Since our last update in June, our rankings have been relatively stable.

The following chart shows the value and momentum scores for the ten broad asset classes we consider. The upper right area is the ideal spot for an investment, indicating both attractive value and positive momentum. You can see that value and momentum are usually opposites, with most investments attractive in terms of one, but not both.

Source: Mariposa Capital Management, LLC

As of 11/12/2015, the two most attractive asset classes using value and momentum are:

1. Emerging Market Stocks
2. Cash

The most unattractive asset classes are:

9. US Stocks
10. Commodities

Even with the market volatility over the summer, the relative rankings at least for these 4 asset classes have not changed. One of the benefits beyond performance of adding value to momentum is reducing the frequency of trading.

Note

For this analysis, we are using the following funds as proxies for each asset class.

To realize this diversification benefit of holding bonds, the bonds held must be of very high quality, otherwise some of the shock absorption feature is lost. The two types of bonds that we primarily consider are US Treasury bonds and US TIPS bonds. Let’s discuss TIPS today.

TIPS stands for Treasury Inflation-Protected Securities. The primary difference from a standard Treasury bond is that TIPS are set up to track inflation. If inflation goes up, TIPS will pay its investors a higher return. This feature makes TIPS a popular option for investors who want to protect their portfolio against unexpectedly high inflation.

Before you get too excited, you should know that just like any other interest rate, today’s yields on TIPS are extremely low. 10-year TIPS bonds currently pay just 0.5% per year over inflation. Not really something to brag about.

Although not too exciting, TIPS along with standard Treasury bonds do play an important role when building a properly diversified portfolio. How much you hold will depend primarily on how risky you want your overall portfolio to be.

And as with other asset classes, I typically use index funds or ETFs that hold dozens of bonds instead of buying individual bonds directly. Unlike other asset classes, buying individual TIPS bonds is not impractical for individual investors, so it could be the better option in some cases.

Here are some of my basic requirements when selecting an investment for any asset class:

• Asset class purity. How well does it represent the asset class I’m looking for?
• Cost. Besides the expense ratio, the turnover ratio is another factor to consider, as trading incurs transaction costs and capital gains taxes.
• Fund management. ETFs and index funds come and go, so stick with managers with a track record of managing these types of investments.

The following is a list of notable funds that track TIPS bonds. For investors looking for TIPS in fund form, this is the place to start.

Criteria

• Fund size of at least $250MM
• Net expense ratio of 0.25% or less
• Minimum initial investment of $50,000 or less
• Average effective duration between 5 and 10
• Available to the public without an advisor

Since our last update in January, our rankings have been relatively stable, but did change slightly in June.

The following chart shows the value and momentum scores for the ten broad asset classes we consider. The upper right area is the ideal spot for an investment, indicating both attractive value and positive momentum. You can see that value and momentum are usually opposites, with most investments attractive in terms of one, but not both.

Source: Mariposa Capital Management, LLC

As of 6/29/2015, the two most attractive asset classes using value and momentum are:

1. Emerging Market Stocks
2. Cash (new)

The most unattractive asset classes are:

9. US Stocks
10. Commodities

Note

For this analysis, we are using the following funds as proxies for each asset class.

Just like you shouldn’t limit your portfolio to stocks in the US, you should consider the global market when investing in real estate. The easiest way for most investors to include foreign real estate in their portfolio is through REITs (also, see options for US REITs). REITs are stocks that own and rent out real estate properties of all kinds, such as apartments, shopping malls, and office buildings.

Although investing in residential, commercial or industrial properties in other countries seems exotic, there are a number of low-cost, diversified funds that make this very similar to investing in more traditional asset classes.

And as with other asset classes, I prefer index funds and ETFs that hold dozens or hundreds of REITs instead of buying individual REITs directly — keeping costs low and diversifying as much as possible. Especially with foreign real estate, buying individual REITs or individual properties is impractical for the average investor.

Here are some of my basic requirements when selecting an investment for any asset class:

• Asset class purity. How well does it represent the asset class I’m looking for?
• Cost. Besides the expense ratio, the turnover ratio is another factor to consider, as trading incurs transaction costs and capital gains taxes.
• Fund management. ETFs and index funds come and go, so stick with managers with a track record of managing these types of investments.

