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Evidence-Based Investing: Learning From The Industry Leaders

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Includes: AGG, BBJP, BND, EPOL, EWL, EWN, EWP, EWU, FLAU, FLCA, FLFR, FLGR, FLIY, FLKR, FLLA, FLTW, FRN, IDX, IEFA, IEMG, IJH, INDA, IVV, QQQ, SPY, THD, VEA, VOO, VTI, VWO
by: ESI Analytics Limited
Summary

Evidence-Based Investing has been increasingly adopted by some of the industry leaders during the past decade.

Retail investors can benefit from evidence-based knowledge and apply it to their portfolio.

Long-term research reveals the risk/reward benefits of a globally diversified portfolio.

Nowadays, retail investors have access to low-cost wealth building portfolios that are robust to large-scale global events.

Introduction

Most have probably never heard of evidence-based investing. It describes the practical application of objective research performed and challenged by academic experts who have no conflict of interest regarding their results. Evidence-based practice has gained much more traction in the field of medicine. The British Medical Journal voted evidence-based medicine among the top 10 medical advances since 1840. It ranks amidst sanitation, antibiotics, vaccines, and medical imaging to give a sense what kind of importance medics assign to it. Most recently, the evidence-based practice found its way into the asset management industry. Nonetheless, the concept is not widespread and predominately applied by some of the industry leaders. Among them is the Government Pension Fund of Norway, which is the largest sovereign wealth fund in the world. Other industry leaders such as Bridgewater Associates, LP and Research Affiliates, LLC are also some well-known examples who rely to a significant extent on evidence-based decision making. We are going to explain what industry leaders do and how a retail investor can benefit from their knowledge.

An Evidence-Based Equity & Bond Portfolio

There are quite a few long-term studies on international equities that arrive at similar conclusions. An important finding is that equities yielded on average roughly 8-9% p.a. over a long-term time frame. This implies that global equity investors doubled their money approximately every 8-9 years over the past century. Moreover, researchers noted that equities protected against inflation in the medium- to long-run. International datasets show that the conclusion above held generally as results were similar across countries. If you would like to dig deeper into this subject and learn more, an excellent place to start are the following academic papers:

  • Dimson, Elroy and Marsh, Paul and Staunton, Mike, Equity Premia Around the World (October 7, 2011)
  • Arnott, Robert D. and Bernstein, Peter L., What Risk Premium is 'Normal'? (January 10, 2002). Financial Analysts Journal, Vol. 58, No. 2, March/April 2002, pp. 64-85
  • Ibbotson, Roger G. and Chen, Peng, Stock Market Returns in the Long Run: Participating in the Real Economy (March 2002). Yale ICF Working Paper No. 00-44
  • Shiller, Robert J. (2000). Irrational Exuberance. Princeton University Press. ISBN 1400824362

Most readers here on Seeking Alpha are probably aware that U.S. American equities performed well throughout history, but it may be new that most overseas markets performed similarly well. However, evidence from financial data also reveals some devastating episodes that equity investors experienced during the past couple of centuries. The most famous three are probably:

  • Nationalization of Eastern Bloc countries and China resulted in a total equity loss, which never recovered.
  • Austrian "Gründerkrach of 1873" led to a 99% loss, which most equity investors never recovered.
  • German equities lost 99% of their value during WWI and the subsequent hyperinflation, which took almost 50 years to recover.

The three examples above are admittedly extreme, but there have been more than two handfuls of other dramatic events during the past couple of decades. Those recorded broad-based losses of more than 75% in equity capital. Moreover, investors that were affected by such events frequently took more than 20 years to recover their capital to pre-crisis levels. The incidents happened throughout the world and Western economies were mostly affected during the Great Depression around 1929-1932. Secular bear markets are certainly not something that belongs inside dusty history books because they are an artifact of the past. They can happen today as well, and the financial crisis in 2007-2009 is the most recent example that recorded broad-based declines of close to 60% in U.S. equities. Another recent example is Japan, which currently ranks as the third-largest economy in the world. Japanese equity investors have not recovered their losses until today if they invested around the all-time high in 1989. Similarly, those who invested in European blue-chips have been trapped in a secular sideways correction and lost money in real terms (inflation-adjusted) since early 2000. The key takeaway from long-term financial datasets is that equities are not only rewarding but also risky during specific periods. Those periods can last multiple decades and not everybody can afford to sit through such large drawdowns. The good news is that research unveils some possibilities to mitigate the risk of getting caught in a secular meltdown.

