The Coward's Portfolio

January 1997 Update -- A New Value Based Index

In the September issue we created two different index based stock portfolios, both of which bested almost all actively managed global mutual funds on a risk adjusted basis. The first is known as the "Coward's Equity Index" ("CEI"), and consists of a mix of small and large cap regional/national indexes. The second is known as the "Small Investor's Coward's Equity Index" and consists mostly of index funds, using actively managed funds for those areas in which index funds are not easily available to the small investor (small cap foreign and Latin American stocks). Both indexes are then combined with short term bond funds to produce a range of return/risk combinations. The 3 year plot covered the 7/93 - 6/96 period, and the 5 year plot covered the 7/91 - 6/96 period.

This latest results for the Coward's Portfolios are in, and once again our cowardly robots have beaten the great majority of institutional global managers. The first graph shows the 3 year plot for both the CEI and SICEI versus the global managers for 1/94 - 12/96. The second graph shows the 5 year return/risk plot for the CEI versus the global managers for the period 1/91 - 12/96. (The SICEI commenced in July 1993 and is not available for the 5 year period.) The individual data points represent global multiasset and asset allocation funds available (Morningstar Principia) for the period.

There is really nothing magic about either the CEI or SICEI. Almost any reasonably balanced global index based allocation strategy will beat the overwhelming majority of global money managers, reinforcing the notion that "professional global asset management" is something of an oxymoron. In fact, about the only way to find an allocation which will not beat the average global money manager is to intentionally pick only the worst performing assets for the period studied. Consider the performance of Jean Marie Evilliard's Sogen International Fund (designated as "SI" in both graphs). Mr. Evilliard is hailed as a money management genius for producing respectable returns with low risk. Indeed he is a genius-- compared to his peers. As you can see, however, he slightly lags the asset allocation robot at 3 years, and bests it only slightly at 5 years.

Those of you who have read the September piece will note that a few more funds have beat the robots this time. This is because the average foreign exposure of the Morningstar global multiasset/asset allocation group is only 20%. Over the past 3 and 5 year periods US assets have outperformed their foreign counterparts, and this advantage has widened over the past 6 months. Given the miserable performance of the EAFE and foreign small cap sectors the performance of the robots (which are 60% foreign equity exposed) relative to the active managers is remarkable indeed. In fact, some may argue that the recent outperformance of US equity obviates the need for international diversification. This is shortsighted and foolish. In any given time period there will always be some regional/national indexes which outperform, and it is a pretty safe bet that the best performing asset of the past 5 or 10 years will not continue to dominate in the next period. For the 1985-89 period, for example, European and Japanese stocks trounced US stocks, only to be followed by the present era of US outperformance.

The Academic Coward's Equity Index

We've added yet another index. There is a growing "cross sectional" literature which demonstrates that "value" stocks seem to reliably produce higher returns than "growth" stocks. The most famous study was published in the June 1992 Journal of Finance by Eugene Fama and Kenneth French. The authors demonstrated that company size and price to book ratio explained all of the differences in return for the period 1963-90. Professor Fama is closely associated with Dimensional Fund Advisors (on whom we already depend for much of the CEI data), the premier provider of index funds to institutions and financial advisors. DFA has now come out with funds in each of the "four corners" of the global stock universe (small US, large US, small foreign, and large foreign) which invest only in stocks in the bottom one third of P/B values.

If Fama and French are right, over the long term the lower third P/B strategy should yield returns about 5% higher than an index of similar market capitalization, so a portfolio consisting of the above four funds should outpace the CEI/SICEI by a similar amount. Accordingly, I've constructed an index consisting of equal amounts of each of the four funds, and dubbed it the "Academic Coward's Equity Index" ("ACEI"). (The funds are the US Small Cap Value Fund, the US Large Cap Value Fund, the International HBM Portfolio, and the International Small Cap Value Portfolio. The ISCV only became available in January 1995; I've simulated its performance before then with an appropriate mix of DFA's older international small cap portfolios.)

The performance of the ACACEI is plotted in the below graph. To reduce clutter, I've expanded the scale from the first 3 year graph.

It's return/risk plot has a most curious appearance. The ACEI's return is about the same as the other two indexes, but it has much lower risk. The low risk of the ACEI is extremely interesting, and is due to at least 4 factors:

1) The high exposure to Japanese equity (18% versus 10% for the CEI/SICEI) serves to lower the SD of the portfolio over this period because of its low correlation with other assets. For the past 3 years Japan's markets have not marched in lockstep with the worldwide bull. The ACEI's exposure to Japan was highly deleterious to its performance.

2) Value portfolios defined by low P/B have slightly lower SD (risk) than the broader market.

3) The correlations among value portoflio components are also slightly lower than among broader market segments.

4) The Coward's Portoflio series assumes quarterly rebalancing, and thus uses SDs calculated form quarterly returns. For some reason, the International Value component quarterly SDs have yielded spuriously low values. Thus, much of the lower SD of the ACEI is somewhat artifactual.

The allure of the ACEI is not that its SD (risk) may be lower, but that it should produce higher returns. So far, because of its higher Japanese exposure, and perhaps other factors, it has not. However, the low P/B approach emerges as a superior study only over long time horizons. For example, although the Fama/French small cap value time series produces returns several points higher than that of the S&P500 over the entire 1963-70 time period, it underperformed the S&P500 for periods of up to a decade within this longer period. The ACEI is still an intriguing concept, and the passage of time, and particularly a global bear market, may yet demonstrate its advantages. We'll keep you posted.

A Last Word of Caution

The three and five year data cover a period of very low volatility in many national and regional equity markets, particularly in the US. It is likely that in general volatilities will be higher in the future. As volatilities rise, correlations among assets also tend to rise. The combination of rising asset volatilities and rising correlations will probably produce a dramatic increase in global portfolio risk over the next several years. For planning purposes, I recommend doubling all of the portfolio SDs plotted above.

copyright (c) 1996, William J. Bernstein