Tuesday, January 4, 2011

2010 Was A Strong Year For Major Asset Classes

While US stocks earned only 2.2 percent a year since the end of 2000, they provided much higher returns in 2010. REITs were the strongest asset class in a year that saw across the board growth in all major asset classes. See the following post from The Capital Spectator.

It was a very good year—no doubt about it. The capital and commodity markets delivered strong gains in 2010. It was nearly a clean sweep, in fact, with prices rising across the board among the major asset classes. But it was also a volatile year. The handsome gains for the past 12 months masks the turmoil that roiled the markets at times. As a result, attempts at trading in pursuit of market-beating returns was a treacherous game. As usual, those who succeeded came at the expense of those who failed. Meantime, a broadly defined, passively weighted mix of everything dispensed middling performance.

Last year’s annual performance tally also gave us an expansive array of returns. As our chart below shows, the return spread was wide—more than 20 percentage points—for the major asset classes in 2010. If you also consider cash, which suffered a near-zero return, the performance spread widens to nearly 30 percentage points among the broadly defined markets.

The big winner in 2010's return race: real estate investment trusts (REITs). Securitized real estate gained nearly 29% last year. In last place (excluding cash): developed-market government bonds excluding the U.S. (in unhedged U.S. dollar terms), dispensing a relatively tepid 5.2% over the past 12 months.

The red bar in the chart above shows the return for the Global Market Index (GMI), a passively weighted, unmanaged benchmark of all the major asset classes. In 2010, GMI rose by a strong 11.4%. In other words, mindlessly buying everything and making no effort to time or trade the components delivered roughly average results vs. the performance records for the constituent parts. Not bad for a know-nothing strategy that can be implemented with low-cost ETFs for around 50 basis points.

How has GMI fared over the past decade? It pales compared with the year that just passed. GMI’s trailing 10-year annualized total return through the end of 2010 is 5.3%, as indicated by the red bar in the second chart below. In addition to suffering a haircut in absolute terms vs. 2010's results, the past decade for GMI is also below average in relative terms as measured by the individual asset classes.

What happened? Returns in the developed world’s equity markets posted unusually modest results. U.S. stocks, for instance, earned only 2.2% a year since the end of 2000. Foreign equities in mature economies didn’t do much better. Because those two pieces of capital markets comprise slightly more than half of GMI’s market cap, the sluggish performance took a toll.

The good news is that there are low-risk methods for boosting return for a multi-asset class strategy, and the decade behind us was no exception. A simple year-end rebalancing of GMI would have boosted the index’s 10-year annualized trailing performance to 6.2%, or comfortably above the 5.3% performance for the unmanaged buy-and-hold version of the benchmark.

Another intriguing possibility is equal weighting GMI’s components, which some observers might label a model-free index design. Whatever you call it, resetting GMI’s constituents to equal weights every December 31 generated an 8.8% annualized total return for the last 10 years.

The lesson once again is that some simple strategies that require no skills or forecasting powers can bring decent results--even in a decade that was burdened with extraordinary financial and economic challenges.

There are, of course, alternative strategies for besting GMI. You could, for instance, buy a handful of asset classes on the assumption that you picked the winners and shunned the losers. Or, you could use actively managed funds to fill out your asset allocation. But history lessons on this front inspire caution. Indeed, as a recent study in The Beta Investment Report reveals, a bit more than half the efforts at active asset allocation in multi-asset class mutual funds trailed GMI return over the last 10 years. The question is whether you’re confident that you’ll be in the half that wins over the next 10 years? This much, at least, is clear: roughly half of investors and institutions are destined for below-average results, relative to GMI's performance. Because this benchmark represents the opportunity set for most conventional investment strategies, it's highly likely to end up as an average performer over time.

One way to improve your chances of doing slightly better than average is embracing broad diversification across all the major asset classes and periodically rebalancing the mix. That's a low-risk methodology with encouraging odds for capturing a big slice of the global risk premium in the long run, and perhaps over shorter periods as well.

Yes, you can do better, but you can also do worse. If you can’t afford to suffer the latter, you should think twice before pursuing the former.

This article has been republished from James Picerno's blog, The Capital Spectator.
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