Consistency of portfolio performance is quite an enigma. On the one hand, it’s what many investors, including your clients, will claim they want. On the other, many won’t stick with a portfolio long enough to ever experience its consistency.
Thus, if a portfolio actually demonstrates performance consistency, will anyone actually notice?
Let’s examine the consistency of rolling five-year annualized returns for 12 major asset class indexes and a portfolio that incorporates all 12 indexes in equal 8.33% allocations. The time frame we’ll look at is the 18-year period from 1998 to 2015, which produced 14 rolling five-year periods.
The 12 indexes in this analysis are the S&P 500, S&P Midcap 400 Index, S&P 600 SmallCap Index, MSCI EAFE Index, MSCI Emerging Markets Index, Dow Jones U.S. Select REIT Index, S&P North American Natural Resources Sector Index, Deutsche Bank Liquid Commodity - Optimum Yield Index, Barclays U.S. Aggregate Bond Index, Barclays U.S. TIPS Index, Barclays Global Treasury ex-U.S. Index and 3-month U.S. Treasury Bills (representing the return of cash).
The combination of all 12 indexes creates a diversified portfolio with a 65% allocation to equities and diversifier asset classes and a 35% allocation to fixed-income asset classes (as shown in “Diversified Portfolio”).
A reasonable measurement standard for a portfolio is its performance over periods of time, a minimum being three to five years. Portfolios or models that have stellar performance for a brief time period and then fall off the next quarter or year are not likely to satisfy clients who desire stability and consistency.
Shown in “Rolling Performance” are the rolling five-year annualized returns for each of the 12 indexes and the diversified 12-index portfolio. Cells highlighted in pink represent a negative five-year return, cells highlighted in green indicate a five-year return above 10% and yellow cells indicate a five-year annualized return above 20%.
As can be seen, the S&P 500 over the 14 five-year rolling periods from 1998 to 2015 had five with a negative annualized return. By comparison, the S&P Midcap 400 only had one five-year period with a negative annualized return. The S&P SmallCap 600 had no five-year periods since 1998 with a negative return, six five-year periods above 10% and one five-year period with an annualized return above 20%.
The S&P 500 produced an average five-year return of 4.6%, whereas the S&P midcap and small- cap indexes have nearly doubled that — both producing an average five-year rolling return of 9.1%.
In terms of raw performance and consistency of performance, the S&P Midcap 400 and S&P SmallCap Index have outperformed the S&P 500 by a considerable margin over the past 18 years, both in raw performance and consistency.
Interestingly, the index with the most rolling five-year periods with returns over 20% since 1998 has been commodities. That may come as a surprise to people who only focus on the recent past, which admittedly has been a rough one for commodities.
The most recent five-year annualized calendar year return for commodities, from Jan. 1, 2011, to Dec. 31, 2015, was -13.8%. That said, commodities have only had three rolling five-year periods with negative returns, compared to five for the S&P 500 over the past 18 years.
The “Rolling Performance” table is divided into two sections: eight asset classes that are performance engines and four asset classes that serve the role of safety brakes. The pink, green and yellow cells are clearly concentrated on the side that includes the “performance engine” asset classes.
With higher performance, one also experiences higher highs and lower lows — the antithesis of performance consistency. Conversely, the asset classes that serve the role as safety brakes (U.S. bonds, TIPS, non-U.S. bonds and cash) demonstrate five-year rolling return patterns that are far more stable and consistent than the performance engines.
The table’s 12-index portfolio represents the performance of a multi-asset model which includes all 12 indexes in equal allocations of 8.33%. The performance of the multi-asset model assumes annual rebalancing.
The multi-asset portfolio had four five-year rolling periods with returns above 10%. It had no five-year periods with a return above 20%, and no periods with a negative five-year rolling return.
The average five-year rolling return for the 12-index portfolio was 7.9%, well ahead of the S&P 500 and the MSCI EAFE. But the impressive statistic is its standard deviation of 4.3%, which is lower than any of the performance engines. As a blend of 65% engines and 35% brakes, the 12-index multi-asset model tends to generate engine-like performance with brake-like volatility.
This is exactly what a broadly diversified, multi-asset-class portfolio should do.
IS CONSISTENCY VALUED?
The rolling-period performance, as well as the annual performance, of a multi-asset portfolio will always be inferior compared to the best-performing individual asset classes in the marketplace.
For example, the best-performing individual asset classes among the 12 asset classes in the 12-index portfolio over the past five calendar years have been large-cap U.S. stock and real estate, at 12.6% and 12.3% respectively. On the other hand, the diversified 12-index portfolio generated a 2.8% five-year annualized return between 2011 and 2015, its lowest five-year rolling return over the 18-year time frame of this analysis.
Nevertheless, the 12-index portfolio has demonstrated better and more consistent five-year performance than the S&P 500 over the past 18 years.
A significant and perpetual problem among investors — and possibly advisers — is performance chasing. When an asset class, such as U.S. large stock, has a period of above-average performance, it will gain attention and your clients may want to move into it.
Sadly, those clients will not likely experience the above-average gains that caught their attention in the first place.
Case in point: The three most recent rolling five-year returns for the S&P 500 have been 17.9%, 15.5% and 12.6%, well above its average rolling five-year return of 4.6% over the period from 1998 to 2015. Clients who are now investing in funds that emulate the S&P 500, or large-cap U.S. stock in general, are not likely to experience those lofty returns over the next four to five years — that is, if the demonstrated five-year performance volatility of the S&P 500 holds true going forward.
THE ENGINES AND THE SAFETY BRAKES
The performance of individual asset classes can be exhilarating, as evidenced by the yellow shaded cells for emerging markets, real estate and commodities. But if consistency of performance is what a client seeks, help them build a diversified portfolio that includes those exciting engine asset classes and also some asset classes that will act as safety brakes.
Once you’ve built a diversified portfolio, give it at least five to 10 years. Here’s why: If you used long-term historical performance patterns as the basis and rationale for your portfolio design, it would seem only reasonable to allow the portfolio a sufficiently long holding period to demonstrate its performance pattern through several market cycles.
Another reality of rolling performance is this: Performance is cyclical. Regression to the mean, both upward and downward, is a powerful gravitational pull in the world of asset performance.
Said differently, if performance in recent five-year periods is significantly above the average five-year return, expect a downturn in performance. On the other hand, if recent five-year rolling performance is below the average five-year return, you can reasonably expect better performance down the road.
Central to the notion of performance consistency, we observe that the rolling five-year returns of the diversified 12-index portfolio wrap more closely around its mean five-year rolling return of 7.9% than the more wildly fluctuating rolling returns of performance engine asset classes wrap around their mean five-year rolling returns. This, of course, is what is being measured by the standard deviation of the five-year rolling returns. The smaller, the better.
Clients who notice — and value — consistency of performance are generally emotionally neutral as it pertains to performance fluctuation. Stable investors tend to downplay periods of stellar performance as well as periods of underperformance. They have learned that, even though a portfolio’s performance will be cyclical, their emotional reaction doesn’t have to be.
Performance consistency — will anyone notice? Sure, they’re the ones who have a diversified portfolio they actually stick with. They notice performance consistency over time, precisely because they value it.
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