A representative market portfolio can be built as the capitalization-weighted average of global equity, real estate and bonds. From 1960 to 2015 such a portfolio would have recorded a dollar-denominated nominal compound return of 8.4%, a real (inflation-adjusted) return of 4.4% and a Sharpe ratio of 0.7. Equity has delivered superior absolute returns, while bonds have delivered superior risk-adjusted returns, consistent with the “low risk effect” theory (view post here). The disinflationary period delivered more than double the returns of the inflationary period. Plausibility and empirical evidence suggest that the market portfolio is not efficient.

Doeswijk, Ronald, Trevin Lam and Laurens Swinkels (2017), “Historical Returns of the Market Portfolio”, June 2017

The post ties in with SRSV’s lecture on implicit subsidies.
The below are excerpts from the paper. Emphasis and cursive text have been added.

Construction of the global market portfolio

“There is only one true benchmark for passive investors. This is the portfolio in which all investable assets are weighed according to their market capitalization weights. As such, the global market portfolio is the portfolio for the true passive investor. At any point in time the global market portfolio mirrors the benchmark with marginal rebalancing to keep track with the benchmark due to differences in issuance and redemptions of asset categories.”

“We define the global market portfolio as all assets held by financial investors. We distinguish four asset categories. The asset category Equities Broad contains the asset classes equities and private equity, the asset category Real Estate resembles the asset class real estate, the asset category Nongovernment Bonds contains the asset classes investment grade credits and high yield bonds, and the asset category Government Bonds contains the asset classes government bonds, inflation-linked bonds, and emerging market debt.”

“For each asset category, we compose a total return series in US dollars. With these series, we basically cover the whole global invested market.”

Performance of the global market portfolio

“We analyze nominal, real, and excess return and risk characteristics of this global multi-asset market portfolio and the asset categories over the period 1960 to 2015.”

During our 56-year sample period, the global market portfolio delivers a compounded annual return of 8.35%. Equities Broad realizes the highest compounded annual return with 9.46%, followed by Real Estate (9.19%), Nongovernment Bonds (7.44%) and Government Bonds (6.98%). An investment in three-month Treasury bills would have returned 4.95%, while inflation has averaged 3.80% during our sample period. This implies that the equity return has been 4.51%-pts above cash, the multiplicative premium is 4.30 bps. Standard deviations for the asset categories vary from 7.1% for Government Bonds Broad to 25.8% for Real Estate.”

The Sharpe ratio of the global market portfolio is 0.69, reflecting asset class Sharp ratios of 0.85 for government bonds, 0.83 for non-government bonds, 0.56 for equity and 0.43 for real estate.

The real value of the global market portfolio grows from 100 at the end of 1959 to 1,105 at year end 2015, which implies a compounded annual return of 4.39%. Equities Broad reach a value of 1,954 (5.45%), followed by Real Estate with 1,699 (5.19%), Nongovernment Bonds with 687 (3.50%) and Government Bonds Broad with 541 (3.06%). The risk-free asset grows to 185 and delivers a compounded annual return of (1.10%).”

In the inflationary period from 1960 to 1979, the average annual real return of the global market portfolio is 2.88% (compounded this is 2.27%, not reported in table), while in the disinflationary period from 1980 to 2015 the global market portfolio has an average return of 6.24% (compounded 5.57%). So, the gap between both periods is 3.41%-pts.”

“The reward for the average investor is a compounded return of 3.25%-points above the saver’s… The figure below shows that the excess return for investors has arisen gradually during time. After this 56-year sample period, the investor achieved a 501% return compared to a saver.”

“There has not been a single decade in our sample period with a negative compounded real return for the global market portfolio, Nongovernment Bonds or Government Bonds Broad. Equities Broad ended in negative territory in the 2000-2009 period, while the same applies to Real Estate in the 1990-1999 period, as mentioned before.”

Inefficiency of the global market portfolio

“There are various reasons to believe that the global market portfolio is not an ex-ante optimal portfolio. From the asset demand side, investors might not be able to incorporate news efficiently into asset prices, leading from time to time to over- and undervaluation at the asset class level… From the asset supply side, corporate managers may time the market by issuing shares that are overvalued and repurchasing those that are undervalued.”

“The asset demand and asset supply side arguments motivate us to examine three heuristic portfolios with fixed-weights that are annually rebalanced. In other words, these portfolios correspond to time-weighted returns, as their allocation does not change over time…The first alternative portfolio is an equally weighted portfolio. For the second portfolio, we take the size of each asset category’s market capitalization into account and form portfolio weights based on its market capitalization rank… Third, we consider a 50/50 portfolio which contains 50% Equities Broad and 50% Government Bonds Broad…All three alternative portfolios result in a higher average compounded return than the return of 4.38% for the global market portfolio. The equally weighted portfolio has an average compounded real return of 4.89%, followed with 4.80% for the rank weighted portfolio and 4.65% for the 50/50 portfolio. The annual compounded return difference with the global market portfolio of at best about 0.50 pps might not be astonishing, but it is economically meaningful. During our sample period, the return relative to the return of the global market portfolio cumulates to 31% for the equal weighted portfolio, 25% for the rank weighted portfolio and 15% for the 50/50 portfolio.”