My estimates came from the book Global Asset Allocation by Meb Faber. I expect it’s less rigorous than the paper you link to, so I suppose we should trust the paper more.
I did find the results of the paper pretty surprising though. It just makes a lot of intuitive sense that bonds with anticorrelate with equities during recessions and real assets will anticorrelate during inflation shocks, which should reduce the risk quite a bit.
Also, all the other estimates I seen show that adding bonds to an all equity portfolio significantly increases sharpe (usually from ~0.3 to ~0.4). (And also that adding real assets helps too, though these estimates are less common.)
I’m wondering if the period used in paper might have been an unusually good time for equities. Meb Faber uses the period 1973-2013. The paper uses 1960 to 2017. 2017 was near a high for the equity market, whereas 2013 was more mid-cycle, which will favour equities. The 60s were a good time for equities, while the 70s were bad, so adding the 60s into the range will boost equities.
Ideally I’d also compare the percentages in each asset. One difference is that Faber’s ‘GAA’ allocation includes 5% gold, which usually seems to improve sharpe quite a bit, since gold was one of the only assets that did well in the 70s*. Faber also gets similar results with what he calls the ‘Arnott Portfolio’ which doesn’t include gold and is fairly in line with my estimate of the global capital portfolio, except using TIPs+REITs+commodities instead of private real estate.
I’d also trust the GMP a lot more out of sample due to the theoretical underpinning.
*My theory for why gold helps sharpe (even though it’s only 1% of total wealth) is that the global capital portfolio includes a lot of private real estate that is not in the global portfolio of listed assets. This means most ‘global market portfolios’ are light on real assets, and adding some gold/TIPs/commodities balances this out, getting you closer to the true global capital portfolio.
I also like GMP, and find the paper kind of surprising. I checked the endpoints stuff a bit and it seems like it can explain a small effect but not a huge one. My best guess is that going from equities to GMP is worth like +1-2% risk-free returns.
My estimates came from the book Global Asset Allocation by Meb Faber. I expect it’s less rigorous than the paper you link to, so I suppose we should trust the paper more.
The data in /Global Asset Allocation/ came from Global Financial Data. I don’t know the details of how GFD’s data is constructed, but I’ve seen it used by quite a few papers and a lot of institutions use it, so I assume it’s pretty reliable. Without having read it, I don’t expect the Doeswijk paper is unreliable either—they probably get different results because (1) they use different time horizons and (2) they don’t include the same countries in their samples (I think Doeswijk includes more).
While I don’t doubt the specific historical results in the paper, in general I would expect the global market portfolio to outperform every individual asset class (on a risk-adjusted basis) in the long run, although it’s expected that some asset classes will outperform GMP for multiple decades in a row. (Faber actually discusses this in Global Asset Allocation!) I agree it’s plausible that the paper happened to pick a good time for equities.
I’m currently helping put together the investment strategy for a DAF and my tentative conclusion is that (contrary to what it says in most EA investment-related articles) it doesn’t make sense to use a leveraged global market portfolio instead of (leveraged) global stocks. Perhaps much of the theory doesn’t apply in practice because it doesn’t take fees and the cost of leverage into account:
Bonds:
Buying bonds/TIPS with a ~0% return at a 0.75% margin loan cost seems like a certain loss. (Perhaps this was different before quantitative easing, so it might make more sense again at some point in the future.) (EDIT: The currently cheapest source of leverage appears to be box spread financing at ~0.55% p.a. for 3 years. The 3y US govt bond yield is 0.2% p.a. So even with cheap sources of leverage, it’s not worth it.)
Bonds (weighted BND + BNDX) slightly underperformed cash in the recent crisis, so perhaps aren’t very anticorrelated with stocks.
Commodities: Commodity ETFs have high TERs of ≥0.58%; buying and rolling individual futures costs time. (EDIT: Even gold (GLD) has a TER of 0.4%.)
(REITs: Already included in stock ETFs.)
(Added some edits in parentheses to the first paragraph.)
Yeah I think it probably makes sense not to hold bonds if you’re using leverage and you can’t get leverage at close to the risk-free rate. I personally don’t hold any long-only bonds. But the argument for holding bonds is that they might be negatively correlated with stocks, in which case a negative expected return might still be worth it. Historically they’ve had close to 0 correlation, not a negative correlation, so I don’t find this argument that persuasive.
