Last week I presented the Global Financial Asset Portfolio (GFAP). In case you missed it here’s a brief summary:
- The GFAP represents the current allocation of the world’s financial assets.
- The GFAP is the only pure “passive” index as this is the index that gives you “what the market gives you”.
- The GFAP is approximately a 55% bonds, 40% stocks, 5% REITs index at present.
- The GFAP has performed extremely well in the last 30 years on both a risk adjusted and nominal basis.
While I think this portfolio could be fine for many people I also believe this analysis has exposed several flaws in the traditional view of “forecast free” and “passive” investing. Instead, this analysis requires us all to take a much more nuanced perspective. It’s very likely that the people selling the idea of a purely “passive” or “forecast free” approach do not understand the underlying dynamics at work. Let me explain.
First, as I explained previously, the true global asset portfolio (as depicted in this paper), is impossible to replicate perfectly. So there is really no such thing as buying exactly what the “market gives you”. You have to alter the index using various subjective assumptions. In the case of my GFAP I removed commodities for instance because I wanted to remove non-financial assets based on the understanding that commodities don’t perform well in real terms over the long-term. Clearly, that’s been somewhat wrong over the last 15 years as some commodities have performed extremely well. But the point is that there’s a degree of subjectivity here that makes this a much more nuanced and active endeavor than we might think.
Second, the GFAP is an ex-post snapshot of what the financial asset world looks like today. Historically, the GFAP should change over time as the underlying balance of assets will inevitably change over time. So the GFAP has to be reactively dynamic to some degree. Therefore, the portfolio requires its own degree of reallocation just to remain consistent with the actual underlying allocation of outstanding financial assets.
Third, because the GFAP is an ex-post snapshot of the underlying financial assets it is inherently reactive. Therefore, it could be positioned in such a manner that it will not provide optimal future returns. For instance, today’s balance of financial assets reflects the falling interest rate environment of the last 30 years. So the GFAP reflects this balance. As a result, the portfolio is bond heavy relative to equities because it has become significantly less expensive to issue debt relative to equity over the last 30 years. As a result we’ve seen a huge decline in equity issuance relative to debt. So the GFAP has shifted from what was a stock heavy portfolio 30 years ago to a bond heavy portfolio today. But this is a reactive shift in the landscape. Any smart asset allocator would look at this environment and argue that there are some unsustainable trends in place here.*
For instance, the Aggregate Bond Index has generated 8%+ annualized returns since 1980. With overnight interest rates at 0% there is about a 0% chance that bonds will generate the same returns in the next 30 years as they have in the past 30 years. So this bond heavy portfolio has an overweight to fixed income thanks to the ex-post nature of this index. But there’s also a strong argument to be made that stocks are expensive in relative terms and likely to be more volatile going forward than they have been in the past. This means that anyone actively choosing to deviate from the GFAP bond heavy allocation is potentially exposing themselves to a high degree of equity market risk which creates a whole other risk for investors in a low interest rate environment.
More specifically, we should caution against the use of a pure market cap weighted index like the GFAP because it could expose investors to higher levels of risk than they believe they are taking. For instance, the equity piece is inherently procyclical and could be overweight stocks in certain parts of the world at their riskiest times. After all, market caps increase because portfolios have performed well in the past. Additionally, on the bond side, investors in certain types of bonds (such as international bonds, high yield bonds, etc) should be aware of the fact that many of these instruments act more like stocks than bonds during times of distress. This means you could be compounding the exposure to tail risk in the GFAP by allocating to these instruments with the assumption that they are true “fixed income” safe havens.
Lastly, we should note that there are many factors that play into an asset allocation decision outside of trying to replicate a “pure” index like the GFAP (there is a degree of indexing overkill in some discussions these days). Clearly, this allocation isn’t appropriate for all investors and you need to be very precise about understanding risk and how it relates to your personal decision before you can allocate your assets appropriately. So generalizations about the GFAP should be taken with a grain of salt as they do not apply to everyone.
All of this presents an interesting conundrum for asset allocators. Using an ex-post snapshot of the financial world is clearly not always an optimal approach for everyone. Most importantly, there’s an obvious contradiction in the idea that we should just accept “what the market gives us” since this implies that the forecasts of the asset issuing entities comprising the current underlying asset allocation, is optimal, and we should therefore just accept the return that their asset issuance generates.
A reliance on a “pure” indexing approach like the GFAP is not necessarily a bad idea for some people, but it has obvious flaws as well. Asset allocation requires a certain degree of active forecasting and “asset picking” based on how we think the future performance of specific asset classes will translate to our risk profile and financial goals. There’s a certain degree of forecasting and guesswork involved in any of this. A reliance on a pure ex-post approach is reactive and static relative to what must be a proactive and dynamic endeavor (asset allocation). Finding the perfect balance will be difficult for all of us to achieve. Hopefully this series helps you put things in the right perspective so you can come a little closer to optimizing your own approach.
* To highlight this point consider the fact that a 40/60 bond/stock portfolio has substantially outperformed a 60/40 bond/stock portfolio over the last 30 years on a risk adjusted basis and only slightly underperformed in nominal terms. In other words, buying the GFAP from 30 years ago when it told us to be stock heavy, was precisely backwards!
- Pragmatic Capitalism: What Every Investor Needs to Know About Money and Finance
- Debunking some Common Investment Myths
- We Are All “Active” Investors
- Most Index Funds are Macro Funds
- Putting the “Underperformance” of Active Managers in Perspective
- Of Course 80% of Active Managers Underperform the Market!
- There’s no Such Thing as “Forecast Free” Investing
- The Importance of Understanding Your Implicit and Explicit Forecasts
- The Importance of Understanding Your General Portfolio Framework
- The Contradiction of “Passive” Index Fund Investing