Wednesday, April 13, 2011

Marston, Portfolio Design

Richard Marston’s Portfolio Design: A Modern Approach to Asset Allocation (Wiley, 2011) was written for sophisticated investment advisors, especially those with high-net-worth or institutional clients. Marston, a professor at the Wharton School, has taught asset allocation to over 5000 financial advisors as part of Wharton’s Certified Investment Management Analyst program.

The book is thoroughly researched and precisely written, which means that even intellectually curious individual investors with a decent-sized portfolio could profit from it. There’s no quant hurdle since it presupposes only a passing familiarity with statistics (basically, correlation and standard deviation). The book is chock full of parsed data, particularly useful for those who ascribe to some version of buy-and-hold or the endowment model of investing. Marston is no market timer.

We encounter the usual suspects in asset allocation: small-cap vs. large-cap stocks, value and growth investing, foreign stocks, emerging markets, bonds, hedge funds, venture capital and private equity, real estate, and commodities. In two chapters the author also offers some spending rules for foundations and retirees.

Let’s look at a couple of specific cases. First, does international diversification significantly boost the returns of a portfolio? Let’s say that an investor has a 70/30 portfolio and that foreign stocks are 40% of the total stock allocation (28% of the overall portfolio allocation). U.S. stocks are represented by the Russell 3000 all-cap stock index, foreign stocks by the MSCI EAFE index. From January 1979 (when the Russell data began) to December 2009 the Sharpe ratios of the U.S.-only portfolio and the portfolio with EAFE are identical, so alpha is zero. If the same time period is considered but emerging markets have a one-third weight in the foreign-stock portion of the portfolio after the EM index was launched in 1990, the risk-adjusted return is 0.3% above that of the U.S.-only portfolio. Not exactly a show stopper.

Summarizing these findings as well as findings from earlier in the book, Marston writes: “The results above suggest that we will have to search more widely for assets to enhance portfolio performance. Diversifying into a range of investment-grade bonds does not add much to portfolio performance. Neither does diversifying the U.S. stock portfolio into small caps and mid caps. It’s true that international stocks do enhance portfolio performance, but less than they did in earlier sample periods. We need alternative investments to improve portfolio performance.” (p. 150)

So, moving on to alternative investments, what about a passive investment in commodities (as measured by the GSCI or DJ UBS)? To make a long story short, “in the recent period, in particular, [Feb 1991-Jun 2009] there is only a weak case for diversifying a portfolio with a passive investment in commodities. Despite having a very low beta, it’s not a miracle drug for the portfolio.” (p. 249)

Managed futures are best compared to hedge funds; “after all, an investor in managed futures funds does not even know whether he or she is long in commodities.” (pp. 252-53) Even here, managed futures indexes have underperformed comparable hedge fund indexes. Still and all, they generate enough alpha that “managed futures should be considered as a possible strategy in a hedge fund portfolio.” (p. 253)

It’s positively obscene to reduce such a rich book to a one-line conclusion, and I’m sure the author would violently disagree, but here goes anyway. Talent trumps indexes. If you can pay for genuine talent, especially in the area of alternative investments, your portfolio may well outperform. If you can’t, agonizing over how to diversify your portfolio (and sticking with that decision over the long haul) may not be worth the mental effort. Without “meddling,” whether through rebalancing or market timing, your diversified portfolio will probably offer only middling improvements in your returns in the long run. But if you yourself are genuinely talented and not just overconfident, whether you are managing your own account or other people’s money, Marston’s book belongs in your library. He’s done the meticulous research you can build on.

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