Friday 8 March 2013

New Improved Model Portfolio: The Smart Beta

Last week's post on the Swensen Seven model portfolio described a classic passive index ETF approach to building and managing a portfolio for long-term investing. It is an approach that uses ETFs whose holdings are selected and weighted by market capitalisation, for example the iShares S&P/TSX 60 Index Fund (symbol: XIU) that comprises the 60 largest capitalisation companies on Canada's TSX stock exchange.

This week we present an alternative approach based on the evolution of modern financial research. Two themes are of special interest for the individual investor.

1) Smart Beta - The research over the years has revealed that though the market index is necessary as the benchmark against which to compare results, it is not the best investing strategy. There are better strategies, and ETFs that use such strategies, to achieve enhanced returns with the same risk, or the same returns with lower risk. Such strategies are often called Smart Beta because they offer broad exposure to the market - the term Beta represents the sensitivity of a stock to the overall market - while intelligently taking advantage of anomalies that can boost returns. (A good source for much of the highly technical research is the EDHEC Risk Institute whose papers are replete with references to all the academic and industry research)

2) Allocation and Rebalancing to Equalize Risk - In addition, research tells us that traditional fixed target allocations, such as those in the Swensen portfolio, do not actually represent the true riskiness of the portfolio. Equity typically has a much greater volatility than fixed income, which means its influence on overall portfolio volatility is much greater than is apparent in its asset weight. By explicitly taking that into account, both at the time of initial assembly of the portfolio and when rebalancing, we can further boost the return vs risk performance of a portfolio. (A thorough, though again highly technical source, is a brand new book by Jacques Lussier, Successful Investing is a Process)

The Smart Beta Portfolio
Smart Beta is exactly the same as the Swensen in terms of asset classes. The main differences between the Smart Beta portfolio below and the Swensen are: 1) most of the ETFs are different; 2) the weightings are changed.

The ETFs
We note that the combined annual expense ratios of the portfolio are about double that of the Swensen - 0.33% vs 0.17%. That is a performance drag that the Smart Beta must overcome in order to be worthwhile, though the research on historical back-tested results indicates it should do so easily.

Principles underlying the portfolio
  • Selection of efficient ETFs - Efficiency means a better risk vs return trade-off than the equivalent cap-weight ETF. The ETFs chosen exploit one or more of the acknowledged stock market anomalies (aka risk factors) - small cap stocks outperform large caps, value stocks (low Price to Book Value or Price to Earnings) outperform growth stocks, momentum stocks outperform in the short term, and lower volatility stocks outperform highest volatility stocks. 
  • Variety of efficient ETFs - Efficient ETFs come in different flavours with one type emphasizing the Small cap factor, e.g. an ETF with Equal Weight on each stock, or Value e.g. an ETF that uses Fundamental accounting factors to select and weight stocks, or selection by Low volatility (aka low beta). In different time periods, one or other factor under- or outperforms, so we have chosen a mix across the flavours as shown in the chart above. That is the reason we have included two different ETFs, one a Fundamental index (PowerShares FTSE RAFI Canadian Fundamental Index, symbol: PXC) and the other a Low Volatility (BMO Low Volatility Canadian Equity ETF, symbol: ZLB) for the single largest asset class, Canadian equity.
  • Risk-balanced for economic environments and stock market conditions - The asset classes match up with those in the four quadrants of economic environments (economic growth or recession across inflation environments of falling or rising inflation- see chart below reproduced from Bridgewater Associates' The All Weather Strategy). Some of the asset classes in the chart are not available to individual investors, so we have boosted the allocation to bonds to bring the risk balance more into line. The variety of ETFs are chosen to respond to the different stock market conditions.
  • Risk-balanced for volatility and correlation - As we noted above, equities are almost always more volatile, i.e. riskier, than fixed income. This is reflected in the 12 month trailing standard deviation for the various ETFs shown in the table of ETFs. We have thus boosted the allocation to the bond ETFs to bring greater balance for the amount of volatility risk each asset class contributes to the portfolio. Another reason to increase the bond allocation is that bonds have the extremely desirable property of being un- or negatively correlated with equities, a property that boosts returns over time through the portfolio rebalancing bonus (see our previous rebalancing post).
Rebalancing is critical
The Lussier book examines in great detail various methods of rebalancing as a return enhancing activity. It concludes that the best method of all is to rebalance to keep constant the overall portfolio volatility. Unfortunately that depends on the movement of the combination of market price volatility and of correlation between assets, the data for which is normally available only to institutional investors. Therefore, we propose the following method for rebalancing, which almost all the time works better than the standard annual rebalancing we proposed in the Swensen: when the major asset class groupings - total equity and total fixed income - deviate more than one quarter (20%) from their assigned weight i.e. the total of fixed income is 40%, so anything below 32% or above 48%, rebalance back to initial weights in all the asset classes.

Set your expectations properly - Smart Beta works on average over many years. Outperformance is not automatic and guaranteed to happen every year. There can be, and have been, lengthy periods of multiple years in the past, such as during the 1990s, when the standard cap-weight approach does better. This would normally be during periods of strong upward equity movements, such as the 1990s tech bubble. Nothing captures market exuberance like cap-weight! On the other hand, the Smart Beta should experience much less extreme downsides, since it will also avoid sky-is-falling fear. We all need to set our expectations appropriately since failing to do so will likely mean bailing out prematurely.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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