The following is a list of notable funds that track foreign real estate the traditional way. For most investors, this is the place to start.

The selection of next generation or smart beta funds for foreign real estate is quite limited. The only notable fund available to the public is one from WisdomTree.

Criteria

• Fund size of at least $100MM
• Net expense ratio of 0.75% or less
• Turnover of less than 50%
• At least 100 holdings
• Available to the public without an advisor

Let’s look at what this analysis tells us in January.

The following chart shows the value and momentum scores for the ten broad asset classes we consider. The upper right area is the ideal spot for an investment, indicating both attractive value and positive momentum. You can see that value and momentum are usually opposites, with most investments attractive in terms of one, but not both.

Source: Mariposa Capital Management, LLC

As of 1/15/2015, the two most attractive asset classes using value and momentum are:

1. Emerging Market Stocks
2. Global Commodity Stocks

The most unattractive asset classes are:

9. US Stocks
10. Commodities

Note

For this analysis, we are using the following funds as proxies for each asset class.

With today’s endless menu of low-cost Emerging Market stock funds, there’s very little reason to keep them out of your strategic portfolio. Once you decide to include them, the tough decision is selecting a fund to use.

As with other asset classes, I prefer index funds and ETFs that hold hundreds of stocks instead of buying individual stocks directly — keeping costs low and diversifying as much as possible. With EM stocks, this really is the only viable option since buying individual stocks is unrealistic for the average investor.

Here are some of my basic requirements when selecting an investment for a given asset class:

• Asset class purity. How well does it represent the asset class I’m looking for?
• Cost. Besides the expense ratio, the turnover ratio is another factor to consider, as trading incurs transaction costs and capital gains taxes.
• Fund management. ETFs and index funds come and go, so stick with managers with a track record of managing these types of investments.

The following is a list of notable ETFs that track traditional EM stock indexes. For most investors, this is the place to start.

Even with EM stocks, there are many next generation or smart beta funds that are available. If your EM stock allocation is large, one of the funds below could be a nice complement to one of the traditional funds above. Surprisingly, there are no traditional EM value index funds available to the public.

Criteria

• Fund size of at least $200MM
• Net expense ratio of 0.75% or less
• Turnover of less than 50%
• At least 200 holdings
• Available to the public without an advisor

Let’s look at what this analysis tells us in October.

The following chart shows the value and momentum scores for the ten broad asset classes we consider. The upper right area is the ideal spot for an investment, indicating both attractive value and positive momentum. You can see that value and momentum are usually opposites, with most investments attractive in terms of one, but not both.

Source: Mariposa Capital Management, LLC

As of 10/16/2014, the two most attractive asset classes using value and momentum are:

1. Emerging Market Stocks
2. US Treasury Bonds

The most unattractive asset classes are:

9. Foreign Real Estate
10. Commodities

Note

For this analysis, we are using the following funds as proxies for each asset class.

The Traditional Rules

Ignoring the technical details, the two primary characteristics of traditional indexes are:

1. Broad coverage of the intended asset class.
2. Weighting by size (market cap).

Some of the most popular indexes are constructed this way: the S&P 500, MSCI EAFE, Wilshire 5000, etc. The S&P 500 aims to represent large US companies, so it contains 500 large US companies (Rule #1) and it weights them by market cap (Rule #2).

Breaking the Rules

If all indexes were set up this way, academics and fund companies wouldn’t have anything interesting to do. So the obvious solution is to break the rules.

The first approach was to break Rule #1 by targeting stocks with certain attributes. Value vs growth stocks was a common way to split the stock market. Vanguard’s value index fund only contains US stocks that have “value” characteristics. It excludes the remaining stocks that it considers to be “growth.” But this fund still weights the filtered list of stocks by market cap, obeying Rule #2.

Eventually indexes that broke Rule #2 were introduced. In 2005, Research Affiliates came out with Fundamental Indexes that weighted stocks not by market cap, but other measures of size: sales, earnings, etc. But these indexes still obeyed Rule #1 by not excluding stocks with certain characteristics.

