There has been much debate on this forum on the role of asset allocation (including on the value of tilting away from the market and on which passive funds to use), security selection (active management), and market timing (specifically on moving average and inverted yield curve timing schemes).
Personally, I don’t think security selection or market timing add much, if anything, after all costs over the long-term. However, in the interests of learning (including to confirm or refute my priors), and to contribute to some of the debate, I have constructed as best I can, a set of low-maintenance portfolios. In each portfolio, one of the three sources of return will dominate: asset allocation, security selection, or market timing (table below). There are three portfolios in each of these three categories. Tracking performance of these over time may provide answers to the following questions:
- 1. Will a DFA portfolio (of similar expected tax efficiency) add 1 to 2% [to 3%] (in alpha) over the same (very similar) factor loaded ETF portfolio?
2. Is it possible to select a future “winning active management” fund following Swensen’s criteria (from his books)? [re: the Fairholme fund]
3. Will a highly concentrated portfolio of the best “public equity” investment ideas of highly regarded “hedge fund” managers outperform?
4. Will the commonly advocated moving average, inverted yield curve, or valuation based market timing schemes add value?
5. Will any of the above outperform a simple total market portfolio?
- Before tax returns are reported above. All portfolios are expected to have an average long-term bond holding of 20-25%,
although with wide variation over time in the case of the market timing portfolios
- (a) The DFA TM portfolio: 17% DFA TM Mktwide Value, 7% DFA TM Targeted Value, 13% DFA TM Small Cap, 17% DFA TM Intl. Value, 11% DFA Intl Large Co., 10% DFA EM, 25% DFA Intermediate Government. Here it is.
(b) The ETF portfolio: 23% Vanguard Midcap Value, 9% iShares S&P600 Value, 5% Bridgeway Ultra-Small Co., 23% iShares EAFE Value, 5% iShares EAFE Small, 10% Vanguard EM, 25% iShares 3-7 yr Treasury. Here it is.
(c) The Total market portfolio: 75% Vanguard Total World Stock Market: 25% Vanguard Total Bond Market. Here it is.
- (a) The Fairholme portfolio (FAIRX) seems to pass Swensen’s ‘active manager’ selection criteria with fairly high marks (see previous link) and has about a 20% bond allocation. Here it is.
(b) The Cummings-Ackman-Lampert portfolio includes the ‘best ideas’ (top two stock holdings) of three highly concentrated ‘hedge fund’ managers (on the assumption they know more about the businesses than any other investors). The resulting portfolio has 6 stocks, following Buffets view that :“If you really know businesses, you probably shouldn’t own more than 6 of them”…”If you can identify six wonderful businesses that is all the diversification you need”. Here is more information and public stock holdings of these managers: Ian Cummings: public stock holdings.Bill Ackman: public stock holdings. Eddie Lampert: public stock holdings. The stock holdings of the Cummings-Ackman-Lampert portfolio will be reviewed quarterly against the the respective 13F SEC submissions, selecting the top two holdings of each. These don’t seem to change much, so turnover is expected to be low. Portfolio changes will be made accordingly. The portfolio has a 75:25 stock:bond target for comparability purposes. Here it is.
(c) The Dodge & Cox portfolio is 75% Dodge and Cox Global Stock:25% iShares 3-7 yr Treasury. While the portfolio is less concentrated than the previous two, it currently only holds 88 stocks compared to the 2,741 stocks in the Vanguard Total World Stock fund. And if earlier analysis is any guide, it will also likely have a value tilt (around a 0.4 value load). In addition to stock selection, the fund allocations across US:EAFE:EM may also vary over time which may be another factor impacting returns.Here it is.
- (a) The 16 month moving average portfolio will be 100% DFA Global Equity [DGEIX] (as a proxy for a globally diversified small cap and value tilted portfolio) when the current ‘price’ is above the 16 mth moving average of the MSCI AC World Value (net) Index & 100% iShares 3-7 yr Treasuries [IEI] when the current ‘price’ is below the 16 mth moving average. The assessment is done at the end of each month with any change starting on the 1st of the month following the cross-over. A 16 month moving average is used (as opposed to the more common 200 day moving average) as it was the best performing moving average period using data from 1926 – based on this earlier analysis. Over time, the portfolio is expected to have about a 25% average bond allocation (as it did in the backtests from 1926). Here it is.
(b) The inverted yield curve portfolio is based on this earlier analysis. The portfolio will be 100% bonds (iShares 3-7 yr Treasury [IEI]) from month 11 to 18 after yield curve inversion, and will have a 83:17 stock:bond target allocation for the rest of the time. As the earlier linked back-test from 1959-2009 had an average 10% bond holding, the average bond holding of the inverted yield curve portfolio is expected to be 25% (17*0.9+100*0.1=25.3 i.e. 17% bond allocation for 90% of the time, then 100% bond holding for 10% of the time, gives an average bond holding on 25.3%) As before, DGEIX is used as a proxy for a global small cap and value tilted portfolio. Again the portfolio is expected to have about a 25% average bond allocation over time. The market timing portfolio back-tests (in the table above) from 2003-08 used the MSCI AC World (Net) Value Index for the equity allocation and the Barclays Capital 3-7 yr Treasury for the bond allocation. Here it is.
(c) The GMO valuation/forecasts portfolio comprises 10 ‘index’ funds aligned to most of the asset classes that GMO provides in its forecasts. It weights each fund/asset class by the expected real return from the GMO 7 yr asset class forecasts at the beginning of each year (equivalent to annual rebalancing to new GMO forecasted real return weights at the beginning of each year). The baseline was based on 30-yr expected returns from the start of 2003 for about a 75:25 stock:bond buy-and-hold portfolio (this influenced the number of asset classes to include. Here it is. Backtests worked just as well with fewer funds.