The Professor's Portfolio
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“We are not in Kansas anymore….”
“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Keynes.
After a rather abrupt landing in Oz, Dorothy said to her dog Toto, “I have a feeling we are not in Kansas anymore, we must be somewhere over the rainbow.
Given the outperformance of U.S. stocks (Kansas) since 2008, the preponderance of media coverage has been about a binary choice – U.S. stocks or U.S. bonds. The rest of the world is often ignored. There is a good chance that the old multi choice, “rainbow” colored quilt charts will make a comeback as the single-country focus may become costly. Diversification will no longer be synonymous with poor performance. Home country bias will surrender ink to the “free lunch” associated with the quilt. More and more articles will surface touting the benefits of good old modern portfolio theory(MPT). Client expectations will follow.
First a “free lunch” refresher from Investopedia:
Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.
Investing in a variety of countries collectively should have less risk than a single economy. While a strong dollar can negatively impact all international equities, this volatility concern often provides the rationale for significantly overweighting U.S. assets despite comparably lower forecasted returns on our shores today.
A point so often forgotten about diversification is that there will always be asset classes within the mix that outperform the group. The most widely covered asset class – the S&P 500 Index – has beaten the group for an unusually long period; along the way, “diversification” became defined as deviating from the S&P.
The media, keenly aware of home-country bias, a phenomenon by which investors in every country prefer to invest in what they know, often unwittingly plays to followers’ expectations. As a result, the “average” equity investor in each country including the U.S. tends to allocate a disproportionate share of assets in their own country. The U.S. stock market accounts for a historically high 60% of global equity capitalization within the bellwether MSCI All Country World Index (“ACWI”). Yet, the average U.S. equity investor allocates roughly just 20% to international stocks, far less than the benchmark’s 40% in international equities.
A critical question is which equity benchmark matches your client’s expectations? The S&P 500 Index, with 100% in US equities? ACWI, with about 60% in the US? Or perhaps 80% US, to match their neighbor?
What will be their expectation tomorrow if, as has happened in the past, the relative performance cycle reverses and global diversification becomes fruitful again? Do you want to be ahead, on or behind the curve?
Do you need to follow benchmarks in the first place? After decades of teaching graduate courses on portfolio construction and serving on investment committees – what makes academic and practical sense today? First, I will highlight my approach and then provide a current example.
Countering the media’s “rearview mirror” influence requires a timeless, academically supported approach -- not “Wizard of Oz” dreamlike bets or market timing, but personalized risk management. My approach is to make incremental shifts to higher-ranking risk-adjusted asset classes within the context of an overall allocation tailored to each client’s needs. The process starts with the numbers, not benchmarks, then factors in practical, qualitative judgements to over or underweight the numbers.
My “five-step investment process” provides an ongoing systematic framework for making portfolio decisions, and further incorporating financial planning and tax considerations into overall portfolio construction.
Start quantitatively. Don’t be a slave to benchmarks; in theory, they should not influence investment decisions, but they do. While clients inevitably rely on benchmarks to hold investment managers accountable, as fiduciary advisors, it is critical to educate and encourage probabilistic decisions based on what is best for their financial rather than emotional time horizons. We can guarantee prudence if not performance. But prudent decisions can be unfortunate! This is an industry wide conundrum – how far can we deviate from media-influenced client expectations while improving the odds clients accomplish their goals?
What are our clients’ planning needs? What are today’s forecasts of returns? Volatility? Downside risks? No one knows for sure what the future holds, but clients may capture a “free lunch” by including lower correlation asset classes, and a “free dinner” by paying attention to valuations – you know the old buy low/sell high, often-forgotten dictum. Remember the compounding killer that big loss years can be. But passing up return opportunities has a compounding price as well.
Meanwhile, focus clients on the true “yellow brick road” to investment success -- controlling what can be managed – risks, costs, taxes, how much they save or spend, and perhaps the biggest wild card for individual investors, their behavior. Advisors and clients alike must first accept the short-term sentiment-driven unpredictability of markets.
Now decide qualitatively how much to under- or overweight your quantitative analysis. Have faith that intrinsic values eventually will prevail, that sooner or later fairy tales and dreams are replaced by spreadsheets! Should the news du jour warrant a change in weightings? We should tune out the noise and tune in new paradigms. What is the difference? For example, the threat of a government shutdown is noise we can largely ignore, at least for now. In hindsight, the Fed’s dovish liquidity starting in 2008 was a new paradigm. Liquidity in general is an underappreciated consideration in portfolio weightings.
Beyond the news, the other major qualitative factor is the client themselves. Very conveniently, I am assuming a relatively ideal client in the portfolio below – no tax price to implement. The client is trusting and patient. They have no great need to measure performance. They have no FOMO, paying limited attention to their neighbor’s performance. The client does have an appropriate fear of running out (FORO). Accordingly, their goal is simple – to not outlive their money.