Long-Term Equity Performance

(Source: Bridgewater Associates, LP)

An evidence-based approach shows the benefits of geographic equity diversification. A basket of 12-20 global equity indices will mitigate extreme events and reduce volatility. The chart above illustrates the benefits of global equity diversification and shows an equally-weighted portfolio, which is rebalanced annually. The most interesting detail is that the basket performed on par with the U.S. market even though it included Russian and German equities. Russian equities resulted in a total loss, and German equities lost 99% of their value as already discussed above. Both events derailed the globally diversified portfolio for a few years only but had no material impact over the medium to long term. Therefore, it is not surprising that globally diversified equity investments are best-practice among industry leaders. It is a core principle of building and maintaining wealth long term. Yet, the vast majority of retail portfolios are geographically concentrated, which is well-known as the home bias puzzle.

Home bias is suboptimal from a long-run investing perspective. Advisors and retail investors can implement a best-in-class portfolio diversification at low cost. Regulated ETFs track broad-based equity indices of the 20 largest economies at a low cost. Adding them to any retail portfolio is simple and does not involve much more time apart from setting the portfolio up and rebalancing it annually in roughly equal weights. The following tickers are examples of equity index ETFs that track more than 20 equity indices from all over the world. Non-democratic countries are omitted or underweighted.

VTI, BBJP, FLGR, FLIN, EWU, FLFR, FLIY, EWN, GFX, EWP, EWL, EPOL, FLAU, FLLA, FLCA, FLKR, FLTW, IDX, THD, and FRN.

An equally weighted portfolio that consisted of these or similar exchange-traded funds had some attractive characteristics. It roughly doubled the invested money every nine years over the past few decades. Moreover, the aggregate portfolio protected to some extent against extreme events and decades of country-specific stagnation. Capturing these positive characteristics did not require any forecasting of crises as long as the portfolio was rebalanced roughly to equal weights annually. Nonetheless, long-term evidence shows that even a globally diversified portfolio remains vulnerable to particular events - global financial crises. These occurred significantly less often than regional crises but had a large impact on portfolios that consisted of equities only regardless of international diversification. Fortunately, there are few methods to mitigate the risk of global turmoil. Fixed-income securities are the cheapest and most liquid risk mitigators.

Not surprisingly, the evidence-based approach leads to the traditional mix between bonds and stocks. The addition of bonds stabilizes portfolios at the cost of some performance. Nevertheless, the benefits from adding bonds, such as capital preservation and a quicker recovery from global financial crises, outweighed foregone profits. International short-term bonds yielded approximately 4-5% p.a. less than equities over the past decade.

Similar principles that apply to equities are also valid for building a bond portfolio and global diversification is among them. Long-term evidence shows that governments with fiscal surpluses, low debt levels, long-term borrowing, and few hidden off-balance items were typically not associated with debt-related problems. Instead, their debt securities were often perceived as a safe haven and increased in value during financial crises. Therefore, it is crucial to screen for financially sound borrowers if they are intended for portfolio stabilization. The following sovereign and corporates borrowers are some examples, which fulfill most attributes today that prevented debt-related problems historically:

Netherlands, Slovakia, Australia, Poland, South Korea, Sweden, Finland, Norway, Czech Republic, Denmark, New Zealand, Taiwan, US, Singapore, Cisco, Toyota, Total, Samsung, BP, and Johnson & Johnson.

Some sophisticated industry leaders get a sense for the risk that they are taking by stressing their portfolio to extreme events, which occurred in the past. The table below shows an approximation of what would have happened to the global portfolios discussed above during the two most severe global events of the past century. For simplicity, we assume that the bonds have a short duration and were held to maturity. The stress test shows that a portfolio consisting of global stocks and bonds would have recovered a maximum loss of 40% during the Great Depression within 7.5 years. Roughly 5.5 years would have taken to recover a loss during the Global Financial Crisis in 2007 to pre-crisis levels. The benefits of a portfolio mix between stocks and bonds become quickly apparent as the mixed asset-class portfolio not only experiences smaller losses. Most importantly, it also recovers faster and preserved liquidity to maneuver through difficult times. Admittedly, this method of risk mitigation costs performance but it also adds significant benefits. After all, the benefits most likely overweight. A globally diversified 60/40 stocks and bonds portfolio that had annual equity component rebalancing roughly doubled every eleven years over the past decade. The main conclusion from that is that it is not only rewarding but also robust to large-scale crises.

Scenario Analysis

(Source: Author)

Conclusion

Historical evidence shows that investing was rewarding over the past century. The results discussed here convey a realistic picture of risk/return expectations as the global economy continues to grow. A global investment portfolio will benefit from growth and mitigate regional effects. Most importantly, it reduces risk from large-scale global crises. Nowadays, retail investors have low-cost access to investing and international diversification. Therefore, a globally diversified low-cost portfolio is the relevant reference for long-term investors instead of benchmarking against a single country index.

Some of the industry leaders build on the blueprint discussed here and optimize their portfolio with some additional factors. We will do a follow-up to this article and elaborate on long-term evidence regarding potential improvements of including further asset classes such as real estate, commodities, and alternative assets to the 60/40 portfolio.

Disclosure: I am/we are short EXPOSURE ON GLOBAL EQUITY INDICES. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.