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Figure 6<br />
Summary Of Three Bond Scenarios<br />
Time Period<br />
Description Of US<br />
Bond Performance<br />
10-Year Annualized<br />
Return Of US Bonds<br />
Growth Of $10,000<br />
In US Bonds<br />
10-Year Annualized<br />
Return Of<br />
12-Asset Portfolio *<br />
Growth Of<br />
$10,000 In A<br />
Diversified Portfolio<br />
2002-2011 Actual Performance 5.78% 17,540 8.93% 23,522<br />
2002-2011<br />
(US bond returns<br />
from 1950-1959)<br />
2002-2011<br />
(US bond returns<br />
from 1982-1991)<br />
Worst-case<br />
Performance<br />
Best-case<br />
Performance<br />
1.34% 11,423 8.54% 22,693<br />
14.09% 37,365 9.65% 25,123<br />
Difference between<br />
Worst-case and Best-case Bond Performance<br />
1,275 bps 25,942 111 bps 2,430<br />
Source: Raw data from Lipper for Investment Management<br />
Note: U.S. bonds have an 8.33% allocation (or 1/12th) in the 7Twelve portfolio. All 12 assets were rebalanced annually over the 10-year period.<br />
For an investor who used a diversified approach (in this<br />
analysis, a 12-asset portfolio), the performance differential<br />
between the worst-case bond period and the best-case bond<br />
period was 111 basis points, or $2,430 in ending account value.<br />
Completely avoiding any asset class in a diversified<br />
portfolio amounts to a guess that it will underperform<br />
and that another asset class will outperform. Building<br />
prudent portfolios is not about guessing and timing;<br />
it’s about broad diversification. A broadly diversified<br />
portfolio is naturally insulated—not <strong><strong>com</strong>plete</strong>ly, but<br />
largely—from the normal swings in performance among<br />
its various <strong>com</strong>ponents. The “underperformance” of one<br />
or several of its ingredients will not sink the performance<br />
of the overall portfolio.<br />
Blitz continued from page 39<br />
Endnotes<br />
1 See, for example, Chow, Hsu, Kalesnik & Little (2011), “A Survey of Alternative Equity Index Strategies,” Financial Analysts Journal, vol. 67, No. 5, pp. 37-57.<br />
2 Blitz (2012), “Strategic Allocation to Premiums in the Equity Market,” Journal of Index Investing, vol. 2, No. 4, pp. 42-49.<br />
3 See Asness (2006), “The Value of Fundamental Indexation,” Institutional Investor, (October), pp. 94-99; Blitz & Swinkels (2008), “Fundamental Indexation: an Active Value<br />
Strategy in Disguise,” Journal of Asset Management, vol. 9, No. 4, pp. 264-269.<br />
4 See Arnott, Hsu & Moore (2005), “Fundamental Indexation,” Financial Analysts Journal, vol. 61, No. 2, pp. 83-99.<br />
5 See Chow, Hsu, Kalesnik & Little (2011), “A Survey of Alternative Equity Index Strategies,” Financial Analysts Journal, vol. 67, No. 5, pp. 37-57.<br />
6 See de Groot & Huij (2011), “Is the Value Premium Really a Compensation for Distress Risk?” SSRN working paper no. 1840551.<br />
7 See Blitz, van der Grient & van Vliet (2010), “Fundamental Indexation: Rebalancing Assumptions and Performance,” Journal of Index Investing, vol. 1, No. 2, pp. 82-88.<br />
8 We note that although MSCI aims for a one-way turnover of no more than 20 percent per annum, on several occasions they have relaxed this constraint. For example, a<br />
methodology change implemented at the end of 2009 caused a turnover of 45 percent at that moment.<br />
9 Stock weights in this index are set inversely proportional to their volatility, so the lowest-volatility stocks get the highest weights.<br />
10 See, for example, Soe (2012), “Low-Volatility Portfolio Construction: Ranking versus Optimization,” Journal of Index Investing, vol. 3, No. 3, pp. 63-73.<br />
11 For a discussion of the low-volatility premium, we refer to Blitz & van Vliet (2007), “The Volatility Effect: Lower Risk Without Lower Return,” Journal of Portfolio<br />
Management, vol. 34, No. 1, pp. 102-113.<br />
12 See Huij, van Vliet, Zhou & de Groot (2012), “How Distress Improves Low-Volatility Strategies: Lessons Learned Since 2006,” Robeco research note.<br />
13 See Clarke, de Silva & Thorley (2011), “Minimum Variance, Maximum Diversification, and Risk Parity: An Analytic Perspective,” SSRN working paper no. 1977577. In their<br />
Table 2, they report a volatility of 19.0 percent for a maximum diversification strategy applied to U.S. equities over the 1968-2010 period, which <strong>com</strong>pares with a volatility<br />
of only 15.6 percent for the cap-weighted index over the same period.<br />
14 Returns for this strategy are publicly available on the website of Prof. Kenneth French: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.<br />
15 See Blitz, Huij & Martens (2011), “Residual Momentum,” Journal of Empirical Finance, vol. 18, No. 3, pp. 506-521.<br />
16 In all fairness, AQR also acknowledges that mechanically following their momentum indexes would be a suboptimal approach, and recognizes the need for a more efficient<br />
implementation strategy.<br />
17 Quoting Eric Falkenstein: “[…] It should be noted that there were several missteps among the index founding fathers. John McQuown and David Booth at Wells Fargo, and<br />
Rex Sinquefield at American National Bank in Chicago, both established the first passive Index Funds in 1973. These were portfolios targeted at institutions. The Wells<br />
Fargo fund was initially an equal-weighted fund on all the stocks on the NYSE, which, given the large number of small stocks, and the fact that a price decline meant you<br />
should buy more, and at a price increase sell more, proved to be an implementation nightmare. It was replaced with a value-weighted index fund of the S&P500 in 1976,<br />
which eliminates this problem. […]” See http://falkenblog.blogspot.nl/2011_09_01_archive.html.<br />
50<br />
March / April 2013