It all looks obvious in hindsight. It always does. But the future has its own brand of consistency: It’s always unclear.
The good news is that the future’s not as unclear as we once thought it was. Revelations in financial economics over the last 20 years or so gives us reason to think that returns are partly predictable when looking out over the medium-to-long-term horizons. In the short term, momentum seems to play a role, perhaps a dominant role.
The trick is figuring out how to blend these insights into one strategic vision. One piece of the puzzle is keeping an eye on the evolving relationship of asset classes through time. On that note, the chart below offers a preview of what we’ll be studying in more depth in the next issue of The Beta Investment Report. The graph shows how the major asset classes performed relative to one another from the end of 1997 through April 30, 2009. It’s a busy graph and so as a favor to your eyes click on the larger version.
The primary message is that there’s been plenty of volatility in the various components that make up the total market index. Speaking of which, our proprietary Global Market Index, a passive weighting of the major asset classes, has performed more or less as you might expect relative to the world’s capital and commodity markets. In other words, GMI’s delivered average performance, give or take. (The heavy broken black line in the chart above is GMI.)
That’s another way of saying that GMI has beaten some asset classes since 1997 and trailed others. The question, as always: Which asset classes will beat GMI in the future? It may be tempting to simply pick the ones that have outperformed in the past as repeat winners, but that’s misguided. Diversification works over time, but a lot depends on what you pay for the individual pieces. That’s especially true if you’re planning on besting GMI. The price of risk, in other words, is critical.
Unsurprisingly, generating alpha relative to what’ available to everyone as beta is tougher than it looks, as the mediocrity in much of the active management industry suggests. That’s not to say that we should simply lie down and accept GMI as the best we can hope to achieve. But neither should we assume that besting Mr. Market’s asset allocation will be easy. Finding the sweet spot is primary mission. After that, the details get messy.