For commodities, their returns are much harder to project than bonds (where you can just look at the yield), so it’s hard to say whether they’re worth it. I personally don’t hold any long-only commodities.
What are your thoughts on high-yield corporate bonds or emerging markets bonds? This kind of bond offers non-zero interest rates but of course also entail higher risk. Also, these markets aren’t (to my knowledge) distorted by the Fed buying huge amounts of bonds.
Theoretically, there should be some diversification benefit from adding this kind of bond, though it’s all positively correlated. But unfortunately, ETFs on these kinds of bonds have much higher fees.
“We find that an expansionary US QE shock has significant effects on financial variables in EMEs. It leads to an exchange rate appreciation, a reduction in long-term bond yields, a stock market boom, and an increase in capital inflows to these countries.”
I don’t know much about emerging market bonds so I can’t make any confident claims, but I can say how I am thinking out it for my personal portfolio. I considered holding emerging market bonds because the yield spread between them and and developed-market bonds is unusually high. I decided not to hold them because I don’t think they provide enough diversification benefit in the tails. Since I invest with leverage, it doesn’t necessarily make sense for me to maximally diversify, I only hold assets if I think the benefit overcomes the extra cost of leverage. But I do believe it might make sense to hold emerging bonds for someone with a less leveraged, more diversified portfolio. That said, I would consider them a “risky” asset, not a “safe” asset, and plan accordingly.
The drawdowns of major ETFs on this (e.g. EMB / JNK) during the corona crash or 2008 are roughly 2⁄3 to 3⁄4 of how much stocks (the S&P 500) went down. So I agree the diversification benefit is limited. The question, bracketing the point on leverage extra cost, is whether the positive EV of emerging markets bonds / high yield bonds is more or less than 2⁄3 to 3⁄4 of the positive EV of stocks. That’s pretty hard to say—there’s a lot of uncertainty on both sides. But if that is the case and one can borrow at very good rates (e.g. through futures or box spread financing) then the best portfolio should be a levered up combination of bonds & stocks rather than just stocks.
FWIW, I’m in a similar position regarding my personal portfolio; I’ve so far not invested in these asset classes but am actively considering it.
My estimates came from the book Global Asset Allocation by Meb Faber. I expect it’s less rigorous than the paper you link to, so I suppose we should trust the paper more.
I did find the results of the paper pretty surprising though. It just makes a lot of intuitive sense that bonds with anticorrelate with equities during recessions and real assets will anticorrelate during inflation shocks, which should reduce the risk quite a bit.
Also, all the other estimates I seen show that adding bonds to an all equity portfolio significantly increases sharpe (usually from ~0.3 to ~0.4). (And also that adding real assets helps too, though these estimates are less common.)
I’m wondering if the period used in paper might have been an unusually good time for equities. Meb Faber uses the period 1973-2013. The paper uses 1960 to 2017. 2017 was near a high for the equity market, whereas 2013 was more mid-cycle, which will favour equities. The 60s were a good time for equities, while the 70s were bad, so adding the 60s into the range will boost equities.
Ideally I’d also compare the percentages in each asset. One difference is that Faber’s ‘GAA’ allocation includes 5% gold, which usually seems to improve sharpe quite a bit, since gold was one of the only assets that did well in the 70s*. Faber also gets similar results with what he calls the ‘Arnott Portfolio’ which doesn’t include gold and is fairly in line with my estimate of the global capital portfolio, except using TIPs+REITs+commodities instead of private real estate.
I’d also trust the GMP a lot more out of sample due to the theoretical underpinning.
*My theory for why gold helps sharpe (even though it’s only 1% of total wealth) is that the global capital portfolio includes a lot of private real estate that is not in the global portfolio of listed assets. This means most ‘global market portfolios’ are light on real assets, and adding some gold/TIPs/commodities balances this out, getting you closer to the true global capital portfolio.
I also like GMP, and find the paper kind of surprising. I checked the endpoints stuff a bit and it seems like it can explain a small effect but not a huge one. My best guess is that going from equities to GMP is worth like +1-2% risk-free returns.
