Over the weekend as I was putting the finishing touches on an article for TSCM I stumbled across a concept that is probably not new, relative to this site, but that I did (by accident?) articulate a little differently.
Over the last eight or nine years one could argue that domestic indexing has not worked. Since the start of 2000 SPY is down about 10%. Since inception (mid 2000) iShares Russell 2000 (IWM) is up a hair under 40% which works out to about 5% annualized.
While very unlikely, what if indexing fails again over the next eight or nine years? Allocating too much to index funds that go nowhere for a decade and half creates a real headwind for reaching financial goals. As I find portfolio construction, and its evolution, to be an interesting topic…
What if indexing doesn’t work or more correctly what could you do if you think it might not work? One solution could be some sort of combo of absolute return/low volatility vehicles and potentially more volatile narrow themes. The ratio of absolute to narrow would depend on the investor but the combo chosen would need provide a chance for long term success and allow the investor to sleep. Putting it all into agriculture stocks would create too much volatility and putting it all into a carry trade ETF would not provide enough growth (at least I don’t think it would).
Unfortunately this would require a lot more work for folks who are accustomed to indexing but if indexing does not work then indexers need to do something different.
As an example, if a portfolio was constructed to have seven themes weighted at 4% each and then 72% in absolute/low volatility; the selecting of the themes would take a lot of work. It may not take long to come up with seven (or six or eight) ideas but it would take some work to study and make sure they are not too closely related and thus vulnerable to the same thing. For example it is a good bet that Vestas Wind (VWDRY) and Vietnam are not vulnerable to the same things but Potash (POT) and Monsanto (client and personal holding) probably are. To put it in Internet bubble terms having a B2B stock, a data farm stock and a search engine stock does not make for a diversified portfolio.
Examples of themes could be commodities (broad or narrow), emerging markets (broad funds, narrow funds, or individual stocks), certain parts of infrastructure, alternative energy (broad like GEX, narrow like FAN or individual stocks), agriculture, some big SPX sectors (like energy now or other things later), certain developed countries and there are plenty of others.
You could buy the ones you like with the hope of holding them forever but I think there needs to be a willingness to sell or at least reduce exposure when they go up a lot. There must also be a willingness to admit to yourself when you get one wrong and sell that as well.
Some examples of absolute/low volatility might include, long short equities, some of the managed futures funds, carry trade funds, other currency products, Canadian hydro funds, certain parts of infrastructure and maybe farmland stocks.
I actually think the theme portion would be easier to manage. You already know what sorts of things fit there (this comment has nothing to do with anyone’s ability to pick which themes to buy). It seems there are fewer categories to choose from and of course when there is a crisis the notion of absolute/low volatility may stop working for a while.
I’m not certain whether hydro funds belong in this conversation or not but during the crisis many of them got hit very hard (debt-intensive businesses) and they also got hit before that in the fall of 2006 when the change in the tax law was announced. The shock is in, the move down made and it is unlikely that they would be prone to yet another shock but if a shock does come I would expect them to go down a lot again.
I think that most of these sorts of things (those that are potentially in the absolute/low volatility category) will go down less than the market during bear cycles and up less than the market during bull cycles but every so often the will deviate from this expected behavior. As with themes it would be very important to spread the risk. Managed futures funds probably have different vulnerabilities than a Canadian income vehicle.
This post was obviously a theoretical exercise. Long time readers will know I work in a couple of these sorts of things into client portfolios because I think they help manage volatility.
Did you watch any of the UEFA Euro Championship yesterday? Wow that was a lot of Scottish broadcasting and only one of them was Scottish.
This will be the last Fenway picture for a while. Obviously this is the Red Sox dugout. Hopefully you have enjoyed them.