If we demonstrate concern, calm and conviction, if we provide ongoing cogent commentary, the client should be ours forever. If this profile doesn’t fit your client, you may want to educate them until it does fit or modify the approach accordingly. The effectiveness of consistent education by advisors versus daily influence by the media is a major challenge!
Applying my approach today
Institutional 10-year forecasts for 2023 generally project returns for U.S. equities in the 6 to 7% range, developed international equities 8 to 10%, emerging market equities 8 to 11% and U.S. bonds a bit below 5%. Most institutional equity forecasts are driven by relative valuations and the “reversion to the mean” concept. If accurate, the accumulation differences by 2033 are material.
Equity allocations: Per forecasts then, international developed and emerging market equities are higher ranking. However higher forecasts have made a compelling, yet fruitless, case for international equities for some time. Client patience can wear thin!
What is practically different now? The yield based on trailing 12-month earnings is much higher today for international equities than the U.S. Plus, the winds appear to have shifted. In the U.S., the quantitative easing tailwind since 2008-2009 looks like a quantitative tightening headwind. For international equites, the currency headwind has recently become a tailwind. Will it continue to blow? The dollar is still at a relatively high point. Currencies tend to level out over time, but who knows. In the meantime, the dollar’s relative strength or weakness has a dramatic impact on foreign equity returns.
Equity risk: What is the relative probability of loss for U.S. versus international equities? Given news headlines, most investors assume higher risks overseas based on tenuous times in a few countries that dominate media coverage. But the numbers reveal that there may be less actual risk abroad because valuations are much lower by most measures – the potential magnitude of a drop is theoretically much less. In 2008, international valuations were higher than the U.S. before the global drop.
In my experience, compared to the more common measure of standard deviation, assessing downside risk based on valuations is more responsive to how clients tend to think about risk of loss. While analysts focus on measures of volatility, clients focus more on how much money they might lose. A fall off the roof can be far more painful than a fall out of a first-floor window. The S&P may still be up on the roof, just at a lower spot after 2022.
There are certainly geopolitical news and events to consider – horrible wars, regime changes…. It may be that once these events appear to abate, the forward-looking markets will move faster than we can. After risks are gone so may be opportunities. Additionally, let’s not forget that geopolitics impact U.S. stocks as well. We still have an interdependent world economy.
Contagion needs to be acknowledged. If there is a worldwide “risk off” event, if all equities drop in unison, clients will be disappointed that equity diversification did not work when needed most. MPT works overtime but not all the time. Again, we are just working with probabilities. The herd does not need an event to change direction. What happened in March of 2000 and March of 2009 to cause such dramatic market shifts? Not much, per my recollection.
U.S. versus international equities: The big question then is how much should one hold in US. versus international? Is there academic support for the convention of starting with the S&P 500 or ACWI and then deciding how much to over or underweight these benchmarks? Capitalization-weighted indexes effectively chase performance, which has no academic support. As a result, the S&P and ACWI are still heavy growth, and heavy in a handful of mostly single sector stocks. Historically, the subsequent performance for top 10 US stocks is not encouraging. It may take quite a while for investors to realize the tremendous growth that made them top 10 is not sustainable. Will things be different this time?
Given greater upside and possibly less downside risk, allocating more than normal to international stocks is prudent. Remember the compounding price of passing up on opportunities. The challenge, as mentioned, is explaining to clients if you underperform your reported benchmarks for a period of time. They may not care about yesterday’s risk or yesterday’s opportunity at that point.
Alternative (other) investments: The term “alternative investment” does not have a universal definition, so I prefer to use the less than sophisticated term “other”. There are many investment opportunities that do not fall into traditional equity or fixed income definitions. Classifications, however, should be secondary to the benefit the asset class brings to the overall portfolio in excess of their cost. The traditional 70/30, 60/40, 50/50… conventional way to think, can hamper decision making by not freely allowing for alternative investments. A very broad IPS is preferable.
A non-traditional asset class can benefit a portfolio if it either reduces overall portfolio risk while maintaining the prospective level of return, or if it increases prospective returns while maintaining portfolio risk. MPT holds that riskier asset classes generally drive higher returns, and that if a group of asset classes have low correlations to each other, the collective risk is less, while the overall return is higher. This is true for equities. This is also true for non-equities. The group of non-traditional asset classes listed below may result in an improved overall risk adjusted profile compared to diversifying using only core bonds or cash.
Bonds: The AGG, our core fixed income “ballast,” may continue to provide limited diversification, then again it may start to work again. Could 2023 be a repeat performance of 2022? If rates continue to rise, the whole portfolio may go down, again. No single event should be allowed to sink the ship. Keeping an overall shorter average duration, especially since yields are higher, seems wise from a portfolio perspective. The downside to holding short-term bonds is not locking in higher yields if the yield curve normalizes. In the meantime, given the current inverted yield curve, longer duration is an uncompensated risk. With no idea where rates are going, and no faith that anyone else does either, the probabilistic decision is to choose higher yields and less overall portfolio risk. That still means there is a good chance the AGG will outperform, but this is where education comes in, and I will hope for understanding clients!
