Morningstar - Q2 2022 - 14

6
8
Dispatches
4.79
3
EXHIBIT 4
Yale Allocation
Conventional Versus Informed Portfolio
Vanguard
Balanced Index
January 1992-December 2021
30-Year Annualized Return
12%
8.79
EXHIBIT 5
Yale
Allocation
Underlying Asset-Class Returns
Vanguard
Balanced Index
January 1992-December 2021
Asset Class*
U.S. Small-Value Stocks
U.S. Stock Market
8.26
8
U.S. High-Yield Bonds
4
Conventional
Portfolio
Source: Morningstar Direct.
Informed
Portfolio
Emerging-Markets Stocks
Foreign Developed Stocks
U.S. Investment-Grade Bonds
Foreign Developed Bonds
S&P 10%
Risk Parity
30-Yr Annlzd
Return (%)
11.99
10.67
7.75
7.60
6.37
5.29
4.45
*Asset classes are represented, respectively, by these indexes: Wilshire
US Small Cap Value, Morningstar US Market, Bloomberg U.S. Corporate
High Yield, MSCI Emerging Markets, MSCI ACWI ex USA, Bloomberg U.S.
Aggregate Bond, and Bloomberg Global Aggregate ex-USD.
Source: Morningstar Direct.
4
Two Lessons
In hindsight, I would have made two mistakes.
One was relatively minor and easy to address.
When forming my portfolio, I didn't think enough
about how it would behave when investors
collectively ran for shelter. I knew that small-value
stocks and high-yield bonds were related
investments, as both are unusually vulnerable to
recessionary fears. However, I failed to recognize
that even though emerging-markets stocks
often follow different economic cycles, they
nonetheless suffer during such " flights to safety. "
In Practice
But in practice, I was wrong. Over the next 30
years, the traditional portfolio outgained
my allegedly informed portfolio by half a percent
per year. To be sure, the informed portfolio
fared well, in absolute terms ( EXHIBIT 4 ). Its
nominal annualized return of 8.3%, when
combined with the period's paltry 2.4% inflation
rate, would have enabled investors to reach
their goals. But it still would have trailed the
simple, traditional strategy.
(Properly speaking, I should have depicted
each portfolio's risk-adjusted performance
rather than its returns alone. However,
the risks of the two approaches were quite similar.
The informed portfolio had a slightly lower
standard deviation, but that advantage was
offset by steeper losses during the 2008
global financial crisis and 2020's coronavirus
downturn. Call it a wash.)
My first two decisions paid. Although small-value
stocks trailed two major bull markets, during
the late 1990s and then again last decade, they
nevertheless topped the overall U.S. stock market
( EXHIBIT 5 ). Score one for the professors!
High-yield bond funds also justified my support by
thumping their investment-grade rivals over
the 30-year period. Selecting those two asset
14
Morningstar Q2 2022
classes would have been both prescient and savvy.
The first was decidedly unglamorous and
the second had been deeply disgraced when the
junk-bond market collapsed in 1990.
Unfortunately, I would have fluffed my advantage
entirely with my third decision, to invest
aggressively overseas. Technically, investing half
the portfolio's equities and 25% of its bonds
internationally would still have been underweight
foreign securities, which dominated both
markets, but in practice, since most investors
strongly prefer investments from their home
country, adopting such a global approach would
have meant betting against the United States.
To channel Ronald Reagan, never make such a
wager! Staying home worked for several
reasons. The biggest was technology stocks. Over
the years, U.S. stock market indexes have
owned about twice as much technology as their
foreign counterparts-a great advantage,
given that sector's success. Also important were
avoiding the struggling Japanese stock market,
and the American doctrine of shareholder
value. Domestic businesses were likelier to reward
their outside investors than were their overseas
rivals. Finally, the U.S. dollar has strengthened over
the past three decades, thereby lowering
foreign-denominated returns.
Thus, while the informed portfolio was not more
volatile than the traditional portfolio, thereby
supporting the key principle of Modern
Portfolio Theory, it was riskier than it needed to
be. I should have combined the assets more
carefully. That problem can be solved by adjusting
the mix to include investments that thrive
during panics, such as long Treasury bonds.
The second error was major and difficult to fix.
That was my failure to appreciate national
discrepancies. I did not foresee either that the U.S.
would benefit heavily from its technology stocks
or that so many emerging-markets companies
would squander the advantages conveyed by their
countries' economic growth through
mismanagement or corruption. Nor did I realize
that the dollar would rebound from what
at the time had been a prolonged decline.
In short, improving upon traditional asset
allocation meant not only knowing the requisite
investment math and learning the asset-class
histories, but also understanding the
macroeconomic backdrop that would affect future
results. Adding new asset classes was not
enough. To outdo convention, I also needed to
recognize which assets to omit. That is a stern
assignment indeed.
Ten years from now, I will likely be writing a
follow-up column demonstrating how
the traditional 60/40 strategy remains valid. K
John Rekenthaler is a vice president at Morningstar
Research Services LLC. He is quick to point out that the
views expressed in Ivory Towers are his own.
https://www.morningstar.com/authors/208/john-rekenthaler
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