February 23, 2004

During the last fifteen years, U.S. stocks have systematically outperformed the rest of the world. The superior performance of the U.S. equity markets during the last fifteen years is offset by a steady underperformance of the previous fifteen years. That is music to the ears of believers in the mean reversion of returns. An implication of this hypothesis is that even though temporary deviations from historical patterns may be observed, historical relationships such as market returns and the variance-covariance matrix constitute the relevant data for strategic asset allocation. According to the mean reverting hypothesis, identifying the historical optimal mix will serve the investor best over the long run. Mean reversion is the asset allocation version of indexing. However, we believe that an active asset allocation strategy is capable of producing returns that are superior to those of the passive, mean reversion generated asset-allocating strategy.

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