The five-step investment process
Step 1 – Asset need
Assume the financial plan indicates a need to beat inflation by 4%. If the real return need is lower, there would be less in equities. A higher real return target would require more in equities. Too high of a target – then revisit the financial plan!
Step 2 – Asset allocation
22% Large US
11 % Small US
12% Large Dev Intl
6 % Small Dev Intl
9% Emerging Market
10% Other – US REIT
5% Other – Hedged EMD
5% Other – Bank Loan
10% Bonds – Core
10% Bonds – 2 Year Treasury
Equities: From the perspective of ACWI, the S&P or the “average U.S. investor,” my U.S. allocation is clearly underweighted. From the perspective of forecasted returns and downside risk, my 55% U.S. equity allocation is quantitatively overweighted!
How do I qualitatively justify my own U.S. overweight? I have pseudo-U.S. equities in REITs, which after last year’s loss have higher forecasted returns. Plus, REITS may be an inflation hedge, a “real asset” with a real return. Additionally, too much in currency-driven international will spike volatility. Volatility-driven losses can cause compounding pain. Also, there may be a new paradigm that harms international equities disproportionally – autocracy risk where our capitalistic assumptions come into question. Plus, COVID may be a more profound issue abroad. Finally, I cannot assume unending client patience in the case that international comes up short, again.
Other: REITS, bank loans and hedged EMD are largely in different markets with different risks and may have somewhat lower correlations to equities. All have higher forecasted returns than AGG. As a group, these three asset classes are additive to the overall portfolio. Of course, a “risk off” event may cause these asset classes to drop along with equities.
Bonds: The combination of traditional core bonds with the short-term Treasury allocation offers an overall shorter and safer duration as noted above. The Treasury securities with yields exceeding 4% should insulate a portion of the portfolio from a potential global recession.
Excluded asset classes: In tune with Einstein’s, “Everything should be as simple as possible but not simpler,” certain investments options that otherwise have ample merit are excluded. Examples include quality and high-dividend U.S. equities, high-yield municipals, and commodity-related equities. Private markets can also be meritorious assuming access at reasonable costs and a higher-ranking management history in at least the second quartile.
Step 3 – Asset capture
My hypothetical client conveniently doesn’t measure success by beating benchmarks over the short-term. Per Einstein’s mantra, holding low-cost and tax-efficient ETFs are generally preferable. With respect to passive versus active security selection, in taxable accounts the odds are low that active will win the accumulation game after expenses and taxes are considered. But investing in actively managed funds in a retirement account can work well, especially if institutional pricing is available, or if lower cost passive options are flawed. Actively managed funds may also provide a risk management benefit. Keep in mind that the time spent on actively managing the active managers can be a subtle drag on the other four steps.
Step 4 – Asset location
It is optimal to hold the majority of REIT, bank loan, and EMD positions in retirement accounts as they produce higher ordinary taxable income.
Roth IRAs, if available, should hold the assets with the highest expected total returns and, this currently includes International and EM equities. Tax-free growth for many years is powerful at higher rates of return.
The remaining funds should be split into both taxable and retirement accounts using the taxable portion to harvest losses, gifting, and possible step-up in basis. The retirement account portions may be used to take tax-free rebalancing gains. I prefer to hold active equities in retirement accounts to avoid capital gain distributions and to readily sell, without tax, if in the future it makes sense to switch managers.
If a client has a large enough taxable account, it can make sense to use direct indexing for a portion of the equities.
Step 5 – Asset rebalancing
Trading triggers are primarily driven by changes in Steps 1- 4: Revisions in the financial plan; investor comfort change; new substantive forecasts; new risks; new paradigms; new worthwhile asset classes; new investment vehicles; changes in the tax code; loss harvesting; gain harvesting – selling outperformers; buying underperformers.
In conclusion, along with planning, counseling and overall coordination of finances, there are extensive opportunities as a truly holistic wealth manager to add value throughout the five steps. The CIO hat you wear may be your most critical role, however. Is there urgency? Think about car mirrors: “Objects may be closer than they appear.. Being too conventional may compromise client goals too much!
Through persistent education, you can create “forever clients” with this quantitative, qualitative approach. Being different in the marketplace has its rewards, especially if you are right early on. Per John Maynard Keynes, being different also has its risks, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” Investors like company. As the media likely shifts expectations and global diversification becomes commonplace, your clients will have the company they need to stay put and tell their friends!
Professor Glenn Frank was the founding director of Bentley University’s Master’s in Financial Planning program in 1996 where he taught capstone portfolio construction courses until 2015. He has been a member of investment committees for over 30 years and continues to teach investment courses. Glenn is the Director of Education at fee-only Lexington Wealth Management in Lexington MA. He is a frequent speaker for advisor groups often on his favorite topic – integrating happiness and time management into the Financial Planning Process. The professor maintains a website for his students: timemoneyandjoy.com.