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What is Countercyclical Indexing?

A standard indexing strategy such as a 60/40 stock/bond portfolio has many wonderful characteristics. It’s diverse, low fee and tax efficient. The problem with this portfolio is that it deviates meaningfully from the Global Financial Asset Portfolio (the one true market cap weighted portfolio) and this exaggerates the risk skew by creating a portfolio that is inherently more procyclical than the GFAP. The reason for this is that a 60/40 portfolio generates 85%+ of its risk from the 60% slice thereby resulting in an unbalanced risk profile overall. Rebalancing this portfolio back to 60% stocks reduces the procyclicality of the portfolio, but does not account for the way the risks change over time. For instance, a 60/40 portfolio in 2008 is very different from a 60/40 portfolio in 2010. And while rebalancing back to 60% stocks reduces the inherent allocation drift in the portfolio (that is, the natural growth of the stocks versus the bonds) it still exposes the investor to significant drawdowns at the worst times.

All of this is magnified by poor investor behavior across time as we tend to chase the recent procyclical trends (buying the recent hot fund or strategy and ultimately buying high and selling low). For instance, I calculated the average retail investor’s relative total net asset allocation over the last 30 years and found that retail investors, by being procyclical, are consistently positioned in the exact wrong way during the business cycle:

retail_oops

You can see what happens here. Investors chase stocks in bull markets and they sell them into bear markets. And by doing so they end up being underweight stocks early in the market cycle and overweight stocks late in the market cycle when they’re riskiest.  This is further exaggerated by the the fact that we know that most individual investors perform poorly due to very high cash balances as they shift entirely out of these asset classes at certain times and fail to get back in.

The most interesting part about this is that doing the opposite of this allocation (inverting the stock/bond allocation) actually generated similar nominal returns as the market cap weighting (8.2% per year vs 8.9% per year), but improved the risk adjusted returns by a significant margin (standard deviation of 6.4 vs 13.8).  In other words, betting against the procyclical market cap weighting actually generated a better overall return.

A Countercyclical Indexing strategy overbalances the portfolio trying to magnify William Sharpe’s “rebalancing bonus” by creating a portfolio that has greater risk parity across time. This strategy takes all of the basic passive indexing tenets we know are important (low fees, tax efficiency, diversification, etc) and applies them in a more behaviorally consistent manner so we are creating a smoother average return over time.

Most importantly, what this does is better align an indexer’s profile with their exposure to various asset classes over the course of the market cycle because you’re essentially reducing risk to permanent loss as stocks become riskier and you’re increasing your exposure to stocks as they become less risky (when they decline in relative value). This is extremely important as the main factor in investment performance is not stocking picking or generating market alpha, but YOUR BEHAVIOR. Countercyclical Indexing creates a plan that systematically rebalances a portfolio so that you’re always rebalancing against your behavioral balances. This controls for emotional biases and keeps the investor to a disciplined plan through thick and thin. And the beauty is, you can do this in a highly tax and fee efficient manner if you have the patience to actually let the approach play out over time.

Why Countercyclical Indexing Works

  1. It’s low fee and tax efficient.
  2. It rebalances portfolios in a manner that better manages risk than a static indexing strategy.
  3. We optimize for behavioral alpha instead of market alpha thereby creating a portfolio you’re more likely to stick with even in tough times.
  4. Countercyclical Indexing is a form of a “permanent portfolio”. A permanent portfolio is a type of portfolio that will work relatively well in any environment. This takes a lot of the emotional guesswork out of the equation.

Of course, you can tweak this sort of an approach in numerous ways. But the findings are interesting – countercyclical indexing might actually be a superior approach to market cap weighted procyclical indexing.

Read our white paper on Countercyclical Indexing here.

* It should be noted that even a static allocation that rebalances is always rebalancing back to imbalanced degrees of risk during the market cycle.  That is, a 60/40 is actually a much riskier portfolio late in the market cycle than it is early in the market cycle. This leaves the investor who buys the 60/40 in 2009 owning a much less risky portfolio than the investor who buys a 60/40 in 2007.