Wanted, an effective asset allocation index

Despite the plethora of index funds and ETFs (exchange traded funds), there is one investment solution that index investors still need, that does not exist yet in a suitable form, and that is an effective asset allocation index, opines Lewis Braham in ‘ The House that Bogle Built ' (www.tatamcgrawhill.com).

He cites a landmark study by Gary Brinson in 1986, which found that 93.6 per cent of the variation in quarterly portfolio returns is due to the asset allocation of portfolios, not the individual security selection. In this context, an interesting analogy for ‘unmanaged' index funds, as the author puts it, is of ‘tools without a carpenter or an architect to put them to good use.' More importantly, he is of the view that one of the greatest failings of the total stock market index is that it does not answer the fundamental question of whether it is worth owning stocks at all.

Common arguments

Braham traces how the efficient market hypothesis and its concomitant capital asset pricing model (CAPM) were supposed to answer the ‘why-own-stocks' question via the notion of an equity risk premium – that investors are rewarded, for the additional risks they take in stocks, with greater returns than those on bonds. He mentions the argument that those with long time horizons, who can stand the greater volatility, should always allocate more to stocks than to bonds, regardless of what the respective valuations of the different asset classes are at the time.

The author reminds that allocations under CAPM were determined based on past performance, past volatility, and past correlations – all of which are ultimately derived from the historical price movements of asset classes, not their current valuations or underlying business or economic fundamentals. He hastens to point out that every mutual fund prospectus is yet required to carry the legal disclaimer, ‘Past performance is no guarantee of future results.'

Faith questioned

It is justifiable, therefore, that CAPM is being questioned after two brutal crashes, says Braham. He contends forcefully that CAPM and the efficient market hypothesis are really a political and religious ideology masquerading as a social science. For, underlying these concepts is a basic faith that in the long run, stocks always go up; that human beings are rational, efficient allocators of capital; and that they will always be rewarded appropriately for the rational risks they take over the long term.

“When extrapolated to the larger society, as these theories were meant to be by their libertarian architects, they sought to validate via the scientific method a belief that capital markets get it right by themselves and that no government or social intervention of any sort is needed.” Alas, the results of such extrapolation have been disastrous, frets Braham, because individual investors are irrational and bad allocators of capital, and also because their corporate and financial agents have little interest or ability in rational allocation either.

Bubbles beware

The book makes a reference to an article by Robert Arnott in the ‘Journal of Indexes,' about how CAPM's equity risk premium model has fared so poorly, of late, that over a 41-year period from 1968 through February 2009, stock investors earned no noticeable return premium over 20-year Treasury bonds at all, despite taking on considerable amounts of business risk and experiencing far more volatility in returns. While the inference from the above is not that bonds are better than stocks, the author is amazed that investors currently pour tonnes of money into bonds, as irrationally as with the stock bubble in 1999.

So the question, as Braham summarises, is whether there is a reasonable means for index investors to achieve an effective allocation of capital between stocks, bonds, cash, and perhaps alternative investments without getting caught up in bubbles. To those who would suggest in response that asset allocation decisions are what financial planners are for, the author's protest is that such an intermediary adds to the cost, thus reducing investors' returns typically by about one percentage point a year.

Is it possible to create an allocation fund that reaps all potential gains that indexers normally enjoy without paying extra for financial advice, asks Braham. “This seems to me to be the primary challenge for indexing going forward.”

Insightful read for investors who are not satisfied with just scratching the surface.

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