The data in /Global Asset Allocation/ came from Global Financial Data. I don’t know the details of how GFD’s data is constructed, but I’ve seen it used by quite a few papers and a lot of institutions use it, so I assume it’s pretty reliable. Without having read it, I don’t expect the Doeswijk paper is unreliable either—they probably get different results because (1) they use different time horizons and (2) they don’t include the same countries in their samples (I think Doeswijk includes more).
While I don’t doubt the specific historical results in the paper, in general I would expect the global market portfolio to outperform every individual asset class (on a risk-adjusted basis) in the long run, although it’s expected that some asset classes will outperform GMP for multiple decades in a row. (Faber actually discusses this in Global Asset Allocation!) I agree it’s plausible that the paper happened to pick a good time for equities.
I’m currently helping put together the investment strategy for a DAF and my tentative conclusion is that (contrary to what it says in most EA investment-related articles) it doesn’t make sense to use a leveraged global market portfolio instead of (leveraged) global stocks. Perhaps much of the theory doesn’t apply in practice because it doesn’t take fees and the cost of leverage into account:
Bonds:
Buying bonds/TIPS with a ~0% return at a 0.75% margin loan cost seems like a certain loss. (Perhaps this was different before quantitative easing, so it might make more sense again at some point in the future.) (EDIT: The currently cheapest source of leverage appears to be box spread financing at ~0.55% p.a. for 3 years. The 3y US govt bond yield is 0.2% p.a. So even with cheap sources of leverage, it’s not worth it.)
Bonds (weighted BND + BNDX) slightly underperformed cash in the recent crisis, so perhaps aren’t very anticorrelated with stocks.
Commodities: Commodity ETFs have high TERs of ≥0.58%; buying and rolling individual futures costs time. (EDIT: Even gold (GLD) has a TER of 0.4%.)
(REITs: Already included in stock ETFs.)
(Added some edits in parentheses to the first paragraph.)
Yeah I think it probably makes sense not to hold bonds if you’re using leverage and you can’t get leverage at close to the risk-free rate. I personally don’t hold any long-only bonds. But the argument for holding bonds is that they might be negatively correlated with stocks, in which case a negative expected return might still be worth it. Historically they’ve had close to 0 correlation, not a negative correlation, so I don’t find this argument that persuasive.
For commodities, their returns are much harder to project than bonds (where you can just look at the yield), so it’s hard to say whether they’re worth it. I personally don’t hold any long-only commodities.
What are your thoughts on high-yield corporate bonds or emerging markets bonds? This kind of bond offers non-zero interest rates but of course also entail higher risk. Also, these markets aren’t (to my knowledge) distorted by the Fed buying huge amounts of bonds.
Theoretically, there should be some diversification benefit from adding this kind of bond, though it’s all positively correlated. But unfortunately, ETFs on these kinds of bonds have much higher fees.
[disclosure: not an economist or investment professional]
This seems wrong — the spillover effects of 2008–13 QE on EM capital markets are fairly well-established (cf the ‘Taper Tantrum’ of 2013).
see e.g. Effects of US Quantitative Easing on Emerging Market Economies
I don’t know much about emerging market bonds so I can’t make any confident claims, but I can say how I am thinking out it for my personal portfolio. I considered holding emerging market bonds because the yield spread between them and and developed-market bonds is unusually high. I decided not to hold them because I don’t think they provide enough diversification benefit in the tails. Since I invest with leverage, it doesn’t necessarily make sense for me to maximally diversify, I only hold assets if I think the benefit overcomes the extra cost of leverage. But I do believe it might make sense to hold emerging bonds for someone with a less leveraged, more diversified portfolio. That said, I would consider them a “risky” asset, not a “safe” asset, and plan accordingly.
The drawdowns of major ETFs on this (e.g. EMB / JNK) during the corona crash or 2008 are roughly 2⁄3 to 3⁄4 of how much stocks (the S&P 500) went down. So I agree the diversification benefit is limited. The question, bracketing the point on leverage extra cost, is whether the positive EV of emerging markets bonds / high yield bonds is more or less than 2⁄3 to 3⁄4 of the positive EV of stocks. That’s pretty hard to say—there’s a lot of uncertainty on both sides. But if that is the case and one can borrow at very good rates (e.g. through futures or box spread financing) then the best portfolio should be a levered up combination of bonds & stocks rather than just stocks.
FWIW, I’m in a similar position regarding my personal portfolio; I’ve so far not invested in these asset classes but am actively considering it.
(moved up)