Figure 6 Summary Of Three Bond Scenarios Time Period Description Of US Bond Performance 10-Year Annualized Return Of US Bonds Growth Of $10,000 In US Bonds 10-Year Annualized Return Of 12-Asset Portfolio * Growth Of $10,000 In A Diversified Portfolio 2002-2011 Actual Performance 5.78% 17,540 8.93% 23,522 2002-2011 (US bond returns from 1950-1959) 2002-2011 (US bond returns from 1982-1991) Worst-case Performance Best-case Performance 1.34% 11,423 8.54% 22,693 14.09% 37,365 9.65% 25,123 Difference between Worst-case and Best-case Bond Performance 1,275 bps 25,942 111 bps 2,430 Source: Raw data from Lipper for Investment Management 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. For an investor who used a diversified approach (in this analysis, a 12-asset portfolio), the performance differential between the worst-case bond period and the best-case bond period was 111 basis points, or $2,430 in ending account value. Completely avoiding any asset class in a diversified portfolio amounts to a guess that it will underperform and that another asset class will outperform. Building prudent portfolios is not about guessing and timing; it’s about broad diversification. A broadly diversified portfolio is naturally insulated—not <strong><strong>com</strong>plete</strong>ly, but largely—from the normal swings in performance among its various <strong>com</strong>ponents. The “underperformance” of one or several of its ingredients will not sink the performance of the overall portfolio. Blitz continued from page 39 Endnotes 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. 2 Blitz (2012), “Strategic Allocation to Premiums in the Equity Market,” Journal of Index Investing, vol. 2, No. 4, pp. 42-49. 3 See Asness (2006), “The Value of Fundamental Indexation,” Institutional Investor, (October), pp. 94-99; Blitz & Swinkels (2008), “Fundamental Indexation: an Active Value Strategy in Disguise,” Journal of Asset Management, vol. 9, No. 4, pp. 264-269. 4 See Arnott, Hsu & Moore (2005), “Fundamental Indexation,” Financial Analysts Journal, vol. 61, No. 2, pp. 83-99. 5 See Chow, Hsu, Kalesnik & Little (2011), “A Survey of Alternative Equity Index Strategies,” Financial Analysts Journal, vol. 67, No. 5, pp. 37-57. 6 See de Groot & Huij (2011), “Is the Value Premium Really a Compensation for Distress Risk?” SSRN working paper no. 1840551. 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. 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 methodology change implemented at the end of 2009 caused a turnover of 45 percent at that moment. 9 Stock weights in this index are set inversely proportional to their volatility, so the lowest-volatility stocks get the highest weights. 10 See, for example, Soe (2012), “Low-Volatility Portfolio Construction: Ranking versus Optimization,” Journal of Index Investing, vol. 3, No. 3, pp. 63-73. 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 Management, vol. 34, No. 1, pp. 102-113. 12 See Huij, van Vliet, Zhou & de Groot (2012), “How Distress Improves Low-Volatility Strategies: Lessons Learned Since 2006,” Robeco research note. 13 See Clarke, de Silva & Thorley (2011), “Minimum Variance, Maximum Diversification, and Risk Parity: An Analytic Perspective,” SSRN working paper no. 1977577. In their 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 of only 15.6 percent for the cap-weighted index over the same period. 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. 15 See Blitz, Huij & Martens (2011), “Residual Momentum,” Journal of Empirical Finance, vol. 18, No. 3, pp. 506-521. 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 implementation strategy. 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 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 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 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, which eliminates this problem. […]” See http://falkenblog.blogspot.nl/2011_09_01_archive.html. 50 March / April 2013
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