Ditch The Nonsense, Build A Portfolio Like An Expert

Includes: EFV, PRF, PXF, VB, VSS, VTV, VWO
by: Efficient Alpha

By Peter Pearce

Take a long hard look at your portfolio and ask yourself if you have a coherent strategy based on research or have you picked a bunch of stocks you’re hoping will perform? Many people focus too heavily on the wrong stuff without getting the portfolio fundamentals right, so empty your head of all that nonsense and let’s fill it with some real finance.

A study by Brinson, Hood and Beebower found that in 91 of the largest U.S. pension funds, on average 93.6% of the variation in returns could be explained by the asset allocation. This leaves about 6% for both market timing and individual stock selection. Despite this, millions of investors, looking to improve their returns but not having a clue as to how to do it, turn on their TV’s and flick on their favourite business program. They listen to “insiders” try to time the market and pick stocks. One after another, these “insiders” smile into the camera and explain what “they like” and what they think the market will do next, generously sharing their knowledge and predictions with millions of complete strangers.

I’m going to let you in on a little secret: if I knew for certain what the market was going to do tomorrow, next week, or even next year, I wouldn’t write an article about it and I definitely wouldn’t go on TV and share it with a few million people. Instead, I’d mortgage everything I owned, buy options and sail into the sunset!

These shows avoid any discussion of academic research done in the last 60 years and pretend that markets are so inefficient that the information they’re giving you hasn’t already been priced in. You’ll never hear any mention of Modern Portfolio Theory, let alone that Efficiency Theorem heresy! Success isn’t measured on the validity of the investment advice but instead on the ratings, and they don’t want to screw anything up with boring and complicated discussions of how markets really work.

These shows are just a hair short of being total wastes of time. Everyone is entitled to their prediction, but it’s totally nuts to believe that these guys would share for free precious research about what the market was going to do. The reality is that these shows are the ultimate public relations platform and an interview on one of these shows validates the “insider” as an expert player in the business. Careers are made in minutes, so it’s not the time to be prudent or wishy-washy about an answer.

You will have to take responsibility for your own financial education. If millions didn’t seriously believe that this stuff will help them build and manage a superior portfolio, then it would be quite funny, but it’s really truly terrible for their financial health.

So let’s dive into some basic portfolio theory that your Financial Advisor knows and you should too. We start with Modern Portfolio Theory (MPT) which is our foundation. It was built on the observation by Harry Markowitz in 1952 that risk at the portfolio level can be reduced below its component averages by combining risky assets which do not move in lockstep as the market goes through its cycle (ie. diversification). He was awarded a Nobel Prize in Economics for it. Without getting into the nitty gritty mathematics, MPT concluded that the optimal portfolio would be a combination of a risk-free asset (Government bonds) and the entire world “market”. MPT has many limiting assumptions, but for all of its limitations, it still offers one of the strongest tools available to the rational investor. For a more complete explanation of MPT, I’d recommend going to the source and reading Markowitz’s "Portfolio Selection."

Fast forward about 30 years to 1986 and out comes the Brinson, Hood and Beebower landmark study which used quite simple but powerful reasoning: only four elements contribute to results: asset allocation, individual security selection, market timing and costs. They found that they we’re able to explain 93.6% of the Pension Funds’ returns based solely on knowing its asset allocation! That’s quite a remarkable conclusion, the biggest single factor explaining performance was how much a fund should hold in stocks, bonds or cash. The study concluded by showing that actively managing the portfolio actually cost the funds 1.1% per year on average when compared to just holding the appropriate indexes! This fact has been demonstrated a number of times through various research, most recently in a study by Morningstar. The graph below is taken from the book, "The Power of Passive Investing," by Richard Ferri, and highlights this same fact (2/3 of mutual funds do not beat the Vanguard 500).

