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Engineering Your Portfolio For Better Returns

By: Frank Armstrong

It’s child’s play to beat the market over time, especially if you think the market is the S&P 500 or the Dow. Achieving above global market returns has nothing to do with luck, skill or paying some “guru” Wall Street analyst. It has everything to do with portfolio engineering! In other words, a properly structured totally passive investment strategy can be expected to reliably outperform broad market indexes by a comfortable margin over time.

Successful portfolios are based on research and reasonable expectations, not intuition. Illogical investors attempt to guess which manager, stock or asset class will have tomorrow’s best performance. That’s why so many have consistently failed. Successful, rational investors excel because of a clear methodology and, of course, discipline. Remember that no strategy wins every day, month, year or decade. But over time we expect to win far more than lose, and cumulatively we expect to win big. So, you will need discipline during those times when the strategy underperforms, and chasing last year’s results is a sure path to poverty.

Risk and reward are related. An investor must be induced with investment return in order to give up a risk free alternative like the Treasury Bill. The same holds true for small company stock. Wouldn’t you demand a greater return to buy a fledgling, unknown company instead of Exxon, Apple AAPL +0.15%, Google GOOG -0.23% or Microsoft MSFT -0.83%? It’s a no-brainer. There’s more risk involved in the transaction, so you should demand to get paid more, right?

Investing in the equity markets can be a risky proposition. For decades, investors believed that relative volatility (Beta) explained most of a portfolio’s return. As we discussed in the related article, “The Fama-French Three Factor Model” market volatility along with two other key risk factors better explains performance, and it provides a guide for beating the world market index.

All we need to do is engineer or “tilt” the portfolio in a systematic way to overweight small and value companies. Let’s look at the longest most reliable data set we have for our domestic markets, the Center for Research in Security Prices (CRSP). They have every traded stock since 1926, with daily prices, splits, dividends and mergers accounted for. These are pure index returns with not costs or other frictions accounted for, and of course, you couldn’t have bought these indexes since they didn’t even exist then and there were no funds to track them. 

 Of course, we are looking at a very long time frame. But, if we were to slice our time frames up into 10 or 20 year rolling periods we would see that a small value tilt dominates the vast majority of times.

In finance we call the differences in observed and expected returns risk premiums. Investors demand higher returns or premiums for perceived risks. The pricing mechanism insures that they get it by lowering the price of assets until they provide the expected return looking forward. So, stocks have higher returns than bonds, small stocks have higher returns than large, and value stocks have higher returns than growth because investors sort out the perceived risks and price assets accordingly.

Risk and return are related and if you will look at the above table you can see that both rates of return and standard deviation rise together which is exactly what we should expect. 

 

While most investors might not be comfortable with the volatility (risk) in an all small value company portfolio, it’s pretty easy to capture some of this additional return without driving the risk in the portfolio significantly higher than the S& P 500 by diversifying into other asset classes with low correlations (Modern Portfolio Theory or MPT). But, MPT is a discussion for another day.

While portfolios with exposure to small and value may have different risks than the market as a whole, they are not necessarily higher. But those risks show up on different days. Small and value occasionally have significant underperformance for extended time periods. And, it’s not possible to tell in advance when those periods might occur. For instance, results were under expectations during 1997 to 2000 when investors somehow convinced themselves that tech stocks and the S&P 500 could only go up. And during the flight to quality in 2008-2009 investors dumped small and value.

The bottom line is that it’s not a free lunch, and your portfolio will not track the broader market. That means sometimes you will make less or have bigger losses than your friends investing solely in the S&P 500, and other days you will make more. That’s OK, because over the longer haul it’s the dominant portfolio.

Deciding on the degree that your portfolio should participate in the three risk factors is the challenge for the investor. Tilting toward small and value will help you reach above global market returns, but portfolio risk must be tempered by adding other assets with low correlations (for example: Bonds, International, International Small, and International Small Value).

So, what have you learned? A little strategic planning goes a long way. Remember, designing a portfolio that favors small and value companies over pure market risk should deliver higher expected returns over extended periods of time. These benefits can be reliably captured by passive strategies (like index funds) that do not rely on either individual stock selection or market timing. As an example, the simplest possible solution to tilt a domestic portfolio towards small and value would be to divide it into 50% total market index, 25% small company index, and 25% value index. By varying the mix of these three assets, you control (increase) the expected return and the amount that your portfolio might vary from the total market.

You can do the same thing with foreign developed markets and emerging markets.

This is not magic. We are just systematically overweighting the parts of the market with the highest expected returns

As part of their strategic asset allocation strategy, investors can engineer portfolios that deliver above global market index returns by designing a strategic portfolio tilt. These returns plot comfortably above the market line, shouldn’t you be there too?

*Large companies are equivalent to the size of the top half of all companies listed on the New York Stock Exchange

**The total market includes small companies, so the average size is somewhat smaller

***Large Value Companies are the 30% of large companies sorted by the highest Book to Market weight. Book to Market is adjusted Book Value divided by Stock Price, a very reliable way to sort value.

**** Small Companies are equivalent to the size of the bottom half of all companies traded on the New York Stock Exchange. The dollar value of these companies is very small compared to the larger companies.

*****Small Value Companies are the 30% of small companies sorted by the highest Book to Market value.