Countercyclical Indexing is based on a simple premise – a “balanced” index like a 60/40 is practical because it is countercyclical. That is, if the market cap of stock declines the portfolio rebalances back to overweight 60% stocks. And if the market cap of stocks expands the portfolio rebalances away from stocks to reduce the more concentrated risk in stocks. However, we propose that an index such as 60/40 is an inefficient countercyclical approach because it always rebalances back to an equity weighting that is unbalanced in terms of where the relative asset class risk comes from. This is because 85% of the volatility in a 60/40 portfolio comes from the 60% stock slice. This leaves the investor overexposed to drawdowns when stocks are riskiest and exposes them to high levels of behavioral risk. The solution to this problem is to implement a countercyclical strategy that mitigates the stock market risk and better balances the relative asset class risks.
The Discipline Index is our baseline asset allocation metric that measures the relative risks of stocks vs bonds across time. The Index measures macroeconomic and financial conditions to quantify the current relative risks in the market to provide a diversified and passive indexing approach that helps better balance risks in a portfolio across time.
White Paper – What Is Countercyclical Indexing?