“Has it been ten years already?” asks Mr. M.V. from British Columbia. “I think I became a financial advisor almost to the day you created the Financial Post Indexes (i.e. FPX Indices). I feel like they and I have grown up together.” 

When I hear comments like that it always gives me a kind of a warm and fuzzy feeling. Mind you it never lasts long… 

The spotlight dims, and Mr. M.V. strikes with both barrels; “unfortunately, the indexes are based on the faulty theory of asset allocation. There’s some oft quoted line about 90% of returns coming from asset allocation. What a pile of bunk!” 

In support of his position, he asks point blank; “Doesn’t your data prove it? You’ve now got 10 year numbers and the two extreme portfolios - 70 / 30 equity / fixed income (FPX Growth Index) and the polar opposite (FPX Income Index) - provide investors with a difference of only 0.18% per year! Asset allocation, efficient market, wide diversification, ETFs… our industry has to get beyond this stuff, it doesn’t produce.” 

Forgive me, I am a little dazed… I need a moment to think about this. I ask myself, could I have been blinded by eighty years of academic research? Was Harry Markowitz wrong? Has the Capital Asset Pricing Model now been de-bunked? Should pension fund managers move to the sidelines because asset mix no longer matters? Should we throw out university level finance courses, chastise the Chartered Financial Analysts program, ask the Canadian Securities Institute to stop promoting this “pile of bunk?” 

Whoa… calm down now. We need to examine Mr. MV’s argument, and… oh yes, respond. 

For the record I appreciate MV’s passion. However, a couple of points to consider; 1) he is using a single data point to make the case that traditional tools don’t produce, and 2), he is only looking at one side of the equation; return. 

When we talk about efficient markets we are always talking about risk adjusted return. Assets that produce higher returns over long periods tend to be riskier than lower returning assets. Stocks are riskier than bonds, bonds are riskier than cash, etc. 

To measure risk, the investment industry uses a statistical term known as standard deviation. Over the past ten years, the FPX Income Index had an annual standard deviation of 5.44%, compared with 10.66% for the FPX Growth Index. Using that metric, over the past ten years, the FPX Income Index earned a return similar to the FPX Growth Index with half the risk. And since all the FPX indices are passive index based portfolio models, the difference in risk is by definition, a function of the asset mix. 

If we then use Mr. M.V.’s line of reasoning, that asset mix does not produce, why would anyone invest in the riskier portfolio (i.e. FPX Growth). If asset mix does not produce, then the expected return from either portfolio should be the same (as demonstrated in the performance over the past ten years) and therefore, no one would ever buy the riskier asset. Obviously, that’s not the case. 

The problem is that Mr. M.V. is taking his position using a single point in history. If I use that metric, then I can make almost any case using any series of datapoints. The FPX Indices began in April 1996. All three indices started with a base value of 1000. Three years later (April 1999) the FPX Growth Index was at 1509.73 with the FPX Income Index at 1400.34 (a difference of 109.39 points). The gap widened to 282.60 points by the five year mark (April 2001), with the FPX Income Index at 1613.97 compared to 1896.57 for the FPX Growth Index. 

The performance between polar opposite portfolios narrowed when equities fell prey to the second longest bear market in history, and the worst bloodletting in stock values since the 1970s. Which by the way, if we were to look at the difference in the returns of polar opposite portfolios during the 1970s, I suspect we would have seen results similar to what we saw with polar opposite FPX indices over the past ten years. 

Having said that, there would have been wide gaps in the performance of polar opposite portfolios during the 1980s and 1990s. Over that twenty year period, the Dow Jones Industrial Average advanced 1100% from 1000 in 1980 to 11,000 by 2000. Even the S&P TSX composite index, weighed down by oil and commodity stocks, rose more than 600% during that same twenty year period. Bonds also had decent returns during this period, but those returns paled in comparison to the equity freight train.

Perhaps rather than trying to de-value the role of the asset mix, we would be better off trying to understand why there was such a narrow disparity in the performance of polar opposite indices during the past decade. The obvious reason was the hit stocks took during the bear market. Less obvious, was the stellar return that bonds produced during this period, as interest rates fell from more than 10% to less than 4%. 

The real question is this; do you think that bonds will produce the same kind of returns over the next ten years. For bonds to produce similar returns over the next ten years, interest rates would have to fall to 1% level. For rates to get that low, inflation would have to be in negative territory which would imply a depression. 

Personally, I think the economy will likely grow over the next ten years with some obvious bumps along the way. I think a more likely scenario will see a return to the norm, where higher risk assets produce superior returns. In that environment, a 70%/30% equity / fixed income mix, will do much better than a 30%/70% fixed income/equity mix. 

But that too will take us back to square one; will the higher risk portolio produce better risk adjusted returns.