1.
Highly traded markets are usually efficient-that
is, it is extremely difficult to “beat the market” over time by picking out individual securities.
2. Less highly traded markets with less dissemination of information (small caps, emerging markets) have
some inefficiency.Therefore,
it is possible to “beat” broad indexes measuring inefficient markets with active management. However,
it is very difficult to pick those managers who can accomplish this year after year, and who can exceed the “cost drag”
of active management and trading. It is also unclear how well any manager actually matches their investments
to the index to which they are compared.
3. There are occasional gross market inefficiencies, in the broad markets as well as in specific sectors and specific stocks.
These inefficiencies should be noticed and acted on in the investment process of strategic asset allocation.
For example, by early 2000, a student of market history would have clearly noted an unsustainable rise in the price
of most stocks, especially in the tech sector. Similarly, in 2003, the historic 20-year bond bull market
is probably due to end, as interest rates are seemingly too low in a monetary system that ultimately favors inflation.
4. Modern Portfolio Theory teaches that a group of assets that do not strongly correlate with each other’s
performance leads to better portfolio performance and less volatility. The process of picking a portfolio
involves determining which asset classes should be present and in what percentage. All asset classes should
be considered in this process. In a now famous study of pension plans, asset allocation was responsible
for over 90% of portfolio returns (when compared with market timing and individual security selection).
5. Over a century of measurement indicates that equities provide a higher but more volatile return than
do interest bearing investments. A long time horizon of investing is warranted to smooth out this volatility
and capture the long term “risk premium” of equities.
6. Therefore, a strategic asset allocation strategy should seek to “match” the market in most asset
classes (with index funds and ETFs), but can be modified to seek out an occasional active manager that excels in an inefficient
market sector. This process should also recognize when certain market segments are abnormally expensive
or cheap. Within these strategic allocations are tactical “limits” to the
percentage of investments in each sector that would trigger rebalancing transactions. The portfolio requires
regular but not daily or even weekly review.
7. The markets of late 2008 demonstrated that at certain times,
almost all asset classes may "move together," that is, the previously poorly correlated assets become more correlated
in a downside direction. The markets also demonstrated that traditionally "safe" fixed income was often anything
but safe.
MAJOR ASSET CLASSES
U.S. Domestic Equities Large Cap Value Large Cap Growth Small Cap Value Small Cap Growth
International
(Developed) Equities
Emerging Markets
Fixed Income- of various durations Government Corporate High-Yield International Emerging Market
Commodities-including Gold. Energy "in a safe place" Real Estate
