I had the data out to look at another question but thought it useful to look at the following question at the same time [apologies for the long post].
Question
What have been the relative portfolio effects of adding international equities, a value and small cap tilt, REITS, commodities, and fixed income of varying duration and quality?
To try to answer this question I back-tested the following portfolios (1972-2006):
P1 - Baseline
75% US Total Stock Market
25% 5 yr Treasury Notes
P2 – Non-US Market Effect
37.5% US Total Stock Market
37.5% Non-US Developed Market
25.0% 5 yr Treasury Notes
P3 – Emerging Market Effect
37.5% US Total Stock Market
28.0% Non-US Developed Market
09.5% Emerging Market
25.0% 5 yr Treasury Notes
P4 – Small Cap and Value Effect
[same market allocation but with an overall size loading of 0.2 and value loading of 0.4]
37.5% US Total Stock Market
28.0% Non-US Developed Market
09.5% Emerging Market
25.0% 5 yr Treasury Notes
P5 – REIT Effect
[REITs added to P4 – value and size tilted equity allocation – taken from US allocation]
32.5% US Total Stock Market
05.0% US REITs
28.0% Non-US Developed Market
09.5% Emerging Market
25.0% 5 yr Treasury Notes
P6 – Collateralized Commodities Futures Effect
[Commodities added to P4 – value and size tilted equity allocation - taken equally from US:Non-US equity]
35.0% US Total Stock Market
26.5% Non-US Developed Market
08.5% Emerging Market
05.0% Collateralized commodities futures
25.0% 5 yr Treasury Notes
P7 – Term Effect [Shorten Fixed Income duration to 2 yrs]
[P4 equity allocation - overall size loading of 0.2 and value loading of 0.4]
37.5% US Total Stock Market
28.0% Non-US Developed Market
09.5% Emerging Market
25.0% 2 yr Treasury Notes
P8 – Term Effect [Extend Fixed Income duration >10 yrs]
[P4 equity allocation - overall size loading of 0.2 and value loading of 0.4]
37.5% US Total Stock Market
28.0% Non-US Developed Market
09.5% Emerging Market
25.0% Long-term Treasury Bonds
P8 – Default Effect [Add Junk Bonds]
[P4 equity allocation - overall size loading of 0.2 and value loading of 0.4]
37.5% US Total Stock Market
28.0% Non-US Developed Market
09.5% Emerging Market
12.5% 5 yr Treasury Notes
12.5% Junk Bonds
Results
Code: Select all
1972-2006
AR SD Sharpe Growth of $1 [since 1972]
EQUITY EFFECTS
P1- Baseline 10.95 13.64 0.421 38
P2- Non-US Developed Mkt Effect 11.24 13.38 0.448 42
P3- Emerging Market Effect 12.00 13.61 0.479 53
P4- Value and Small Cap Effect 14.29 13.68 0.662 107
ALTERNATIVES EFFECTS
P5- REIT Effect 14.21 13.38 0.668 105
P6- Commodities Effect 14.25 12.42 0.713 106
FIXED INCOME EFFECTS
P7- Term Effect [Shorten to 2 yr] 14.20 13.49 0.663 104
P8- Term Effect [Extend to Long] 14.42 14.20 0.650 111
P9- Default [Junk] 14.33 14.18 0.646 108
AR = Annualized Returns
SD = Standard Deviation
Sharpe = Sharpe Ratio
1. Value and Small Cap exposure had the greatest impact on enhancing the level of portfolio return and return/SD characteristics. By 2006, the (P4) portfolio value would have been twice as large as a portfolio with the same exposure across US, Non-US Developed, and emerging markets but with no value or small cap tilt ($107 vs $53).
2. Emerging market exposure had greatest international diversification impact. EAFE had a smaller impact (not unexpected with similar long-term risks [beyond short-term exchange rate volatility]). The same conclusion can be derived from 1988 when more accurate EM index returns are available [The corresponding portfolio annualized return/SD/Sharpe ratios were with EAFE - 9.31/12.01/0.499; and when EM was added - 10.14/12.50/0.542].
3. REITS marginally enhanced risk return characteristics. Lower volatility of returns (SD) came at the expense of lower return, but led to a slightly higher Sharpe ratio.
4. Collateralized Commodities Futures enhanced risk return characteristics by more than REITs. Inclusion of CCFs lowered portfolio volatility at the expense of marginally lower returns to yield a higher Sharpe ratio (0.713) – the highest among all portfolios.
5. Fixed income: Extending bond duration increased returns but led to higher volatility of returns particularly with use of long-term bonds. Adding junk bonds (default risk) did not add favorable risk/return characteristics – marginally higher return with higher volatility leading to a lower Sharpe Ratio.
6. Equity vs. fixed income factors: The variability in the final dollar value of the back-tested portfolios was much smaller for within fixed income allocation ($104 to $111) versus within equity allocations ($38 to $107).
Answer
Getting back to the original question. The results suggests – at least since 1972 – greatest diversification (or greatest improvement in return/SD characteristics) came from:
1. Tilting to value and small cap stocks.
2. Inclusion of international equities - particularly emerging markets.
3. CCFs reduced overall portfolio volatility (more so than REITs).
4. Shorter term fixed income performed better than long-term fixed income.
5. Lower quality bonds didn’t add value.
Data source:
US Total Stock Market: 1972-2006 from Ken French website.
EAFE Market: 1972-1974 from MSCI website (Net Index), 1975-2006 from Ken French website.
Emerging Market: 1972-1987 from IFA website (added back expenses): 1988-1994 from M* principia indices, 1995-2000 spliced EM index from Vanguard website, 2001-2006 from MSCI.
Value and Small Cap: US-SmB, US-HmL and Intl.-HmL from Ken French website.
REIT Index: 1972-1977: NAREIT Index from Roger Gibson's Asset Allocation Book. 1978-2006: Wilshire REIT Index.
GSCI: 1972-1998: http://www.cme.com/files/Exchange_Traded_Derivat.pdf; 1999-2006 : https://www.oppenheimerfunds.com/pdf/sh ... ochure.pdf
2 yr Treasury Notes: 1972-1991 from IFA website (added back expenses). 1992-2006 Lehman 1-5 year Treasury Index (benchmark for Vanguard Short Term Treasury).
5 yr Treasury Notes: 1972-1991 from Ibbotson. 1992-2006 Lehman 5-10 year Treasury Index (benchmark for Vanguard Intermediate Term Treasury Fund).
20 yr Treasury Notes: 1972-1991 from Ibbotson. 1992-2006 Lehman Long Treasury Index (benchmark for Vanguard Long Term Treasury Fund).
Junk bond: 1972-1978: Simulated from default factor derived from Ibbotson (0.5 default loading); 1979-2006 – Vanguard High Yield Bond Fund.
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