Most Popular ArticlesMerriman’s Response
Director of Research, Merriman, Inc.
August 25, 2009
The three-factor model
The fact that stock returns depend on three factors (Beta, small cap exposure and value exposure) is discussed in the research piece by Eugene Fama and Ken French which is cited in Mr. Considine’s article. 3 We choose the funds and their weights to tilt the portfolio toward value and small-cap. We purposely include an allocation to the S&P 500 to moderate the value tilt of the portfolio.
Mr. Considine casually throws out many of our funds, dramatically changing the portfolio’s size orientation and increasing its value orientation. As measured by the three-factor model, the U.S. component of Mr. Considine’s portfolio actually has a large-cap tilt, while our portfolio has a small-cap tilt.
International exposure
To quote from his article, “Emphasis on international equity exposure is necessary to protect against a weaker dollar.” If that is the case, why does he reduce international exposure from 50 percent of the equity position to 24 percent (excluding bonds and commodities)? As a comparison, U.S. equities make up 43 percent of the total world capitalization, with non-U.S. equities comprising 57 percent.
Mr. Considine is giving international equities less than half their market weight in his portfolio, with absolutely no exposure to the developed international markets, even though they make up 45 percent of the world’s equities. Why does he do this when he believes that the dollar will weaken? That amounts to a very large bet against the developed countries in the world market, which adds unnecessary risk to the portfolio.
Other issues
Time horizon
With regard to our portfolio, Mr. Considine says, “the vast majority of the performance is driven by the S&P 500.” Correlations of asset classes certainly increased during the recent financial crisis, and also may have generally gone up due to increased globalization. However, correlations, and the resulting diversification benefits, can vary over time.
As an example of this, we reviewed the rolling three-year correlations of the S&P 500 with DFA’s Large Cap Value portfolio, which has return history from March 1993. The highest correlation, at 0.98, is for the three-year period ending in July 2009, which is the time frame used in his article. The lowest correlation is 0.67 for the three-year period ending August 2001. We do not believe a portfolio should be built on only three years of data; doing so adds unnecessary risk.
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