Photograph:  Mykonos Island, Greece

In 1992, Fama and French broke out their three-factor and changed the way we construct portfolios.  Again, quoting from Hebner as to how the three-factor model advanced the relationship between return and risk as it relates to a portfolio.  While the Sharpe model argues the amount of a portfolio invested in stocks accounts for the greatest return, their are still missing factors.  F&F filled in some of the gaps.

“The Fama/French model added two other fundamental determinants.  Fama and French sought to determine the factors that best describe why there are differences among the returns of stock asset classes over long periods of time.  They first studied the period starting in 1964, the year that reliable computer data was available.  It was later updated and confirmed with data dating back to 1926.  In short they tried to identify the factors that explained the remaining 30% of returns left unexplained by Sharpe.”

If you have been reading this blog, you now know what two additional factors F&F studied to account for most of the “missing 30%.”

“Fama and French concluded that exposure to three risk factors–market, size, and value (book-to-market)–collectively do the best job pinpointing the sources of investment risk that account for stock market returns.  Risk factors are sources of risk that the stock market seems to reward over the long run.  Based on the Fama/French findings, these three risk factors constitute the dimensions of stock returns.”

Construction of the AA-Mosaic Portfolio is following the F&F research in that we skew the portfolio toward value and also toward small-cap equities.

Photograph: Just shy of being Sampson. Ephesus, Turkey

Why include bonds in a portfolio? I think I asked this question before, but it is worth reviewing. After reading a blog moments ago where a CFA was recommending a proper blend of stocks and bonds, what came to mind was a spreadsheet of stock and bond performances beginning in 1929. Using five-year rolling performance periods, only four times from 1929 through 2007 have bonds added value to the portfolio. Several of those alpha adding periods by bonds came in the 1970s when stocks suffered. Are we entering another such period? That is impossible to say, but I am betting bonds are not going to be the place to invest money over the next ten years. Instead, I will go with higher risk small-cap stocks, commodities, international developed countries, and emerging markets. It even looks like REITs may soon turn the corner. REITs tend to provide a good yield as well as some growth.

In the Mean Variance Optimization (MVO) database, I do have bond data included. Right now, if I move down the efficient frontier graph toward a lower return, lower risk option, the MVO software shows or recommends a minimum investment of 5% in bonds. However, if I move up the efficient frontier graph and ask for a little higher return, the bond request goes to 0%. Under current market conditions, I am requesting a little higher return and sacrificing risk.

Photograph: Rooftop Restaurant in Santorini, Greece

Several weeks ago I wrote about the Fama/French research related to value. We will return to that argument, but before we do, it is time to address the reason we are skewing the AA-Mosaic Portfolio toward smaller stocks or ETFs. We earlier touched on the fact that the first risk factor is to be in the market and to be there with stocks. The greater the exposure to stocks the greater the return in comparison to the T-bills. William Sharpe showed us that 70% of the portfolio return is due to participating in the market.

Again, I want to refer to Hebner’s remarkable book, “Index Funds.” On page 146 he writes the following.

“The second risk factor in the Fama/French model is the amount of exposure to small company stocks or the size risk factor. Exposure to this factor is determined by the amount of portfolio that is invested in small company stocks. The greater this exposure, the higher the return in comparison to large company stocks.”

“Small company stocks have small market capitalization. The market cap is determined by multiplying the total number of shares times the price per share. These stocks are generally perceived as riskier than large company stocks because small companies have fewer financial resources and more uncertain earnings than large companies. Small companies are also less able to survive prolonged periods of economic downturns. Even when small companies have good track records, these track records aren’t very long, adding more uncertainty and greater risk to their stocks. Because investing in small company stocks is riskier, investors demand a higher rate of return.”

“It’s important to understand that the average return of small-cap company stocks have significantly outperformed large company stocks over the last 80 years by 3.13% per year.” But to get higher returns, investors must accept a step up in the uncertainty of those returns.”

As a small investor, I found I was not able to locate and analyze small stocks to my satisfaction. To fill the small-cap void in the portfolio, I chose to move to ETFs. ETFs such as IJS, VBR, VB, VBK, and IJT. I wanted exposure to this “second-factor” of F&F research in order to capture some of that 3.13% advantage.

Photograph: Small Gorge on the Yangtze River, China. This area was not available except on very small boats before the Three Gorges Dam was constructed. The cliffs are approximately 800 to 1000 meters high. Note the boat just making the bend of the river near the center of the page.

What does an average risk portfolio look like? How are the assets allocated for an average portfolio? Here is the breakdown from Hebner’s Index Fund book. These results are the “Risk Capacity 50 – Sea Green” portfolio.

• Large-Cap Blend – 12%
• Large-Cap Value – 12%
• Micro-Cap Blend – 6% (This is one asset class where there is no ETF (yet) to match the DFA Index Fund)
• Small-Cap Value – 6%
• REITs – 6%
• International REITs Value – 6% (The third asset class that is difficult to match with DFA)
• Small-Cap International – 3% (This is another asset class that is hard to match up)
• Small-Cap Value International – 3% (Another index difficult to match with an ETF)
• Emerging Markets Value – 1.8%
• Emerging Markets – 1.8%
• Emerging Markets Small-Cap – 2.4%
• One-Year Fixed Income – 10%
• Two-Year Global Fixed Income – 10%
• Five-Year Government Income Index – 10%
• Five-Year Global Fixed Income Index – 10%

There are several asset classes in the recommended DFA portfolio that are hard to replicate using ETFs. As the number of ETFs expand, we should find it easier to match DFA recommendations.

Photograph: Warrior in the hills over looking Ollantaytambo, Peru.

The Monday edition of the Oregonian published Paul Krugman’s article, “We’ve been partying like it’s 1929 again.” Here is a reference to the entire article.

http://economistsview.typepad.com/economistsview/2008/03/paul-krugman-pa.html

As passive investors, what do we do with this information? Holding more than 1% of the portfolio in cash is not the worst idea. Reducing exposure to growth stocks is another prudent tack. Although I have not done so with the AA-Mosaic Portfolio, a tactical move would be to increase the percentage in large-cap value asset class. Whatever moves one might take, be prepared for a rough ride over the next 12 to 18 months.