Of course, there are now funds that break both rules. Take a look at Guggenheim’s S&P 500 Pure Value ETF (RPV). First, it filters US stocks to those showing strong value characteristics — a filter that’s far more strict than Vanguard’s value fund above. Then it weights the stocks, not by market cap or another measure of size, but by their value scores. It’s a far more intense “value” fund than Vanguard’s.

Why Bother?

So why are investors attracted to these “smart beta” indexes and funds? Most of these funds are capturing effects that students of investing already know about — the strong track records associated with attributes like value, small cap, momentum, profitability/quality, and low beta/volatility. The various “smart beta” funds attempt to capture these effects in slightly different ways, in different combinations, or in different asset classes, but really that’s all they’re doing.

And if you accept that these effects work, “smart beta” funds that provide a more precise and effective exposure to them can be a useful part of your portfolio.

Appendix

Interested in some examples? Here are some smart beta alternatives to traditional US stock index funds.

Let’s look at what this analysis tells us this month.

The following chart shows the value and momentum scores for the ten broad asset classes we consider. The upper right area is the ideal spot for an investment, indicating both attractive value and positive momentum. You can see that value and momentum are usually opposites, with most investments attractive in terms of one, but not both.

Source: Mariposa Capital Management, LLC

As of 7/9/2014, the two most attractive asset classes using value and momentum are:

1. Global Commodity Stocks
2. Emerging Market Stocks

The most unattractive asset classes are:

9. Commodities
10. US Real Estate

Note

For this analysis, we are using the following funds as proxies for each asset class.

“[To be a superior investor,] this is the bottom line: not whether you dare to be different or to be wrong, but whether you dare to look wrong.” – Howard Marks, Oaktree Capital Management

The toughest qualification for being a successful investor is the ability to stick with a strategy even when it’s not working. Even when the strategy is making you look foolish. Even when there was much money to be made by following a different strategy.

One consequence of following an evidence-based investment strategy is that your portfolio does not look like a traditional portfolio. Your level of diversification is much higher. Unlike your friends, you may not even own a single stock — only disciplined, diversified funds. Your level of trading? Very likely much lower.

The expected result from this deviation is superior performance over time. Why else would we choose this strategy in the first place? However, to be able to earn this superior performance, returns would have to be different over any given month or year. Different, which can mean either higher or lower. And when that difference is lower, investing can be quite unenjoyable.

Let’s focus on diversification as an example. Most US investors primarily hold US stocks in their long-term portfolio. More sophisticated investors tend to accept the rationale for diversification and end up with far more diversified portfolios. To explore these two approaches, let’s compare the historical performance of US stocks vs the performance of a very simply diversified portfolio of US stocks, foreign stocks, and US REITs.

Looking at the performance table above, the diversified portfolio beats US stocks in terms of returns, standard deviation of returns, and risk-adjusted performance as measured by the Sharpe ratio. It seems like an easy decision to go with the diversified portfolio over just US stocks — better returns, lower risk, where’s the downside?

However, those superior results were earned over a period of more than 40 years. As investors, we don’t experience investment returns 40 years at a time — we assess it far more frequently. The following chart shows the return of the diversified portfolio relative to the S&P 500 over rolling 3 year periods. When the line is positive, the diversified portfolio did better than the S&P 500 over the prior 3 years. When the line is negative, the diversified portfolio did worse.

Over these 40 years, there have already been 6 distinct periods when holding a diversified portfolio looked foolish, with one of those occurring right now. Two of those periods looked completely disastrous for diversification. Try to imagine the resolve needed to stick with a diversified portfolio in the early 1990s and then again in the late 1990s, while everyone around you is profiting from following a naive US-only strategy. It can take years for the “right” strategy to actually outperform.

Although diversification may seem like a “free lunch” when looking at the table of 40+ year returns, the chart above exhibits the price we do pay for that superior performance. The price is that occasionally we will look wrong, and some of those times completely wrong and foolish. It takes an independent, disciplined mind to be able to withstand these periods and not give up on a strategy that we expect to perform better over time.

Figuring out how to earn superior performance over time is not too difficult. Even just following Basic Strategy would be a noticeable improvement for most investors. However, having the discipline to stick with such strategies, especially when it looks wrong in the moment, is a far more difficult task.