(Click to enlarge)

I do not intend to dissuade you from actively managing a small part of your portfolio, and there is a theory that advocates exactly this called the Treynor-Black model. However make sure the fundamentals of your portfolio are sound and you have a proper asset allocation for your desired level of risk before you start stock picking.

A quick note on terminology: High book-to-market (BTM) firms (ie. value stocks) tend to have low P/E’s, low return on equity, low return on assets, slow growth and other discouraging financial results. Even though they have large assets, the market has driven down the price of their stock because they are troubled. Low BTM firms (ie. growth stocks) are the opposite, high growth, high P/E firms that generally have low dividends because they re-invest profits into their many investment opportunities.

Now we jump ahead another decade to 1992 and University of Chicago professors Eugene Fama and Kenneth French publish a study that has two stunning conclusions. First, it finds that small capitalization stocks had much higher rates of return than larger-capitalization stock but also had much higher risk, measured by standard deviation. They also found that high BTM (ie. value stocks) firms had higher rates of return than low-BTM stocks (ie. growth stocks) without any higher risk! One of the implications of the original MPT was that the optimal portfolio, which generated the most return per unit of risk, was a combination of the entire market and a risk free asset. The Fama-French research showed that investors could do considerably better than the market by more heavily weighting their portfolio with value and small cap stocks. I wrote an article last week on a portfolio strategy based on the Fama-French research.

A very rough explanation goes like this: When you run a large company and issue bonds, you generally have to pay a lower interest rate than a small company because of the lower risk you offer. Inversely, if you issue stock, you command a higher price in the market than a small company because of the increased liquidity and lowered risk. In the same manner, well-run firms have a lower interest rates and higher stock prices than poorly run or distressed firms. High cost of capital for small cap and value stocks means depressed stock prices and translates into higher expected returns. Their June 1992 article The Cross-Section of Expected Stock Returns, published in the Journal of Finance is available here (pdf).

I admit, it’s difficult to get excited about an investment strategy that advocates buying sick and small companies and it’s hard to imagine generating a lot of envy as you describe your portfolio of downtrodden losers. However, the returns generated by a portfolio diversified by distressed and small cap firms will more than make up for the lack of glamour.

So, according to these three studies, our optimal portfolio should be globally diversified and weighted more heavily towards small-cap and value companies. So let’s draw up an example portfolio allocation. Note: This portfolio is a very slightly modified version of the one presented in my earlier article, I’ve simply changed some of the weights. As usual, change the weighting of Equity vs. Fixed Income to reflect your desired level of risk.

  • Domestic Large-cap Equity: 7.5% Claymore Canadian Fundamental [TSE:CRQ]
  • Domestic Small-cap Equity: 7.5% iShares Small Cap [TSE:XCS]
  • U.S. Large-cap Equity: 7.5% PowerShares FTSE RAFI US 1000 (PRF)
  • U.S. Value Equity: 7.5% Vanguard Value (VTV)
  • U.S. Small-cap Equity: 7.5% Vanguard Small-cap (VB)
  • International Large-cap Equity: 7.5% PowerShares FTSE RAFI ex-US (PXF)
  • International Value Equity: 7.5% iShares MSCI EAFE Value (EFV)
  • International Small-cap Equity: 7.5% Vanguard World ex-US Small-cap (VSS)
  • Global Real Estate: 5.0% Claymore Global Real Estate (NYSEMKT:CGR)
  • Emerging Markets Equity: 5.0% Vanguard Emerging Markets (NYSEARCA:VWO)
  • Short Term Bonds: 30.0% Claymore 1-5yr Laddered Gov't [TSE:CLF]

This portfolio should out-perform the S&P 500 while taking less risk. We built this by making no forecasts, selecting no individual stocks, and not attempting to time the markets. We’re not picking the “best” asset class or trading frantically, but simply combining a number of attractive asset classes together in a way that makes sense.

This portfolio is just an example, but builds on some real financial research so you won’t have to watch the markets 24 hours a day and can leave your phone in the cart while you’re out playing golf.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.