2005 – The Year In Review
Essay Preview: 2005 – The Year In Review
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We can still vividly recall the pointed questions in the late 1990s regarding diversified approaches: “Why do foreign stocks make sense?”, “Why are alternative asset classes worth the trouble?” and “Why should endowment funds hold bonds?” were among the most common inquiries. These were not easy questions to answer as the incredible success of large capitalization growth stocks during just a few short years appeared to undo decades of history in support of the notion that better returns with less risk could be earned by pursuing a diversified approach.

Moving beyond returns themselves, the fact is that it doesnt take long for investors to fall prey to the overconfidence that pushes risks of any form quickly to the back seat. The quintessential expression of this attitude appeared in a major business magazine article back in 2000 that effectively referred to those who pursue diversified approaches as incompetent and foolish (the article actually used harsher language than this).

Included among the important ideas that were lost during this period was a longer term perspective on returns along with the knowledge that markets are cyclical and that conditions would unexpectedly change.

Controlling and managing risk is exceptionally important for endowed funds as they must be allocated heavily to fairly risky asset classes in order to have a solid opportunity to preserve purchasing power. Late 1990s “weakness” in relative returns for some of these funds was not the product of an inferior strategy, but was instead caused by reduced risk created via broad diversification. This, of course, became quite apparent in the years that followed and led to the new set of mistakes we are seeing today.

As we enter 2006, the benefits of diversified strategies have indeed risen to the fore and risk control has become so important that some investors may now be constructing portfolios which are unable to achieve their return objectives. Among the most visible and potentially painful problems involves the levels of capital that have been allocated to high fee, average talent in the alternatives area.

Given that broad enthusiasm is usually driven by too much focus on the recent past, the following table is not surprising:
Annualized Rate of Return
Asset Class
1/1/00 to 12/31/05
Large Capitalization US Equity
– 1.1%
Large Capitalization US Growth Equity
-7.0%
Mid Capitalization US Equity
+8.4%
Small Capitalization US Equity
+6.3%
International Equity
+1.5%
Emerging Markets Equity
+9.1%
Commodities
+14.0%
Hedge Funds
+7.3%
High Yield Fixed Income
+7.1%
REITs
+20.6%
The average premium over the “default” asset class (Large Capitalization US Equity) is more than 8% per year which translates into nearly 6000 basis points of cumulative out-performance. During a difficult period for large stocks in general and last cycles hero, large capitalization growth, the use of other asset classes was exceptionally and unusually valuable.

As some investors jump in based on the numbers above rather than the long term logic of broad diversification, we cant help but worry about the fact that everything is cyclical and the current wave of acceptance presages the next period of trouble. While the theory and logic for broad diversification is and always will be sound, a cyclical downturn in results earned and perception is inevitable, and with every successful year, closer to reality.

The way we see this unfolding is related to the fact that investors as a group have shifted their portfolios towards vastly higher fee structures without demanding commensurately higher levels of talent or opportunity for return. Unfortunately, fees, complexity and liquidity are such that the average return in most alternative classes is unacceptably low. Of course most investors consider themselves to be above average, although simple logic dictates that this cannot be the case.

As a result, many investors will look back on their experience with broad asset class diversification and discover that yes, volatility was dampened. However, reduced “risk” will produce reduced returns that fall short of objectives. This “discovery” combined with the fact that returns from core classes such as large capitalization equities may soon lead the return pack, will likely establish the next phase of the cycle of perception related to broad diversification.

It should come as no surprise that we would welcome this change in perception as the only problem occurs if our clients portfolios are somehow harmed by unwise shifts away from intelligent diversification. In fact, poor returns and meaningful outflows from an asset class create opportunities and are a cause for optimism rather than concern.

In the years to come, 2005 may be remembered as the beginning of a change in attitudes. Yet, from our perspective today, it was an exceptional year for broad diversification.

#1 – International strategies led the way as performance cycles are alive and well
After lagging the US market for most of the 1990s, EAFE out-performed again in 2005 and has now out-performed the S&P 500 for four consecutive years. The surprise here is that this occurred in an environment where the US dollar strengthened considerably producing losses for un-hedged US investors in excess

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Short Years And Large Capitalization Us Equity. (May 31, 2021). Retrieved from https://www.freeessays.education/short-years-and-large-capitalization-us-equity-essay/