In contrast, the 16-asset-class portfolio described in previous issues of Fundamentals,4 which has far less concentration to equities, fared considerably better generating a cumulative return of –13.4% on a buy and hold basis. This result is 630 bps better than the 60/40 portfolio return! An overreliance on equities was a sizeable form of negative alpha… despite the scale of the recovery since March!5
What about rebalancing? If we rebalanced once at calendar year-end 2008 (a common and simple rebalancing rule), the 16-asset-class portfolio’s return would have improved to –12.1%, a premium of 130 bps over the buy-and-hold portfolio. Of course, risky markets have rebounded since March, but don’t forget that in the first two months of 2009, the rebalancer’s staying power would have been severely tested as we went into Take No Prisoners Redux.
So far, the first two pillars of negative alpha “saved” investors 7.5%! At mid-year 2009, how many investors were down only 12% from year-end 2007? And these are simple ideas to embrace.
But the investor also needs to be disciplined to avoid chasing winners. How many of us, in managing our 401(k) assets, begin by asking a simple pair of questions: Which of the investments available to me have been awful over the past one, three, and five years? Are any of these now bargains? Intuitively, we know this is a good way to invest. But, most of us pursue the opposite—and flawed—approach: Which of the investments available to me have been wonderful over the past one, three, and five years? Are there reasons to buy more of these?
Suppose an investor addressed the first two sources of negative alpha—she adopted the 16-asset portfolio approach in the beginning of 2008 and rebalanced at year-end 2008. But, in an effort to boost returns, she eliminated the two worst performing assets over the previous five years in the 16-asset-class mix (short-term bonds and core bonds) and doubled up on the two best performing categories (emerging markets equities and global ex-U.S. stocks). Amazingly, this Chasing Winners portfolio would have lost 540 bps relative to our simple 16-asset-class portfolio with rebalancing. Almost the entire benefit of rebalancing and broad diversification are wiped out!
Negative Alpha within Equities
Index funds are a wonderful way to avoid the alpha-chasing game—a contest which assuredly produces more losers than winners. But the capitalization-weighted construction methodology has problems of its own, directly linked to the three sources we just described. It chases winners, allocating more money to any asset that’s soaring. It never rebalances except at the bottom of the list where it replaces the worst performers with those that have appreciated enough to graduate to “large cap”: selling low and buying high! It, therefore, produces a negative alpha6 relative to its opportunity set. With no rebalancing mechanism, with a focus on whatever has risen most in price, cap-weighted indexes can become concentrated, forgoing the diversification that investors should seek in broad-based market proxies.
The Fundamental Index™ strategy ties portfolio weights to the economic scale of the company rather than its price. With this anchor, it can effectively rebalance, avoid chasing winners, and bypass the effects of bubbles on portfolio weights. It contratrades against the market’s most extreme bets, whether those bets are the tech bubble of 2000 or the finance anti-bubble of 2009. It provides a solution to the negative alpha embedded in traditional indexes. So how did avoiding the negative alpha of capitalization weighting in global equities play out in the past 18 months?
Figure 2 displays the cumulative returns of a Global All Country Fundamental Index (FTSE RAFI All World 3000 Index) versus a comparable cap-weighted index (MSCI All Country World Index). Although both indexes produced dreadful total returns consistent with the severity of the crisis, the Fundamental Index approach produced an excess return of 3.1%. In an environment that saw negative excess returns for many alpha seekers, a focus on negative alpha within equities was a rare and welcome source of positive value add during this stretch. Was this due to the much-vaunted value bias of the Fundamental Index portfolios? Not by any classical definition of value investing: the value indexes were savaged relative to the growth indexes, both in the United States and abroad, over this 18-month span.
The great “alpha letdown” of 2008 seared a lasting memory into the psyches of all investors. The next decade may well see a resulting trend toward simplicity and transparency. In this back-to-basics revolution, eliminating negative alpha should rise to the top of investors’ “to-do” lists, both at the total portfolio level and within equities, through better-structured passive and simple enhanced products.