Portfolio Design: A Modern Approach to Asset Allocation

Preface xiii

Acknowledgements xv

About the Author xvii

About the Book xix

Disclaimers xxi

CHAPTER 1 Asset Allocation 1

Ingredients of Asset Allocation 3

Lessons of the Recent Downturn 6

So Are Bonds the Place to Invest? 10

So What Happens When the Economy Turns Up? 13

Some Necessary Tools for Analysis 15

Appendix: Description of the Statistical Tools 16

CHAPTER 2 Long-Run Returns on Stocks and Bonds 21

Stocks and Bonds Since 1951 22

How Much More Attractive Are Stocks than Bonds? 24

Real Returns 25

Reconsidering Bond Returns 27

Reconsidering Stock Returns 30

Alternative Estimates of Long-Run Stock Returns 32

Upper and Lower Bounds for Equity Returns 35

Appendix: Alternative Estimates of Stock Returns 36

CHAPTER 3 Small-Cap Stocks 41

What Do We Mean by Small-Cap Stocks? 43

Relative Performance of Large-Cap and Small-Cap Stocks—Russell Series 45

Relative Performance of Large-Cap and Small-Cap Stocks—SBBI Series 48

Relative Performance of Large-Cap and Small-Cap Stocks—Broader Analysis 50

Large-Cap and Small-Cap Stocks in a Portfolio Context 52

Summary—Key Features of Small-Cap Stocks 55

CHAPTER 4 Value and Growth Investing 57

Description of the Russell 1000 Indexes 57

Relative Performance of Growth and Value Indexes 59

Value and Growth Indexes for Earlier Periods 64

Relative Performance of Small-Cap Growth and Value Stocks 65

Portfolios with Growth and Value 69

Summary—Key Features of Growth and Value Stocks 71

CHAPTER 5 Foreign Stocks 73

Returns on Foreign and U.S. Stocks 75

Currency Capital Gains and Foreign Stock Returns 79

Diversification Benefits of Foreign Stock Investing 85

Are There Shortcuts to Owning Foreign Stocks? 90

Summary—Key Features of Foreign Stocks 93

CHAPTER 6 Emerging Markets 97

What Is An Emerging Market? 98

Emerging Stock Market Indexes 101

Emerging Stock Market Returns 103

Risks of Investing in Emerging Stock Markets 107

Emerging Market Bonds—A Brief History 113

Returns on Emerging Market Bonds 114

Summary—Key Features of Emerging Market Stocks and Bonds 117

CHAPTER 7 Bonds 121

Treasury Bonds 122

The Wider U.S. Bond Market 127

Returns on U.S. Bonds 131

Bond Markets Outside the United States 133

Summary—Key Features of Bonds 140

CHAPTER 8 Strategic Asset Allocation 143

Expanding the Portfolio to Include Other Bonds and Stocks 145

Expanding the Portfolio to Include Foreign Stocks 147

The Dirty Secret of Optimization 150

Alternative Approaches to Optimization 154

Estimating Portfolio Returns—the Premium Method 155

Portfolios in Practice—Example of MarketWatch.com’s Lazy Portfolios 159

Beyond the Traditional Efficient Frontier 163

CHAPTER 9 Hedge Funds 167

Investment Strategies 169

Hedge Fund Returns 172

Hedge Fund Biases 178

Performance Across Managers 181

Fund of Funds 182

Hedge Funds in a Portfolio 186

Summary—Key Features of Hedge Funds 187

CHAPTER 10 Venture Capital and Private Equity 191

Common Features of Venture Capital and Buyout Funds 192

Venture Capital 195

Returns on Venture Capital 198

Buyout Funds 205

Returns on Buyout Funds 207

Key Features of Private Equity 211

CHAPTER 11 Real Assets—Real Estate 213

Real Estate Investment Trusts 214

Direct Ownership of Real Estate 220

Home Ownership 223

Concluding Remarks 231

CHAPTER 12 Real Assets—Commodities 235

Sources of Return on Commodity Futures 236

Returns on Commodity Futures 239

Performance in a Portfolio 245

Does Gold Belong in the Portfolio? 249

Active Investment in Commodities—Managed Futures 251

Summary—Key Features of Commodity Investments 253

CHAPTER 13 Asset Allocation with Alternative Investments 257

Diversifying into Real Estate—Alternatives for Ordinary Investors 258

Expanding the Menu of Alternative Assets 262

High Net Worth (HNW) Portfolios 264

Ultra HNW Portfolios 266

Lessons about Alternatives from the Yale Endowment 269

Lessons about Alternative Investments Learned in the Financial Crisis 277

Verdict on Alternative Investments 280

CHAPTER 14 Investing and Spending by Foundations 285

Spending Rules 286

Estimating Future Bond and Stock Returns 288

Volatility and Uncertainty 288

Portfolios of Stocks and Bonds 290

Description of the Spending Plan 291

Using Historical Returns Since 1951 to Set Spending Rules 292

Effect of Lower Stock Returns on Spending Rules 294

Effects of Different Stock/Bond Allocations 296

Concluding Comments 299

CHAPTER 15 Investing and Spending in Retirement 303

Longevity 306

Spending Rules for Retirement 308

Portfolios of Stocks and Bonds 309

Baseline Case: Can Two Live More Cheaply Than One? 310

Effects of Bequests and Variable Spending Rules 311

How Can I Turn a Defined Contribution Plan into a Defined Benefit Plan? 313

Concluding Comments—Postpone Retirement? 314

CHAPTER 16 The Discipline of Asset Allocation—Rebalancing 319

Rebalancing Defined 320

Rebalancing When Times Are Good 321

Rebalancing When Times Are Bad 323

References 325

Index 331