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What is the neutral portfolio?

John Rekenthaler  |  29 Oct 2020Text size  Decrease  Increase  |  
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Investing by habit

The bold favour stocks and the cautious bonds. Those in the middle own balanced funds: 60 per cent stocks and 40 per cent bonds. Vanguard’s STAR Fund (VGSTX), designed for one-stop shoppers, carries the 60/40 allocation, as (largely) does the company’s Managed Allocation Fund. That is also the average position for the industry’s target-date 2030 funds, which serve those who are one decade away from retirement.

The 60/40 arrangement is entirely arbitrary. If the approach ever was supported by an investment argument, that explanation was lost long ago. Portfolio managers create 60/40 portfolios for moderate investors because 60/40 portfolios are what moderate investors receive. Ask no questions, receive no lies.

This column considers three alternate strategies for determining a neutral allocation for middle-of-the-road investors: 1) the 1/N heuristic; 2) analytic solutions; and 3) market weightings.

One divided by N

If investing by rule of thumb, then why not simplify the rule, by placing equal amounts in each asset class? (This tactic has various names, including 1/N, uniform investing, and the naïve diversification strategy.) Allocating half the portfolio to stocks and half to bonds seems more logical than using the traditional 60/40 mix, unless the investor has six fingers on one hand and four on the other.

Notably, the highly rational Dr. Harry Markowitz (who celebrated his 95th birthday this year, three decades after receiving his Nobel Prize in Economic Sciences) adopted such an approach when beginning his investment career. Said Markowitz, “I visualized my grief if the market went way up and I wasn’t in it—or if it went way down and I was in it completely. My intention was to minimize my future regret. So I split my contributions 50/50 between bonds and equities.”

Should lowering the portfolio’s stock exposure feel too conservative, investors can compensate by adjusting the bond allocation. Switching from investment-grade to high-yield bonds effectively increases a portfolio’s equity position. Holding 50 per cent stocks, 25 per cent high-grade bonds, and 25 per cent junk bonds would lead to performance closely matching that of the Vanguard Balanced Index (VBIAX).

The 1/N approach can be further expanded by using additional asset classes. For example, one could buy equal shares of six investments: 1) large-company US stocks; 2) small-company US stocks; 3) international stocks; 4) investment-grade US bonds; 5) investment-grade foreign bonds; and 6) high-yield US bonds. Or, perhaps, equal shares of seven investments, by adding a sleeve of commodities.

Maths is hard

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If this all seems absurdly amateurish, rest assured: There are scientific methods. While working on his Ph.D.—he had not yet received his degree!—Markowitz published the paper that would latter serve as the bedrock for his Nobel Prize in Economics Science, on portfolio allocation. That article provided the framework to allocate assets analytically.

Unfortunately, while Markowitz’s recommendation is mathematically sound, it is devilishly tricky to implement. Forming portfolios based on the interplay of each asset class’s returns, risks, and correlations requires knowing those returns, risks, and correlations—easy enough when evaluating the past, but an impossible task for what matters: the future. Consequently, institutional investors typically observe the spirit of Modern Portfolio Theory, by embracing individually risky assets that benefit a diversified portfolio, without relying on the underlying math.

In other words, they coat a base of arbitrary decisions with scientific polish. This is how it should be. As researchers have since discovered, when put into practice the 1/N investment strategy outperforms most allocations that are analytically derived. For example, in a 2009 study, three professors measured the out-of-sample performance of 14 models based on Markowitz’s mean-variance optimization, and found none to be superior to investing by 1/N. The authors concluded that “the errors in estimating means and covariances eroded all the gains” that the models attempted to deliver.

Another systematic approach is risk-parity investing, which applies the 1/N mindset to portfolio risk. That is, rather than divide the allocation equally among each asset class, the risk-parity tactic equal-weights the risk of each asset class, so that each allocation is equally volatile. In practice, this leads to many fewer stocks and many more bonds; in fact, risk-parity portfolios often leverage their bond positions. Whether such a stance is theoretically superior can be debated, but I think not the timing. Now would not be the ideal moment to load up on bonds.

Choosing to index

Rather than attempt to outthink the marketplace, one might instead mimic it, by defining a neutral portfolio as being that allocation which occurs in real life. Calculate the total market capitalization of stocks and bonds, along with potentially other assets, then create portfolios that replicate those exposures.

That’s not a bad idea, but it does face three challenges. One is whether to address home-country bias. The public US stock market is worth US$36 trillion, while the bond market is valued at something north of US$40 trillion. That implies an asset allocation of 47 per cent equities, 53 per cent bonds. However, the global allocation contains more bonds. With worldwide equities at US$90 trillion and bonds at just under US$130 trillion, the neutral global allocation is 41 per cent stocks, 59 per cent bonds. (Perhaps the difference can be split.)

A second problem is how to treat real estate and commodities. In several countries, although not the US, “properties” are widely available through the public markets. Should those positions count when determining the neutral portfolio for US investors? Of greater importance, should private real estate wealth be considered when calculating the global investment portfolio? If so, real estate will be its largest asset.

With commodities, one could measure solely their investable values, as represented by futures trading; or include physical assets that are in storage; or also include proven reserves (as with oil). If the former, commodities will account for only a tiny fraction of the neutral portfolio. If the latter, they will be a significant position, being about two thirds as large as the equity holdings.

Finally, there is a theoretical difficulty. Whereas the logic behind a stock-market index is indisputable, it’s not so clear that indexing makes sense across asset classes. For example, if bonds outgain equities, should one really hold tight, as cap-weighted indexing suggests, or should one rebalance, as suggested by standard asset-allocation counsel? (I do not know the answer to that question.)

Wrapping up

There’s no defending the popularity of the 60/40 portfolio, except that as standards go, it is not clearly worse than the alternatives. The 1/N heuristic and marketplace capitalizations (both domestic and global) suggest that splitting assets equally between stocks and bonds might make more sense. With that I agree, although not strongly. There doesn’t seem to be an ideal neutral portfolio--a reality that no doubt explains why balanced funds remain the benchmark.

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

is vice president of research for Morningstar.

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