Using Index ETFs for Multi-Asset-Class Investing:
Shifting the Efficient Frontier Up

Abstract

This article provides evidence and analysis to show that a MAC (multi-asset-class) diversified portfolio performed well in mean–variance space and under varying market conditions, including the very adverse 2008 market crash. The portfolio also delivered during the two bull phases in the full period over which asset history existed. The construction of the covariance matrix for the efficient frontiers was independent of any return estimates or dynamic volatility-switching mechanisms. To abstract from hindsight bias, a 1/N equal-weighted portfolio was constructed and tested, consistent with some literature—it may still be the best alternative. In any case, the minimum-variance portfolios and the 1/N portfolio far exceeded the Sharpe ratio of the capitalization-weighted Russell 1000 equity index. The efficiency gains are potentially attributed to a lower overlap of the return-generating vectors, something that is not possible, to that extent, in an all-equity portfolio, irrespective of the extent of diversification in the non-negative space. Toward that, a scalar construct of overall dependencies called generalized variance is used as a measure of the overall spread within the covariance matrix. Two actual efficient frontiers are built with return data over the full length of the study and are tested for portfolio efficiencies. Finally, with the objective of making such alternate asset and risk-allocation processes available to a wider set of investors, the portfolio components chosen to represent the low-correlation asset classes were among the most liquid index ETFs available on U.S. exchanges.

TOPICS: Exchange-traded funds and applications, portfolio construction, financial crises and financial market history