors achieve the long-term relative out-performance offered without necessarily suffering the full brunt of short-term underperformance.
 These models/investment strategies are not available for investment through Newfound. These hypothetical models were constructed in January 2016 for purposes of evaluating historical market performance (and therefore are backtested). Please see the Important Disclosures at the end of this document for more details regarding the objectives and components of each of the five portfolios, as well as other important information.
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