Butler, Philbrick, Gordillo & Associates

A couple of weeks ago, I had the pleasure of a short correspondence with Lars Kestner, a well known quant and derivatives trader, and creator of the thoughtful K-ratio as a measure of risk adjusted performance. We connected on the definition of alpha, and how the term has been so abused in media and marketing as to become almost meaningless.

It?s that time of year again. Yup, that jolly, happy time of year when the soothsayers of Wall Street start trumpeting their views on what?s going to happen in 2015, and how to position portfolios to profit. Esteemed Wharton professor, Jeremy Siegel, author of the permabull bible, Stocks for the Long Run, recently joined the merry parade with his own forecast that Dow 20,000 ?could happen? in 2015. Astute investors might take stakes now in large manufacturers of confetti, party horns, and streamers.

We just love a good debate, and there seems to be quite a heated debate at the moment about the relative utility of passive versus active investing. Perhaps this debate is as timeless as investment management itself, but a flurry of recent studies may have finally armed passive advocates with enough ammunition to settle the argument once and for all.

The question of whether to commit new funds to stocks here is nuanced and complex, not least because it isnt obvious that traditional alternatives - bonds or cash - offer any better value. We are very near all-time low interest rates across most developed government bond markets, credit spreads are near all-time tights, and rates are negative out to 5 or more years in real terms.

Click to viewWe endorse the decisive evidence that markets and economies are complex, dynamic systems which are not reducible to normal cause-effect analysis. However, we are willing to acknowledge the likelihood that the future is likely to rhyme with the past. Thus, we believe there is substantial value in applying simple statistical models to discover average estimates of what the future may hold over meaningful investment horizons (10+ years), while acknowledging the wide range of possibilities that exist around these averages.

Our last few articles dealt with the Permanent Portfolio, a widely embraced static asset allocation concept proposed by Harry Browne in 1982. To review, the simple Permanent Portfolio consists of equal weight allocations to cash (T-bills), Treasuries, stocks and gold to ward against the four major financial states of the world.

In our Permanent Portfolio Shakedown Part 1 we investigated the history of the approach, tracing it back to Harry Browne in 1982. The company he helped to found, The Permanent Portfolio Family of Funds, has been running their version of the strategy in a mutual fund for almost 30 years, with fairly impressive results. Harry's thoughts about the portfolio are worth repeating in this second installment.

The Permanent Portfolio is an asset allocation concept first introduced by Harry Browne in 1982. The Permanent Portfolio Family of Funds website has this to say about the strategy, which they have been running in mutual fund format for about 20 years.

Modern Portfolio Theory has been derided by practitioners, academics, and the media over the past ten years because the dominant application of the theory, Strategic Asset Allocation, has delivered poor performance and high volatility since the millennial technology crash. Strategic Asset Allocation probably deserves the negative press it receives, but the mathematical identity described by Markowitz in his 1967 paper is axiomatic in the same way Pythagoras' equations describe the properties of right triangles, or Schrodinger's equations describe the positional probabilities of electrons.

This is a 'Canadian-ized' version of anarticlewe published on Monday, December 19, 2011, which featured a study of US equity and fixed-income markets. As we are located in Canada, we were motivated to see how well the same techniques work in our home market using the S&P/TSX Composite. As expected, it turns out that they work quite well.

This is a 'Japan-amized' version of an article we published on 12/19, which featured a study of US equity and fixed-income markets. The Japanese experience since 1993 was dramatically different than the U.S. Japanese investors endured a seemingly endless series of intermediate term extremes of hope and despair as markets oscillated wildly above and below their long-term negative trend. Japans multi-decade crash and stagnation is unique among modern market economies (so far), so we wanted to see how well our volatility adjusted rebalancing framework worked in this difficult environment.

Investors would do much better to heed the results of robust statistical analyses of actual market history, and play to the relative odds. This analysis suggests that markets are currently expensive, and asserts a very high probability of low returns to stocks (and possibly other asset classes) in the future. Remember, any returns earned above the average are necessarily earned at someone else's expense, so it will likely be necessary to do something radically different than everyone else to capture excess returns going forward.

Investors would do well to heed the results of robust statistical analyses of actual market history, and play to the relative odds. This analysis suggests that markets are currently expensive, and asserts a very high probability of low returns to stocks (and possibly other asset classes) in the future. Remember, any returns earned above the average are necessarily earned at someone else's expense, so it will likely be necessary to do something radically different than everyone else to capture excess returns going forward.