Much has been written about the significant historical underperformance of the average retail investor. One of the most well known annual publications to document this phenomenon is the Quantitative Analysis of Investor Behavior, published annually by Dalbar. While each year the numbers may change slightly the fact remains that there is a rather large disparity between the average annual returns of retail investors and that of even the most rudimentary indices. Over a trailing 20-year period the average annual return of the average asset allocation investor is less than 3%, while over this same measurement period the S&P 500 has averaged close to 9% and the Barclays Aggregate Bond Index has averaged 6%.
To put this into perspective, this would mean that the average asset allocation investor would have seen an investment of $100,000.00 grow to become little more than $180,000.00 over this period, while an investor simply holding the Barclays Aggregate Bond Index would have seen their investment triple in size up to more than $320,000.00, and investors in the S&P 500 would quintupled their investment to more than $560,000.00.
As you might imagine, there are a number of factors impacting the retail investor that leads them to generate these lagging returns. The field of behavioral finance provides us with a number of explanations, from fear and greed, to knee-jerk reactions to market moving headlines, to the propensity for investors to chase returns. There is seemingly no shortfall for explanations, but in the end the right investment approach comes down to maintaining discipline.
In addition to discipline we believe there are a number of additional factors that should be considered: the total cost of investing, how a portfolio is constructed, and the investment process utilized. Since discipline ultimately comes down to the individual themselves, for the remainder of this article we will focus our efforts on providing the average retail investor with insights as to how one can better construct and manage an appropriate asset allocation.
The Value of Keeping Expenses Low
Beyond a lack of discipline, one of the most critical errors investors can make is utilizing investments that possess a high cost of ownership; from paying high internal costs within the investment (which investors do not see and many are painstakingly unaware exist), to paying out exceeding high costs to a financial services professional who fails to provide value added services to your specific situation, high costs as much as anything else can quickly erode the potential for meaningful returns.
In our book, Asset Rotation, we made reference to the SPIVA U.S. Scorecare Report, produced quarterly by S&P Dow Jones Indices. This "Standard & Poor's Index Versus Active" methodology is intended to provide investors with an accurate and objective apples-to-apples comparison between actively managed funds and the indexes they are benchmarked against (many of which are available to be utilized by investors in a low cost ETF structure). This is a free report and one we believe investors should pay attention to.
Much like the annual Dalbar study, the long-term results highlighted in the SPIVA U.S. Scorecard Report tend to change very little. While the numbers may vary from one quarter to the next, the reality is that long-term we see that the performance of the vast majority of active managers simply fails to outperform the index itself. At which point, in a traditional asset allocation, it makes the most sense to fulfill the allocation with low cost indices that stand a greater chance of providing superior performance.
Of course this is not to say traditional active managers will not outperform from time to time, of course they will, but we also know their outperformance is not likely to continue and we also know that investors have a tendency to buy them after they have outperformed and they are in all actuality likely to underperform. Additionally, we know there are often higher transaction costs or internal fees in these actively managed funds than there are in buying low cost ETFs (many custodians like TD Ameritrade even have a number of ETFs that you don't have to pay commissions to trade). Taking all of this into account and recognizing that cost can very quickly negatively impact returns it stands to reason that an investor wishing to construct a low cost asset allocation with ETFs stands a better chance to succeed than one who is doing so utilizing expensive mutual funds.
Surely a great many debates exist about how to construct and manage the most efficient portfolio, and we certainly have our own opinions, but the reality is that the vast majority of investors continue to ascribe to the virtues of Modern Portfolio Theory and rely on MPT based asset allocation models. Rather than provide a discussion on all of the counter arguments to this approach, in the context of this article we will simply focus on how those that employ this approach can and should do it better than they currently do. Keeping costs low should be the first objective. The next step is to put into context the correlation present among the underlying investments utilized in the asset allocation and whether these investments can be expected to provide diversification when investors need it the most.
One of the biggest mistakes we often see asset allocation investors make is to utilize investments that truly do not fulfill the desired objective. For example, in a truly diversified asset allocation the fixed income portion of the portfolio first and foremost is intended to provide relative stability versus the equity portion of the portfolio. One cannot achieve this objective when utilizing fixed income components whose performance is more akin to equity dressed in drag.
In an effort to juice up returns in a rising market and increase yield, investors will often increase their holdings in higher risk fixed income investments with lower credit ratings such as high yield bonds, or increase exposure to foreign investments such as emerging market bonds. In doing so investors take on exceptionally more risk should less than favorable equity market conditions arise. Historically, when the stock market does bad so do these sub-sectors of fixed income. While on the surface diversification may have been increased, the fundamental pretenses of building out a fixed income sleeve that will offset losses when equity markets decline has been violated. In our view, this dramatically compromises the integrity of a MPT based portfolio.
