Immediate Ways To Improve Your Investment Portfolio

2014-05-22

 

by Eric D. Nelson, CFA

Follow us @ServoWealth

 

In the course of meeting with potential clients, we often come across investment portfolios that are ill suited to achieve the individual or family’s goals.  Many accounts are littered with a random amalgamation of individual stocks or high-cost actively managed funds that were bought (or sold to them) based on past performance.  Others are mostly concentrated in basic index funds like the S&P 500 or Total Stock Indexes which are heavily focused on the biggest blue-chip companies.  

 

Even before we are hired and set about creating a customized asset allocation that is designed to achieve their unique objectives, we are able to illustrate a few simple and immediate ways these folks can improve their portfolios.  Here we will focus our attention on the US-stock segment of their allocations:

 

STEP 1: Diversify Across Large and Small Stocks

 

Currently, Total Stock Indexes have around 90% in large and medium-sized stocks, with only about 10% in small cap stocks, so they are anything but “total.”  Small cap stocks not only have had higher historical, as well as future-expected returns, but they’ve also provided helpful diversification as large and small companies don’t always move in unison.  Table 1 below shows that, from 1975-2013, splitting the US-stock allocation of a diversified portfolio 60% into large cap stocks and 40% into small cap stocks and rebalancing annually has resulted in over 1% per year higher returns when compared to a traditional index fund, with only a slight increase in volatility.  This return also came without much “tracking error” relative to the market’s return, meaning its outperformance didn’t result in significant short-term differences in return compared to the market index (i.e. the two portfolios tracked each other fairly closely).

 

STEP 2: Separate Stocks By Value and Profitability

 

Total Stock Indexes, as well as standard large cap or small cap indexes (to a lesser extent) weight stocks based on their price and therefore tend to overweight the companies that have had the highest recent returns and by extension the lowest future-expected returns.  This would be fine, except that most of these “cap-weighted”  indexes are underrepresented in the lowest-priced value stocks as well as the most-profitable growth stocks, which both have higher-than-market expected returns.  What’s more, these opposite sides of the market (value and growth) also tend to move up and down at different periods of time.  Further splitting our 60/40 portfolio above into equal halves “low-priced value” and “highly-profitable growth” indexes and rebalancing annually, the "Diversified Asset Class Index" in Table 1 has increased historical returns by almost 4% per year over the market with slightly less volatility than the simple large cap/small cap index mix.  What’s more, there was hardly any additional market “tracking error” for this portfolio compared to the simple large/small index, and it resulted in the highest “tracking error premium.”

 

STEP 3: Consider An All-Value Approach If You Dare

 

While both low-priced value stocks and highly-profitable growth stocks have historically generated higher-than-market returns, the clear winner over the last four decades between the two has been value.  And the smaller the value stocks the better.  So for investors with a strong stomach and tolerance for a portfolio that looks very different from the market in terms of return and risk over the short run, flipping the large/small split to 40/60 and using only value-stock asset classes for both has added another 2% in returns over the more diversified asset class index when rebalanced annually.  As we’d expect when we decrease diversification (by eliminating the growth asset classes), the volatility of the "All-Value Asset Class Index" goes up as well by almost 3%, a significant jump when compared to the leap from the US Total Stock Index to the Diversified Asset Class Index.

 

And volatility alone doesn’t tell the whole story here.  Despite considerable long-term historical outperformance, during the short-term periods from 1984-1990, 1995-1999, and 2007-2008, the all-value mix underperformed the market by -3.1%, -7.3%, and -8% per year!  Of course, the diversified asset class mix also trailed the market, but by a much more palatable -1.8%, -4%, and -2.6% per year.  This is “tracking error” on display, of which the all-value approach had twice the amount of the more diversified asset class portfolio and is therefore less “efficient” when looked at in terms of how much excess market return you've earned versus how different the performance has been compared to the market return.

 

TABLE 1: Historical Risk and Return of Various Index Portfolios (1975-2013*)

 INDEX PORTFOLIO

Annualized Return

Standard Deviation

Improvement Over The Index

“Tracking Error” Premium**

US “Total” Stock Index

+12.5%

17.3

 

0.00

Large & Small Stock Index

+13.8%

18.3

+1.3%

0.32

Diversified Asset Class Index

+15.8%

18.1

+3.3%

0.52

All-Value Asset Class Index

+18.0%

20.7

+5.5%

0.43

*1975 is the inception of the DFA US large and small growth indexes.  1975 coincides with the first year of a bull market after the significant 1973-1974 downturn, and also represents a period of above-average inflation - all of which result in 3-5% per year higher-absolute returns for each index mix relative to what we might expect going forward.  Relative differences will likely be smaller as well, but the direction of the return differences are expected to persist.

**I made up this term, it’s actually called the information ratio but I like my description better - it measures the amount of annual outperformance over the market compared to how different the portfolio has behaved (“tracked”) the market index

 

Highly-respected financial theory such as the work from Eugene Fama and Ken French, and well-managed asset class mutual funds including those from Dimensional Fund Advisors (whose funds are based on the indexes we’ve used above) provide us with the knowledge and tools to design investment portfolios with superior risk-adjusted returns compared to traditional investment approaches and basic indexes.  That much is clear from our simple examples above. 

 

Which approach will make the most sense for each investor?  That, on the other hand, is based on their unique financial situations and how well they might be able to tolerate periods when their portfolios look different from the overall market.  Understanding where each client falls on this spectrum is one of the most important jobs of an investment advisor and can only be determined after extensive conversations, pointed questions, a thorough review of the long-term investment evidence, as well as an understanding of their past-portfolio decisions.  It’s a time-consuming process and requires a significant amount of advisor experience, but the client’s time and effort is well-rewarded with immediate ways to improve their investment portfolios.

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Source of data: DFA Returns 2.0

 

US Total Stock Index = CRSP 1-10 Index

Large & Small Stock Index = 60% S&P 500 Index, 40% CRSP 6-10 Index, rebalanced annually.

Diversified Asset Class Index = 30% DFA US Large Growth Index, 30% DFA US Large Value Index, 20% DFA US Small Growth Index, 20% DFA US Small Value Index, rebalanced annually.

All-Value Asset Class Index = 40% DFA US Large Value Index, 60% DFA US Small Value Index, rebalanced annually.

 

Past performance is not a guarantee of future results.  You cannot invest directly in an index.  There are limitations inherent in model index performance; it does not reflect trading in actual accounts and may not reflect the impact that economic and market factors may have had on an advisor’s decision-making if the advisor were managing actual client money.  Model performance is hypothetical and is for illustrative purposes only.  Model performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted.  This content is provided for informational purposes and  is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.