Equally weighted asset allocation strategy

Investment strategists have been telling us for years that asset allocation — owning several asset classes, such as stocks, bonds and real estate — is the way to successfully manage risk and return in pursuit of financial goals.

It’s never been easier to diversify, thanks to the growing list of low-cost exchange-traded funds, or ETFs, that target specific pieces of the world’s markets. But that still leaves the critical decisions of picking funds and determining how to manage the mix.

It’s easy to be confused by all the products and the free flow of advice. How can you maintain strategic perspective in a world that’s becoming more complex by the day? You can create a simple benchmark: an equally weighted portfolio of all the major asset classes. For example, the investment landscape can be carved up into 10 primary markets. In that case, equally weighting simply means each piece represents 10 percent of the total investment pie.

Why an equal-weight benchmark? Because it’s truly passive. By contrast, conventional cap-weighted benchmarking holds assets in proportion to their relative values. The underlying assumption: The market’s always “right.” If the market value of stocks is twice that of bonds, stocks receive twice the weight in a portfolio.

By the way, don’t confuse the equal weighting of an asset allocation strategy with equal weightings of individual investments within a fund. You can buy ETFs that are equally weighted or market-capitalization weighted — or both — to implement an equally weighted asset allocation plan, for instance.

This benchmark, which can be built with a core set of ETFs, requires no investment skill. And it tends to earn average to above-average returns relative to most of the competing strategies. What’s the catch? You’ll have to crunch the numbers yourself, but that’s easily done by computing the average return for 10 broadly defined ETFs that represent each asset class. The table on the next page provides some fund examples.

Equally weighting a broad spectrum of ETFs may not be suitable as your investment strategy. But it’s a useful guideline for analyzing and monitoring the investment landscape because it’s a neutral measure of all, or at least most, global opportunities. Only you (or your financial adviser) can determine what’s appropriate for you, but at least there’s no mystery about how to begin.

Better than the traditional yardstick

It’s a “reasonable” benchmark for asset allocation, says Mebane Faber, chief investment officer at Cambria Investment Management and author of “The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets.”

The traditional yardstick is the so-called 60-40 strategy, a domestic mix of 60 percent stocks and 40 percent bonds. But the classic 60-40 portfolio is vulnerable to 21st-century levels of volatility.

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 class Index Tickers of

representative ETFs

U.S. stocks Russell 3000 VTI, IWV, SCHB
Foreign developed-market stocks MSCI EAFE VEA, EFA
Emerging-market stocks MSCI EM VWO, EEM
U.S. bonds Barclays US Aggregate Bond BND, AGG
Inflation-indexed Treasuries Barclays Treasury TIPS TIP, IPE
Foreign developed-market bonds Citigroup WGBI ex-US BWX, IGOV
Emerging-market bonds Citigroup ESBI-C EMLC, EMB, PCY
High-yield bonds iBoxx High Yield HYG, JNK
Commodities DJ-UBS Commodity GSG, DJP, RJI
Real Estate
Real estate investment trusts MSCI REIT VNQ, 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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