To put this into perspective, consider the long term correlations and performance among the following sub-sectors of fixed income versus the S&P 500, as illustrated over the trailing 15 year period:
- High yield: as illustrated by the Barclays High Yield Corporate TR Index
- Corporate Bonds: as illustrated by the Barclays Long US Corporate TR Index
- Emerging Market Bonds: as illustrated by the Bank of America Merrill Lynch Emerging Market Credit TR Index
- Total bond market: as illustrated by the Barclays US Aggregate Bond TR Index
- Long Term Treasuries: as illustrated by the Barclays US Treasury 20+ Year TR Index
- Intermediate Term Treasuries: as illustrated by the Barclays US Treasury 7-10 Year TR Index
- Short Term Treasuries: as illustrated by the Barclays US Treasury 1-3 Year TR Index
As you can see, over this 15 year period only laddered US Treasuries and the Barclays Aggregate Bond Index demonstrated a negative correlation to the S&P 500. These four indices also demonstrated a negative beta versus the all equity benchmark. However, the higher risk bond indices over this period demonstrated a much higher correlation to stocks as a whole, as the Barclays High Yield Corporate TR Index generated returns that were 66% correlated to the S&P 500, while the Bank of America Merrill Lynch Emerging Credit TR Index produced a 53% correlation.
When correlations are relatively high to equities, one might expect that when the equity markets are under duress, as they were in the Great Recession of 2008, that these securities may be more likely to behave more like a stock than they would the US Treasury Bond.
While we don't propose 2008 to be a normalized environment by any stretch of the imagination, our point remains the same. Within the fixed income markets the US Treasury Bond has always served as a flight to safety that would produce a relative margin of capital preservation when stock markets have come under prolonged duress. We don't expect this will change, even in a potentially rising interest rate environment.
Taking correlations and historical relationships between subsets of fixed income in stock market declines into account, as well as the intended purpose of the fixed income portion of a traditionally allocated portfolio, we believe investors constructing these MPT based asset allocation portfolios should simply fulfill their fixed income allocations with the Barclays Aggregate Bond Index and laddered maturities of Treasuries rather than chase higher risk classes of fixed income whose performance behaves much more like stocks. In doing so one can build a more efficient MPT based asset allocation and reduce overall portfolio risk.
In order to illustrate this point we have provided our readers with the results of two very rudimentary asset allocation portfolios comprised of ETFs. Both portfolios possess a 50% exposure to global equities, and 50% to fixed income. The only difference between the portfolios is the fixed income sleeve, at that only 37.5% of the total portfolio.
MPT Portfolio #1:
- 37.5% Vanguard Total Stock Market ETF (TICKER: VTI)
- 12.5% Vanguard FTSE All World Ex US ETF (TICKER: VEU)
- 12.5% Vanguard Total Bond Market ETF (TICKER: BND)
- 12.5% iShares 20+ Year Treasury ETF (TICKER: TLT)
- 12.5% iShares 7-10 Year Treasury ETF (TICKER: IEF)
- 12.5% iShares 3-7 Year Treasury ETF (TICKER: IEI)
MPT Portfolio #2:
- 37.5% Vanguard Total Stock Market ETF
- 12.5% Vanguard FTSE All World Ex US ETF
- 12.5% Vanguard Total Bond Market ETF
- 12.5% iShares iBoxx Investment Grade Corporate Bond ETF (TICKER: LQD)
- 12.5% iShares iBoxx High Yield Corporate Bond ETF (TICKER: HYG)
- 12.5% iShares JP Morgan USD Emerging Market Bond ETF (TICKER: EMB)
As we look at the differences between these two basic asset allocation portfolios what should immediately stand out is the relatively profound differences in the risk/reward attributes of the overall portfolios, despite both allocations maintaining the same 50/50 ratio of stocks to bonds:
- The standard deviation on MPT Portfolio #1 is 27% less than MPT Portfolio #2.
- The beta on MPT Portfolio #1 is 33% less than MPT Portfolio #2.
- The alpha is 138% higher for MPT Portfolio #1 than MPT Portfolio #2.
- The Sharpe ratio of MPT Portfolio #1 is 45% higher than MPT Portfolio #2.
- The max drawdown of MPT Portfolio #1 is 32% lower than MPT Portfolio #2.
- In a more difficult market environments for stocks, MPT Portfolio #1 took on far less downside risk than MPT Portfolio #2; as highlighted by a 2008 portfolio return of -10.6% versus -23.8%.
Of course not only did MPT Portfolio #1 outperform on a risk/reward basis, but it also would have provided investors with superior average annual returns of 7.25%, versus 6.54%. It should further be noted that these returns are net of the internal expenses of the ETFs utilized in the portfolio (which in this case are extremely low), whereas the returns of the benchmark S&P 500 Index reflect the index itself and not an ETF representative of the index (which would take into account internal expenses of the fund and thus very slightly underperform the S&P 500 Index itself).
