How does that benchmark compare to the work of professional managers? We get one answer when we review the universe of 300-plus mutual funds and ETFs in Morningstar's "moderate allocation" category. For the ten years through this past May, the annualized total return ranged from a gain of nearly 18% per year to a loss of more than 8%. Far more revealing is the fact that less than one-tenth of these funds earned 5% or more per year for the decade through May.
Beating a naïve benchmark, it seems, wasn't so easy after all.

"Clever" Portfolio Strategies
Professor John Cochrane of the University of Chicago has written extensively on the evolution and trade-offs between what he calls the old and new theories of finance. A key challenge is deciding how far to stray from conventional portfolio theory. The new finance tells us that investment returns are sensitive to risk factors beyond the broad market portfolio beta identified in the classic interpretation of modern portfolio theory.

Small cap and value measures, for instance, offer a fuller explanation for the general equity risk premium against a broadly defined market-cap index of stocks. But this is merely the tip of the iceberg. Financial economics continues to identify additional risk factors. The ongoing revelations suggest that the basic notion of alpha-an active manager's ability to beat the benchmark-may be a misnomer after all. Instead, the investment landscape seems to be populated with two broad types of systematic risk factors, says Cochrane-the betas we know, and those we have yet to identify.

The new insights imply that it's time to jettison the old finance. There's now a wider menu of risk factors to consider in asset allocation. That opens the door for minting higher returns for those investors who choose to customize their portfolios. But those investors will also face down the additional hazards bound up with alternative betas.

For instance, there's a case for carving out a separate allocation for small-cap and value stocks. But there's a limit on the number of investors who can chase these investments without driving down the expected excess return into negative territory. That's probably one reason why the realized risk premiums for these stocks have evaporated at times. Similar caveats apply to other nontraditional risk-pricing strategies as well, such as taking advantage of the momentum effect, the liquidity risk premium, merger arbitrage, etc.

Modern portfolio theory's standard advice, in other words, is still worthy when you're considering how to modify your investment strategy (if at all). The old finance advises that the broad market portfolio is optimal for the average investor over the long term. But no one is average. Cochrane says the first step in synthesizing the old and new world orders in finance is asking how one investor's risk profile is different from others. For instance, if one investor works in the oil industry, there's a case for minimizing, eliminating or even shorting energy stocks in his equity allocation.

The next step is diversifying broadly across asset classes and avoiding taxes, Cochrane says. "Then we can be clever."

Tactical Allure
The steep, synchronized losses of virtually everything during the financial crisis of 2008 convinced many advisors that intelligent investing and risk management mean more than developing a strategic asset allocation and holding fast to the mix. For many, tactical asset allocation (TAA) and related techniques are the solution.

But how much can a person do? However much you might want to dynamically manage the investment mix, you can't totally replace a long-term strategic asset allocation, says Leslie Strebel, a principal at the Strebel Planning Group in Ithaca, N.Y. "You have to employ both."

That means the investor must do some active asset allocation to defend himself in case his buy-and-hold strategy stumbles in the short run. The bear market in stocks in 2000-2002 convinced Robert Leahy of Leahy Wealth Management Group to use a more active approach for managing the asset mix. Yet he also recognizes that tactical asset allocation has a price. "It's much more time consuming and involves a lot more thought and research than a buy-and-hold modern portfolio theory portfolio," he says.