Following these wild mispricings, as the deleveraging took a pause long enough for investors to reassess relative value, we did indeed see many asset classes recover handsomely in November/December 2008. Eight of the 16 asset classes produced gains, which would have caused an equally weighted portfolio to produce a gain of 1.5%. Interestingly, this rebound was not led by the stock market. The S&P 500 actually finished 12th out of the 16 asset classes during Stage Three.

A model-driven GTAA strategy is designed to capitalize on the opportunities created by these types of price dislocations. Institutional investment committees aren't equipped to make the necessary asset allocation decisions. The contrarian strategy—moving into distressed assets when they are most feared—runs counter to human emotions and confronts people with the dreaded "maverick risk." These issues are particularly problematical when out-of-mainstream "niche" asset classes are involved. These classes are typically the first to be abandoned in a period of market duress. Perhaps this is why diversified portfolios tend to outperform as the economy comes out of periods of severe market stress. Figure 2 displays the returns of the 16-asset-class portfolio (equally weighted) compared with the returns of a traditional 60% S&P 500/40% Barclays Capital Aggregate Bond portfolio in the three years subsequent to three financial crises of the past 20 years.

We think 2008 has provided several key lessons on asset allocation. First and foremost, 2008 taught us that extrapolating historical return characteristics, even very long-term characteristics, is dangerous. Every rule has an exception. However, to let the massive meltdown in September and October 2008 serve as a primary guide to our future decisions would be equally dangerous; this market was nothing if not extraordinary. Rising correlations may be part of an increasingly intertwined global financial community, but a doubling of the average cross-correlation is extreme and unsustainable. Furthermore, the three-stage analysis shows that active asset allocation provided opportunities before and after a dreadful stretch in the market. We think this characteristic will continue: Assets will be repriced to deliver a "fair" return for the corresponding risk. That truism combined with a wealth of low-hanging fruit bodes well for advocates of GTAA.

The Fundamental Index Approach

The Fundamental Index approach produced mixed results vis-à-vis capitalization-weighted indexes in 2008. The published FTSE RAFI^® series witnessed relative performance successes (there were no absolute victories in 2008!) in Japan, Australia, Canada, international small companies, and the emerging markets. However, since the launch of the RAFI methodology was commercialized in late 2005, 2008 marked the first and only calendar year of shortfall, albeit slight, by a global all-country RAFI strategy relative to a global, all-country cap-weighted index. The RAFI strategy posted a decline of -42.5% versus the MSCI All Country World Index of -41.9%, a slight shortfall of 0.6 percentage points, following outperformance of 6.0% and 2.0% in 2007 and 2008, respectively. Combining the entire post-2005 experience, the global, all-country Fundamental Index strategy has outperformed the MSCI World by a very respectable 1.8% annualized over three years.[4]

Unquestionably, the largest drag on the global Fundamental Index strategy was the U.S. market. There will always be exceptions to the rule—outliers in statistical speak. Last year, that outlier was the United States. The FTSE RAFI US 1000 Index trailed the S&P 500 by nearly 3 percentage points. As we have commented, the Fundamental Index approach typically enjoys a tailwind-boosting performance when value stocks are winning in the market. Thus, many followers of the Fundamental Index strategy were surprised by the U.S. shortfall, because value stocks seemed to outperform in 2008. The Russell 1000 Value Index outperformed the Russell 1000 Growth Index by 159 basis points. However, many observers would disagree with the notion that 2008 was a value year. As shown in Figure 3, the S&P/Citigroup Growth and Value Indexes showed the opposite—the S&P 500/Citigroup Value underperformed the Growth index by 430 basis points.[5] Combining the two series, we find that 2008 was probably a down year—or at best a flat year-for value stocks relative to growth stocks in the United States.

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