A Process for Determining Asset Weightings
The basic MPT portfolios outlined above were intended simply to illustrate how utilizing lesser correlated fixed income investments (ideally inversely correlated to stocks) can significantly reduce the overall risk of the portfolio. However, suffice it to say these allocations are very basic and do not illustrate any strategic weightings into more opportunistic asset classes. For example, rather than equally weight each of the laddered Treasury maturities one could over/underweight each respective maturity taking into consideration our current stage in the interest rate cycle and likely outcomes (this is far more difficult than one might imagine and should not be attempted by the novice investor).
More commonly we see institutions taking a strategic approach to size and style asset class weightings and geographic exposure. Making the appropriate strategic over/underweighting can provide additional benefits to portfolio performance by reducing exposure to what is most expensive and increasing exposure to what is cheap. We refer to this practice as mean reversion and it is quite commonly used in institutional approaches to asset allocation. The question is how is a retail investor supposed to know how to do this with any reasonable confidence? The answer is far easier than one might imagine.
Let's start with some basic assumptions. For illustrative purposes we will focus our efforts on some very simple traditional asset allocations: a growth approach consisting of 80% stocks / 20% bonds; a growth & income portfolio consisting of 60% stocks / 40% bonds, and an income & growth portfolio consisting of 40% stocks / 60% bonds.
For simplicity, let's just say that the fixed income portion in each portfolio will remain as illustrated in our portfolios above: 25% in the Barclays Aggregate Bond Index, and the remaining portion of the fixed income equally weighted in laddered maturities of Treasury ETFs. For our equity exposure, let's assume a 75% weighting in domestic equities and 25% in a combination of developed international and emerging markets. Therefore, our various MPT based traditional asset allocation portfolios should look like this:
- Growth: 60% US equity, 20% international equity, 20% fixed income
- Growth & Income: 45% US equity, 15% international equity, and 40% fixed income
- Income & Growth: 30% US equity, 10% international equity, and 60% fixed income
Our next question then becomes within our domestic and international equity holdings, how much do we weight each respective capitalization and style (large cap/mid/small as well as growth/value), and how much weighting do we place on each respective international demographic (developed/emerging markets)? To answer this question in depth might very well take another article of equal length, so let's just keep this point simple: within domestic equities large cap should generally represent the largest percentage weighting, followed by mid cap, and then small cap; within the international space developed international tends to have a greater weighting than emerging markets. Taking into account these basic tenets, one should develop a baseline allocation in which there is no difference in the weightings between growth and value, only a difference by capitalization. One can also generally place 2/3 of the international weighting in developed international equities and 1/3 into emerging market equities. The next step then is to determine strategic over/underweightings around this base allocation.
We have made reference to this free publication in previous articles we have had published, but we strongly feel the easiest way for the majority of retail investors to determine their strategic weightings is by using the JP Morgan Guide to the Markets quarterly report as a guidepost.
For example, on slide 8 of the Q1 2015 JP Morgan Guide to the Markets, on the right hand side of the slide they illustrate the current valuations of domestic equities by size and style. Using current P/E as a percentage of 20-year average P/E one can clearly see growth is currently trading at a significant discount to value, with large cap growth being the cheapest. Such valuations for those employing a mean reversion approach would lead one to slightly underweight value and overweight growth for each respective capitalization. Year to date through March 31, 2015 this would have paid off handsomely as growth has significantly outperformed value.
On slide 52 we can see the current valuations of the largest developed markets in the world and where they are trading relative to historical levels. From this slide one can clearly see that the US is currently trading well above historical norms, though developed international markets as measured by the MSCI EAFE index are not that far behind from a valuation standpoint. Nonetheless, such an observation would lead an asset allocator to modestly reduce baseline exposure to US equities and slightly increase exposure to the EAFE.
On slide 53 we see the current valuations for emerging market equities. What stands out to us as much as anything else is that emerging markets (as measured by the EM Index) are currently trading at levels that are relatively significantly cheaper than both domestic and developed international equities (as illustrated on slide 52). Therefore, a strategic asset allocator would modestly overweight emerging markets relative to their baseline asset allocation. After seven years of generating a negative cumulative return versus the S&P 500 being up over 155%, it should be noted that year to date through April 17, 2015 the MSCI Emerging Market Index is up nearly 9.5%, while the more "expensive" S&P 500 is up only 1.67%.
The bottom line after reading all of this is that the average asset allocation investor has historically rather significantly underperformed rudimentary benchmarks, but they don't have to. By keeping costs low, constructing a portfolio of diversified asset classes that truly have low correlations to each other, and understanding a basic process for determining strategic under/overweighting of asset classes retail investors can very easily generate returns in-line with institutional asset allocators. Beyond that, all one really needs is just the discipline to stay committed; discipline which from our perspective is far more likely when investors have a greater understanding of the landscape and for the reasons behind the efficacy of the process.
Disclosure: The author is long TLT, IEF.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.