The Arithmetic of Active Asset Allocation in a Global Financial World

At the aggregate level there is just one portfolio of all outstanding financial assets. These financial assets generate “the market” return. This means that the holders of these financial assets must, by definition, generate the post-tax and post-fee return. That is, the average investor will generate the top line return from all outstanding financial assets MINUS any taxes and fees paid. This means that, in the aggregate, no one “beats the market”.

Of course, some investors must, by definition, outperform other investors inside of this aggregate portfolio. Since the Global Financial Asset Portfolio is the one true benchmark of all outstanding financial assets then anyone who deviates from this market cap weighted portfolio is essentially an “active” investor. And since almost all investors deviate from global cap weighting then some investors MUST, by definition, “pick assets” in a more efficient and more intelligent manner than others.  This means that some level of strategic asset allocation is not only intelligent, but necessary.

This highlights another key point, however. The only way to guarantee higher returns is by reducing the tax and fee frictions. Yes, no one can perfectly replicate the pre-tax and pre-fee return of a benchmark. But we can reduce the frictions that cause us to deviate from that benchmark. Deciding how and when to be allocated into certain assets is, of course, a whole different matter.