In part one of this series, we explained two measures of risk, standard deviation and beta. In part two we talked about correlation and how it is the key driver of total portfolio risk (while most investors only consider beta and standard deviation). In part three we defined ?alternative assets? and looked at a couple of these alternative asset classes; namely real estate and commodities and how their returns correlated to the S&P 500. In part four, we will go further in depth on this topic and look at the returns generated by various combinations of the S&P 500 Index (a proxy for the U.S. stock market), the NAREIT Equity REIT Index (a proxy for real estate), the MLM Index (a proxy for managed futures) and the 10 Year U.S. Treasury Bond Index.
Past performance is no guarantee of future results. The S&P 500 Index includes reinvested dividends. The NAREIT Equity REIT index is intended as a broad measure of the performance of publicly traded real estate firms investing primarily in the equity of properties. The index is market-capitalization weighted of publicly traded real estate securities. The MLM Index is a diversified portfolio of 25 liquid futures contracts traded on U.S. Exchanges. Per MLM, ?Each contract represents a four percent allocation and positions are rebalanced at the end of each month. An important feature of the Index is the ability for the individual components to either be long or short. The determination to go long or short each contract is made on the last day of each month, based on a trend-following algorithm. This unique feature has historically allowed the Index to profit when long-term prices are trending either up or down. It is a measure of the available returns in the futures market from passive management as opposed to a reflection simply of price changes as represented by most other futures indices.? The above results do not include taxes or expenses which would decrease annual returns. Sources: Federal Reserve of St. Louis, Ibbotson and Associates, Mount Lucas Management and Aspen Partners.
After glancing at the table above, you may be wondering why we chose these particular time periods. We chose 1972 as our starting point because that was the inception date for the NAREIT Index. Given that fact, we first looked at the 1972-2003 time period (or, 32 years) and the results speak for themselves! Note, in particular, how the two ?portfolios? utilizing real estate and managed futures (CAS Index #1 and #2) achieved much greater returns with significantly less risk (remember, risk is defined as standard deviation is a statistical measure of how much an investment's returns vary from its mean). Next we observed the 1980-2003 time period which includes one of the greatest stock bull markets in U.S. history (1980-1999), expecting the S&P 500 to have vastly outperformed the two other CAS Indices. However, that was not the case at all, as CAS Index #1 performed right in line the S&P 500 and managed to achieve this return with significantly less risk (are you noticing a pattern here?). The question then becomes, why would you want to take more risk to achieve and almost identical return?
Now that we?ve established that the CAS Indices outperformed the S&P 500 with less risk over time periods in which we had a bull stock market, what happens when we have a bear stock market? This is where true diversification can really make a difference. Take note of the 1972-1981 results. Over this time period, the S&P 500 Index achieved annual growth of only 1.87% (which includes dividend reinvestments) while our two indices returned 11.02% and 9.70% per year, respectively. (The U.S. bear stock market actually lasted from 1969-1981 (13 years), over which time the S&P 500 returned only 1.19% per year). What this means for you is that $100,000 invested in the S&P 500 would have grown to only $123,000 while $100,000 invested in CAS Index #2 would have grown to $316,000! What if you had been 50 years old in 1972 thinking about retiring in about 10 years? For someone without a 30 or 40 year time horizon it is critical that you find alternative sources of return outside of the U.S. stock market. This is exacerbated if one believes that we are not at the beginning of the next great U.S. bull stock market. Although this may be your opinion if you listen to MSNBC and other news stations, some of the greatest investors of all time have a vastly different opinion. This is the topic of our final piece in the series ?Putting Risk in Its Place in Your Portfolio.?