ITA Wealth Management

Photograph: Galaxy Ball

While MVO software, such as MVOPlus, is a wealth management tool, there needs to be a warning label placed on the box. Evensky provides us with such a warning and it goes like this.

“In spite of my strong defense of Markowitz’s optimization, it should be clear that I consider an MV optimizer a potentially dangerous instrument, one that needs to be heavily constrained by a knowledgeable wealth manager. Simply developing the input for an MV optimizer requires a significant leap of faith in one’s ability to divine an image of the future.”

Here are some follow up comments to Evensky’s necessary and timely warning.

• When using the MVO tool, I do not project future gains or losses for any asset class. I am not able to divine the future so I rely only on historical data.
• I place lower and upper percentage constraints on each of the fourteen (14) asset classes within the MVO database. I am forcing the portfolio into my “asset allocation shoe” of choice as a means of taming MVO. This is how one keeps the MVO software from directing the investor toward a portfolio that makes absolutely no sense.
• While MVO principles work on a theoretical basis, when permitted to recommend portfolios without constraints, there are many times when the recommendations are absurd. Percentage constraints applied to each asset class of interest brings the MVO projections into balance with the investment policy guidelines.

Lowell Herr

The “Special Projects” portfolio is one of seven or eight passive portfolios I watch over. What is unusual about this portfolio is the cash it carries as the money will be needed for “special projects,” hence the name of the portfolio. Despite the high cash level, the portfolio has done quite well since the early 2000s due in large part because of the flat market over this long period.

Even with one-third of the portfolio in cash, it managed to outperform the VTSMX benchmark by approximately 4 percentage points. What is not so unusual is the low risk involved, and that is due to all the cash in the account. This portfolio has a sigma percentage that is well below 10% for all periods. Since inception, the sigma value is approximately 7%, an extremely low value. With an alpha value of 10.3%, the Reward/Risk ratio is an unusually high 1.48. Ratio values over one are rare indeed. In all my active investing days, I have never been able to match this high Reward/Risk ratio.

Lowell Herr

Photograph: Parthenon, with a crane or two removed. If you look carefully, you will see scaffolding through the pillars on the left side of the building. Athens, Greece

Photograph: Tree in Sunriver, Central Oregon

Investors who continually focus only on return are missing a significant portion of the investing equation. Don’t neglect risk, and one easy way to reduce risk is to construct a well diversified portfolio. Active investors tend to select stocks where they are comfortable or their software tools guide them. Rare is the investor who can select stocks that will enhance their portfolio in a wide variety of asset classes. Instead, they overweight their portfolio frequently in large-cap growth stocks. And we all know, that was not the asset class of choice from 2000 through 2006. Nearly every week I post the “Creme List.” These stocks tend to fall into the mid-cap growth, large-cap core, or large-cap growth asset classes. One is not well served by investing only in this style of stock. Let me quote again from Swensen.

“Overweighting assets that produced strong past performance and underweighting assets that produced weak past performance provides a poor recipe for pleasing prospective results. Strong evidence exists that markets exhibit mean-reverting behavior, a tendency for good performance to follow bad and bad performance to follow good. In markets characterized by mean reversion, investors who fail to rebalance portfolios to long-term targets end up with outsized exposure to recently appreciated assets that prove most vunerable to poor future results. Only by regularly rebalancing portfolios to long-term targets do investors realize the results that correspond to the policy asset-allocation decision.”

There is a lot of “beef” in that paragraph. 1) Set up a portfolio policy. Too few investors take the time to think through this process 2) Populate that portfolio with index vehicles. We recommend ETFs unless one is investing small amounts each month. If one is investing small amounts, then use index funds. 3) Rebalance the asset classes when they are out of target. We recommend upper and lower limits of 30%. If 10% is the target for a particular asset class, then keep the investments within 7% to 13% of the total portfolio.

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.

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: 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: 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:  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: Entering harbor of Cartagena, Columbia

Systematic risk refers to the risk one enters into by being involved in the stock market. Over the last 80 years, this systematic risk resulted in approximately a 10% gain each year. For periods in duration of fewer than 10 years, the volatility is considerable. But as time is extended to longer periods, the volatility smooths out and we begin to see returns that approach the 10% average. In other words if we take 20-year rolling averages, the annual return is much more consistent than we find for five-year rolling averages.

Quoting from Hebner, “Individual stocks and bonds contain both systematic and non-systematic risk. If investors hold the market portfolio of stocks like the Wilshire 5000, they have eliminated non-systematic risk and they have not concentrated their portfolio on fewer stocks than the market. Concentration risk occurs when investors try to pick stocks and bonds that they think will outperform the market. Concentration of investments is akin to speculation and adds risk, but provides no additional expected return.”

Until the Fama/French study became available, we had only the one-factor model developed by William Sharpe. His model explained approximately 70% of the returns of the stock market. What about the other 30%? That explanation comes from the Fama/French study.

Photograph: Typical Chinese dinner presentation in China

Hebner makes an issue of the connection between return and risk — as he should. If one moves down the ladder of sample portfolios in his book, the more conservative the portfolio the lower the return and the lower the risk. Quoting from page 140 of his book, we read the following discussion.

“Risk is most commonly measured in terms of standard deviation or the volatility around a given average. Prior to the groundbreaking Fama/French research, stock market risk was measured as volatility around the average return of the total stock market. However, Fama and French added two more dimensions to the measurement of investment risk — size and value.”

Keep those two term in the frontal section of your brain. SIZE and VALUE. Both will have an influence as to how we go about constructing the AA-Mosaic Portfolio.

“Risk is one of the most avoided, least quantified and misunderstood subjects by those working in the financial services industry. This is unfortunate because the primary purpose of investment professionals is the intelligent management of financial risks and the alignment of an investor’s risk capacity with the appropriate exposure to financial risk or uncertainty.”