investing

Equally weighted asset allocation strategy

Fortunately, some of the hazards can be minimized by holding additional asset classes beyond the usual suspects, Faber says.

Joel Bickford of Bickford Investment Management Services agrees that an equal-weighted strategy is a practical benchmark, assuming it's designed properly. "The key is including enough asset classes to avoid the risks that can be eliminated through diversification."

History's first asset allocation strategy

The idea of spreading wealth evenly goes back to the Babylonian Talmud, an ancient Jewish text, which recommends holding equal amounts of property, business and what now's referred to as liquid assets.

"As it turns out, the Talmudic wise people knew what they were talking about," according to an analysis in the winter 2009 issue of The Journal of Portfolio Management. Another research paper published that year in The Review of Financial Studies reported that equally weighting a U.S. stock portfolio was competitive if not superior against more than a dozen other "smart" models.

No wonder equally weighted ETFs have fared well relative to their conventionally allocated counterparts in recent years. Consider the Guggenheim Standard & Poor's 500 Equal Weight ETF (RSP) and the SPDR S&P 500 (SPY). Each holds the same 500 U.S. companies and tracks the same stock market index. But the equal-weighted fund beat its market-capitalization-weighted counterpart by a comfortable margin over the past three years through June 15, 2012: 17.4 percent per year vs. 15.3 percent, respectively, according to Morningstar.

Equally weighting asset classes has an encouraging record, too. Consider a portfolio that initially holds identical amounts of the 10 asset classes listed in the nearby table. This passive strategy earned 8.8 percent a year for the decade through the end of 2011, based on an equal mix of the 10 indexes. That compares with just 2.9 percent for the U.S. stock market as measured by the Standard & Poor's 500 index. (Of course, in reality you can't invest directly in an index, but rather a fund that replicates an index, and returns will be reduced by fund costs. But this serves as an example.)

Even more telling: the equal-weighted strategy for those 10 asset classes beat 90 percent of 1,200-plus professionally managed asset allocation mutual funds with histories of at least 10 years over that period, according to analysis of Morningstar data.

Major asset classes

Asset allocation helps reduce risk. When equally weighted in a portfolio, the indexes listed below produced a superior return with less risk. To assemble such a portfolio, an investor would choose one ETF from each asset class and give it a 10 percent weighting. Past performance is no guarantee of future results.

Asset classIndexTickers of
representative ETFs
Stocks
U.S. stocksRussell 3000VTI, IWV, SCHB
Foreign developed-market stocksMSCI EAFEVEA, EFA
Emerging-market stocksMSCI EMVWO, EEM
Bonds
U.S. bondsBarclays US Aggregate BondBND, AGG
Inflation-indexed TreasuriesBarclays Treasury TIPSTIP, IPE
Foreign developed-market bondsCitigroup WGBI ex-USBWX, IGOV
Emerging-market bondsCitigroup ESBI-CEMLC, EMB, PCY
High-yield bondsiBoxx High YieldHYG, JNK
Commodities
CommoditiesDJ-UBS CommodityGSG, DJP, RJI
Real Estate
Real estate investment trustsMSCI REITVNQ, RWR

Risk management makes the difference

What's equal weighting's secret? In a word, rebalancing. Maintaining equal weights requires periodic selling and buying to keep market fluctuations from pushing a portfolio to extremes. Rebalancing can be dangerous for a limited pool of securities or asset classes. But casting a wide net keeps a lid on risk by imposing the discipline of buying low and selling high. The equal-weighted strategy using the asset classes in the table, for instance, was rebalanced at the end of each calendar year.

If you own a broad array of assets and refrain from extreme bets, history suggests that the winners will have a modest edge in the long run. There'll be losers, of course, particularly in the short run. But asset classes don't go out of business. Meanwhile, the global economy's bias for growth will help smooth over any rough edges in the long run.

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