Originally published in the Brandywine Asset Management Monthly Report.
Since the 1960s, asset classes have dominated the investment landscape. Originally “invented” out of necessity, they evolved to serve as the foundation of conventional portfolio diversification. They got their start shortly after Harry Markowitz published his seminal paper “Portfolio Selection.” This paper eventually led to the popular adoption of mean-variance modeling to create “optimally” diversified investment portfolios. But in order to determine an optimal stock portfolio, the Markowitz model required a person to calculate the covariance of every stock in a portfolio in relation to all others. Because computer technology was in its infancy and the “cost” (not just in computer resources but in actual dollars and cents as well) to do this was exorbitant, a simpler method needed to be devised. Enter Bill Sharpe, who developed a simplified system that instead compared each stock to the market as a whole. The “market as a whole” became an asset class. Initially, there were just a few asset classes, such as stocks, bonds and cash.
Over the years, investment professionals have established increasingly varied asset classes (and sub-asset class “categories”). For example, many now consider real estate and commodities to be asset classes. And emerging market stocks and high-yield bonds may still be considered to be part of the stock and bond asset classes, but they are also understood to behave differently and are therefore considered to be sub-categories of their asset classes.
All this would be just an interesting (to some) academic discussion if it weren’t for the fact that trillions of dollars in investment decisions are based on allocating capital across asset classes. This makes asset classes an important and integral part of investing. And that is a problem, because the use of asset classes imposes an unnecessary constraint on a person’s ability to create a truly diversified portfolio. But before we explain why, we’d like to introduce the concept of return drivers.
From Asset Classes to Return Drivers
One of the innovations supporting Brandywine’s investment philosophy is our use of return drivers. As Mike Dever states in his book, “a return driver is the primary underlying condition that drives the price of a market” and “every return driver has a time period (and markets) over which it is relevant.” Realizing that the best way to explain the return driver concept is by example, in the opening chapter of his book Mike displays the result of research that shows the relative influence of the two primary return drivers that power stock prices (which are people’s sentiment towards stocks and the growth of corporate earnings). You can read a complimentary copy of the book’s Introduction and first chapter here: https://www.brandywine.com/pdf/special/JackassInvesting_BookThruMyth1.pdf.
Once those return drivers have been identified, they can be exploited to serve as the basis for trading strategies. Mike demonstrates this in the book’s Action Section, where he shows how to develop a specific trading strategy that uses ETF money flows to exploit short-term sentiment in stock indexes and bond markets. This is an actual trading strategy being used by Brandywine today.
The basic nature and elegance of return drivers becomes apparent when you realize that all an asset class is, is a specifically constrained trading strategy employed against a group of related markets. For example, corporate earnings growth is the dominant return driver of U.S. equity prices over periods of 30 years or more. So the U.S. equity “asset class” is simply the application of a trading strategy (holding naive long positions), applied to U.S. equities, designed to capture that return driver.
But there are potentially dozens of sound, logical return drivers (as equally sound as earnings growth driving long term stock prices) that can be exploited to profit from trading in the U.S. equity markets. And there are potentially hundreds of additional return drivers that can be exploited to profit from trading in the hundreds of other freely-traded global financial and commodity markets. To ignore those and exploit just one creates a logical inconsistency. The stated desire of most institutional investors and their consultants (as well as most individual investors) is to create a diversified investment portfolio. But their dependence on asset classes immediately constrains their ability to do so.
One way to attempt to fix this is to expand the universe of asset classes. In the past few years, firms such as Goldman Sachs have suggested that volatility be considered an asset class. We understand their desire to do this. Volatility trading in equities is based on a sound, logical return driver that produces returns that are uncorrelated to equities. It provides tremendous portfolio diversification. But pigeonholing volatility into the asset class construct is awkward and cosmetic. It’s not a true fix.
Brandywine’s Use of Return Drivers
Return driver based investing provides that true fix. Once you recognize that every asset class is powered by return drivers, and is therefore simply a subset of a single trading strategy, it actually becomes illogical to pursue an asset class approach instead of a diversified return driver based approach to investing. That is why return drivers are one of the key concepts underpinning Brandywine’s investment philosophy and an integral contributor to our performance. In contrast, there is an inherent and sizable disadvantage to being asset class constrained.
We pointed this out in our February 2013 report, where we stated that because of the dependence of the S&P 500 on two primary return drivers and Brandywine’s broad diversification across return drivers that “over time, the S&P 500 TR index will be unable to compete on a risk-adjusted basis with the returns earned by Brandywine.” This continues to be our belief today.
Resources
The myth that portfolio diversification can be achieved by allocating money across asset classes is exposed in Chapter 17 of Mr. Dever’s book. You can read a complimentary copy of that chapter here: https://www.brandywine.com/pdf/special/JackassInvesting_Myth17.pdf.
