2-Minute Portfolio or Global Diversification? An Evidence Based Analysis

Is there anything more humbling than being mocked by your spouse? Of course, some of us are more inured against this type of mocking due to acclimation. I’ve been whipped so often that my skin is 3 inches thick. Even so, I don’t blame clients for reaching out for help when they’re under attack.

Yesterday we received a thoughtful inquiry from a client, whose spouse has been following the so-called “2-Minute Portfolio” publicized by vocal advisor critic Rob Carrick at Canada’s The Globe and Mail newspaper. The client was being challenged by his spouse about his choice to diversify, rather than employing this simple Canadian stock-picking strategy. The 2-Minute Portfolio outperformed his own portfolio last year, and at Hindsight Capital, it’s always a good year.

To provide this valued client with some armour against his wife’s ribbing, we dug a little deeper into the 2-Minute Portfolio, which was produced for Rob Carrick by Morningstar CPMS. This portfolio is based on a backtest of data starting in 1986.  The Canadian version of the portfolio is simple to construct: using factors to identify appropriate securities, equally-weight the portfolio across Canada’s equity sectors, and rebalance annually.

Interestingly, a Masters student at Simon Fraser University also took an interest in the strategy, since it was marketed by Rob Carrick in 2012, and published a report on it for his thesis. The author tested the strategy on both Canadian and US markets using independent data, but over a slightly different time period. It is an interesting read in-full, but the author’s conclusion is relatively straightforward:

In other words, yes the Canadian strategy ever-so-slightly outperformed the TSX index over the full test period, but the results are almost certainly due to random chance. Further, adding a screen to prioritize stocks with dividends is not helpful.

Also note the following charts from the paper, showing that the Canadian strategy essentially tracks the S&P/ TSX index, with similar losses in the 2000-2003 and 2008 bear markets, and similar results over the entire period.  In contrast, while the US version, which was tested back to 1991, outperformed early in the period, it then went on to produce negative returns from 2000 through the end of 2012, and vastly underperformed the S&P 500. It also sustained the same losses as the S&P 500 in 2002 and 2008.

The version of the 2-Minute Portfolio followed by Carrick as replicated in the paper shows average annualized returns from 2002-2012 of 1.77% in Canada and -0.12% in the U.S. Performance in the U.S. since 1991 yields similar results.

These values are statistically indistinguishable from their respective benchmarks on both a total return basis, and a risk-adjusted return basis (as measured by Sharpe ratio, which is return/volatility). In other words, there is no discernable value in this strategy, and we believe investors would be better off investing in a low-cost index fund with no transactions.

In fact, the US version is almost statistically significantly worse on all measures than a simple investment in the S&P 500. The fact is, any empirically-based investor like Carrick ought to ensure that, at a minimum, the approach he advocates has a history of success across a much longer time horizon than just 1986, and across all major stock markets, not just Canada.

If an investor wants to invest in a portfolio that simply attempts to outperform a given index, there are much better ways to go about it than the 2-Minute Portfolio. Morningstar CPMS itself offers significantly more robust model portfolios, which are likely to produce materially better returns outside of the backtest. Of course, these portfolios are made of stocks, and are thus still vulnerable to periodic drawdowns of 40-60%. And the ones that will actually produce outperformance will do so erratically, ensuring that most investors will give up on them long before they realize their long-term value.

Investors who have decided to leap off the benchmark-oriented roller-coaster in favour of globally diversified strategies are not attempting to beat any particular stock index. Rather, they are focused on maximizing long-term returns with minimum risk, without any interest in benchmarks. They have awoken to the fact that the performance of Canadian stocks, or any other random benchmark, have nothing to do with their personal financial goals.

Of course, abandoning benchmarks doesn’t mean that investors in globally diversified strategies should abandon hopes of strong performance. In fact, because of the diverse nature of the investment universe that is available once you broaden your perspective, globally diversified strategies can be quite profitable. Even better, they have a much better chance of proving resilient to the regular havoc wreaked on traditional stock-oriented investors.

In the spirit of the rules-based 2-Minute Portfolio discussion, consider a simple rules-based approach derived from the most robust academic validated techniques, applied to a broad universe of global asset classes going back to 1915. The strategy is described in detail in a paper authored by Keller, Butler and Kipnis (2015) called “Momentum and Markowitz: A Golden Combination.”

Source: Keller, Butler, Kipnis (2015), Momentum and Markowitz: A Golden Combination

Note that this methodology, which is a close proxy for the approaches that drive the ReSolve Adaptive Asset Allocation Fund, produced over 15.4% annualized returns at 10.4% volatility over a full century, with a maximum peak-to-trough loss of 22.8%. In other words, the strategy produced 15/10=1.48 units of return per unit of risk. By comparison, according to Rob Carrick’s articles, the backtest of the 2-Minute Portfolio produced annualized returns of roughly 10.3% with 15% volatility, or 10.3/15=0.69 units of return per unit of risk since 1986.

Moreover, since the 2-Minute Portfolio is just a stock strategy, it endured similar losses to stocks during bear markets like the tech wreck in 2000 and the Global Financial Crisis in 2008. These were both periods where the multi-asset strategy cruised through with positive returns.

Before we get too excited about the results of the multi-asset approach, we think that the reality is that most investors will fail to stick to a strategy like the one described in the paper. Why? Because year-over-year it will be substantially different than the Canadian benchmark return that their peers are using to measure success. Their spouses will have all the ammo in the world to berate them when their narrow Canadian benchmark is outperforming them by double digits in many calendar years. While history provides strong evidence that the globally diversified strategy will produce stronger, more steady returns in the long-run, envy is a powerful enemy to the disciplined investor.

Last year, for example, would have been particularly painful for globally diversified investors because the two best-performing markets happened to be those to which Canadians are most behaviorally susceptible: US and Canadian equities. But that’s the thing about diversification: it works even when you don’t want it to. Today, North American investors we talk to are weary of diversification They want a more home biased, 2-minute solution with strong recent returns to satiate their envy and greed.

To add to the hardship of investing unconventionally, the diversified strategies described in the paper did suffer during the period 1937 – 1943, which is a very similar period to what we have been experiencing recently: large political upheaval; major erratic intervention in the economy; expensive markets; and low interest rates.  Of course, while certain markets did produce multi-year periods of strong performance in this period (like US equities today), investors ended up giving back all their temporary gains in the ensuing bear markets.

So in conclusion, while the evidence clearly suggests investors should favour global diversification over a single market 2-minute solution with questionable value, we believe most people will avoid this path because of the pain of social exclusion. If, however, you happen to be one of the remarkable few with the emotional fortitude handle all the behavioural challenges outlined above to reach your long-term goals with the least amount of risk (and weather constant ribbing from your spouse!), it’s time roll up your sleeves and do the homework.

For a more robust exploration of 2016, as well as the reasons we’re encouraged by 2017’s potential, be on the lookout for the public release of our 2016 Year End Review early next week.  In the meantime, we encourage you to learn more about the full potential of global diversification by reading our Risk Parity Solution Brief.