Our 'All-Weather Portfolio' comes up against a storm

Goodhart’s Law used to be fashionable. Named after a British economist, Charles Goodhart, it is most concisely stated as: “when a measure becomes a target, it ceases to be a good measure.” Slot that definition into the context of the UK’s persistently high inflation of the 1970s and it provided a timely and damning comment on the government’s and the Bank of England’s obsession with curbing inflation by controlling the money supply. The more the finance industry police inhibited banks’ ability to create money, the more that bankers found clever ways to create credit without adding to the monetary aggregates.

From this rarefied beginning, Goodhart’s Law has morphed into a generic form – when a data set becomes closely followed, its future performance will always disappoint. The nasty feeling is that a variation on Goodhart’s Law is now being played out in the Investors’ Chronicle All-Weather Portfolio, which aims to be the ultimate low-risk, buy-and-hold portfolio thanks to its steady investment returns.

For this we can partly blame the former prime minister, Liz Truss, and, in particular, her hare-brained scheme to stimulate economic growth by playing fast and loose with the basic laws of economics and – conveniently – doing so without telling her government colleagues beforehand.

It was about a year ago that her chancellor’s autumn Budget put UK government bond markets in a tailspin. The effect was that a downward drift in the price of gilts became a helter-skelter drop, especially for the index-linked variety. For the All-Weather portfolio, that meant the assets that were supposed to steady the ship in stormy times – especially index-linked bonds – only added to the turbulence. Consequently, in the final four months of 2022, the fund turned in its worst performance sequence in the 10 years for which there is authentic data for the six exchange-traded funds (ETF) that are its holdings (see Table 1). True, the fund’s performance has calmed since then and in September its value was 3 per cent up on the year. Even so, its value is still 9 per cent lower than its all-time peak in December 2021.

Chiefly as a result of its poor showing for the 18 months to May 2023, the performance of what we might label the ‘authentic’ ETF-based All-Weather portfolio now contrasts markedly with the much longer record of the notional portfolio using data for the indices on which the ETFs are based (Table 2). Whereas the figures for the best and worst months for both are in the same ballpark, the average monthly return for the authentic fund has taken a turn for the worse.

For the long-term All-Weather data, based on 295 months from December 1997 to June 2022, the average 6.5 per cent return on the year is perfectly satisfactory. It comfortably beats the UK’s average inflation rate of 2.9 per cent for the period and isn’t far short of the 7.2 per cent total return from UK equities.

The same can’t be said for the 120 months starting from October 2012 for the authentic portfolio. Its average annual return has slipped to 4.6 per cent and volatility has risen, as measured by the standard deviation, essentially the variation around the average. Performance is still comfortably ahead of UK inflation, which – measured by the consumer price index – has averaged 2.8 per cent, but it is below the total return for the FTSE All-Share index, running at 6.5 per cent (see Chart 1).

Odder still, as Table 3 shows, the diversification within the All-Weather portfolio looks wasted effort; much better to have invested all the capital into the global equities fund, iShares MSCI ACWI (SSAC), whose 11.1 per cent average return has come in so smoothly it is higher than the portfolio’s volatility and in none of the 120 months were annualised losses greater than 10 per cent. None of the other five ETFs that comprise the All-Weather portfolio can come remotely near that. The ETFs for global government bonds, commodities and for energy were all lossmaking.

Oddest of all, the ETF for UK index-linked gilts showed average returns of 1.3 per cent, less than half the average rate of UK inflation over the whole period. Clearly, that’s not supposed to happen since the whole point of index-linked securities is that their interest payments and their principal on repayment are tied to inflation. Nor is it clear that, for index-linked gilts, the recovery has begun. Losses running at over 30 per cent a year ended early this year but, as of September, they were still 13 per cent.

True, it is worth making the technical point that the bond ETFs in the portfolio are the only two that distribute dividends (the equities ETF is a total-return fund) and their distributions have not been factored into performance. Adjust for that and the performance of the funds and the overall portfolio would have been better, perhaps usefully so. That said, the same is true of the longer-term record, also shown in Table 1, and that did not obviously damage performance.

Also, as a result of the contrary performance of the All-Weather portfolio’s components, weird things have happened to their respective weightings (see Chart 2). The importance of the global equities ETF has doubled from a 30 per cent weighting at the launch to 61 per cent, while the weighting of all the other ETFs has dropped.

In a way, this is what’s supposed to happen. The whole point of diversification is that the momentum of the winners will compensate for the loss of value sustained by the losers. So their weighting will necessarily rise while losers’ weightings will fall; except not so dramatically as has just occurred in the All-Weather portfolio. The effect is that the current weighting of the commodities and energy ETFs, which started off as 7.5 per cent of the portfolio combined, is now down to 2.9 per cent. That’s so small that their effect will hardly be felt when future bull runs come along, as they surely will. After all, going back to 1998, the performance of the Bloomberg Energy Index, which underpins the energy ETF, is the best of the six, with average gains of 13.5 per cent, despite huge volatility.

The solution is that the portfolio will have to be rebalanced. This is a fact of life for many funds, especially for passive index trackers, which typically rebalance every quarter. Even the commercial version of the original All-Weather portfolio, constructed by billionaire hedge fund manager Ray Dalio and run by his firm, Bridgewater Associates, regularly (and secretly) rebalances. However, Dalio said nothing about when and how to rebalance the ultra-simple original version of the portfolio (IC, 16 September 2022). No matter. The task will have to be done. The IC All-Weather portfolio will be shifted back to its original weightings and the future will tell us whether its flirtation with Goodhart’s Law was just a passing phase or something more serious.