Portfolio Allocation Is No Free Lunch
There is no free lunch in portfolio allocation as any scheme that reduces the impact of adverse market conditions also adversely affects returns in bull markets. Most advisers and clients know this but in hindsight there is always backlash.
The explosive rise in stocks with low volatility especially after the 2016 election has put portfolio allocation in a defensive stand with advisers attempting to justify low returns in comparison to stock index total returns.
For example, the 60/40 portfolio using SPY and TLT ETFs for stocks and bonds, respectively, gained 16.7% last year while the total return of SPY ETF was nearly 22%. The performance of the portfolio since 2003 is shown below.
The 60/40 portfolio had limited drawdown in the financial crisis of about -8.5% versus -37% for SPY on a monthly closing basis. However, as expected the portfolio underperforms the benchmark during bull markets: it underperformed in the 1990s bull markets and recently has also started underperforming. In 2017, the 60/40 portfolio ended about 500 basis points behind the benchmark as already noted above.
And while some investors think 500 basis points underperformance of the stock market is significant, imagine the reaction of those who were invested in exotic portfolios, such as the All Weather Portfolio, for example.
Exotic portfolios were sold to the public on the basis of reduced risk but the potential of significantly reduced returns was not explicitly mentioned because no one ever believed that what we are witnessing in the stock markets nowadays will ever occur, i.e., the combination of an explosive uptrend at virtually no volatility.
Below is the All Weather Portfolio performance since 2007.
The performance of this portfolio has been excellent as it may be seen from the above chart until someone disclosed it in a bestselling book in 2014. Is this a coincidence? I do not know the answer but the portfolio performance has crashed since. Specifically, as shown in the chart below, annualized return since 2015 is 4.23% versus 11.26% for the benchmark.
In 2017, this portfolio gained 9% versus nearly 21% for S&P 500 total return. This is a major defeat of this allocation scheme.
What went wrong and may even get worse
1. All trading strategies and allocations may fail when there is a major change in market conditions and a new regime emerges.
2. Investors in passive allocations think, or are convinced, that passive portfolio allocation is safer than active management but in reality it is no different; both strategic investing and tactical investing, are subject to data-mining bias and over-fitting issues. The only major difference is the effort required to execute a strategy.
3. Investors are sold dreams of financial independence when in fact most of those dreams may turn into financial traps. There is not enough dumb money for everyone to profit and market makers along with insiders are first to benefit. Investors come after them if there is anything left on the table either willingly or by error.
4. Naive portfolio allocations are the equivalent of the failed art of technical analysis that ruined millions of retail traders. It is hard to maintain consistent performance when there is no large supply of dumb money.
5. Investors embracing popular portfolios are the new dumb money and they can become the targets of market makers and insiders who know how money is allocated. Actually this is a large component of what machine learning means nowadays, i.e. identifying anomalies caused by dumb money and arbitraging them out.
6. Some portfolio managers have cultivated the impression that they are the answer to the old mistakes although they are no different in principle than the retail trader who had faith in an obscure indicator to risk hard-earned money. Some are even more naive than that because they assume diversification is a magical key to profitability when in fact it may reduce it drastically as shown above by examples.
7. If current market conditions persist for much longer without a major correction, many investors in exotic portfolios will find themselves in a hole. But the worst case scenario is stagflation, when both stocks and bonds fall and although it has very low probability in case it occurs it will cause massive wealth redistribution from investors in passive portfolios to quantitative algo traders. Actually, as it turns out, the 60/40 portfolio poses high risks due to its high correlation with the stock market.
8. International stock markets may not provide sufficient hedging for investors in case of a downturn since those markets tend to lose even more. For U.S. investors, investing in international stocks is equivalent to a bet that the U.S. dollar will drop. This can be accomplished with a plain vanilla forex bet rather than with investment in foreign stocks. Maybe for diversification purposes it is now time to consider the CTA asset class that has grossly underperformed in the last 10 years.
If you have any questions or comments, happy to connect on Twitter:@mikeharrisNY
This article was originally published in Price Action Lab Blog
About the author: Michael Harris is a trader and best selling author. He is also the developer of the first commercial software for identifying parameter-less patterns in price action 17 years ago. In the last seven years he has worked on the development of DLPAL, a software program that can be used to identify short-term anomalies in market data for use with fixed and machine learning models. Click here for more.