Instead of starting with the current assets that a new client transfers to us, we jump up to 10,000 feet and ask the following question, “What should the main considerations be for building this portfolio for this client?” We focus on three areas:
- Portfolio Objectives – What is the investor trying to accomplish? Is it long-term growth, capital preservation, current income or some mixture of these? Is there a required total return? Will there be withdrawals? What is the investor’s tolerance for short-term volatility or tracking error to major indices? This is the discovery stage of portfolio design and it involves asking thoughtful questions and listening carefully to what our client says, and sometimes doesn’t say. These objectives will be somewhat unique to each investor and they will lead us to determine #2.
- Equity vs. Fixed Income Allocation – The percentage of equities to fixed income on a macro basis. This can range from 0% equity to 100% equity. While there is no rule of thumb for determining the perfect mix, it is very possible with experience to determine an appropriate allocation that will vary from investor to investor and sometimes even from account to account.
- Equity & Fixed Income Sub-asset Class Allocation – The relative weights of the various sub-asset classes such as domestic vs. international, large vs. small, growth vs. value, developed country vs. emerging market for equities. The term and credit exposure for fixed income securities. An important point for clients to understand from the beginning is that asset allocation is as much art as science. Many asset combinations can work effectively to achieve the investor’s objectives. Only in hindsight can you plot a portfolio’s place on the efficient frontier. For this reason, we stress to clients that we are forsaking “optimal” for reasonable when building portfolios.
Step 1 – Opportunity Set and Home Bias
Opportunity Set: Financial theory suggests that the global market portfolio is a logical starting point for an equity investor. Assuming that the MSCI All Country World All Cap Index is a fair representation of the world market since it represents 99% of the global market with over 14,000 securities of large, mid and small cap companies in both developed and emerging markets using on a cap weighted basis.
It is well diversified and incorporates the aggregate forward-looking expectations of all market participants. So if this index is the logical starting point, we should be able to rationalize any recommendation to deviate from it.
Home Bias – It is a known fact that investors from every country tend to overweight their home country’s stocks from their country’s actual weight in the global market. For example, Canada makes up about 4% of the global market, yet most Canadians hold far more than 4% of Canadian stocks in their portfolios. The U.S. represents about 52% of the global market, yet most Americans have a higher percentage of U.S. stocks in their portfolios.
There are many possible explanations for this home bias. One good reason is to hedge against foreign currencies. American investors pay for goods and services in U.S. dollars. Gains from international investments must be converted back into U.S. dollars to be spent. A very strong dollar will diminish the gains from international investments, while a weaker dollar will increase these gains, so a home bias may be warranted to protect the cost of domestic consumption.
Step 2 – Exposure to the Drivers of Expected Returns
Decades of research and a few Noble prizes have found that stocks/companies with certain characteristics tend to have higher expected returns over long time periods. Various characteristics have been identified as possible sources of higher expected returns. Within the universe of equities, evidence-based investing suggests that there are four dimensions or drivers of expected returns that can be used as a basis for deviating from the global market baseline:
- Market – Stocks outperform bonds, which outperform cash over time
- Size – Small Cap stocks tend to outperform Large Cap stocks over time
- Relative Price – Value stocks (low P/B) tent to outperform Growth stocks (high P/B) over time
- Profitability – Stocks of companies that are highly profitable tend to outperform stocks of similar, but less profitable companies
These dimensions of return do not show up every year in the investor’s favor and it cannot be predicted when they will be positive, but over a long-term horizon, they have demonstrated outperformance.
Step 3 – Exploring Various Exposures to these Dimensions of Return
By constructing hypothetical globally diversified portfolios with increasing exposure to these four drivers of expected return, we can show clients how they have impacted portfolios in the past. As we increase the tilt of a portfolio to these drivers, we see higher returns, but also higher standard deviation (risk). Again, the dimensions do not show up every year so there is tracking error or underperformance risk associated with increasing the portfolio’s exposure to them. Over longer periods of time, we expect to see higher performance than with a portfolio with less exposure to these drivers.
This is an important point for our clients to understand because it can cause what we call “TV” risk. This is when clients compare their returns on a very short-term basis to whatever market index is being discussed on the nightly news.
Step 4 – Allocation Recommendations
Using all of the above, we reach an allocation decision that we believe is reasonable for a particular client. Not perfect, not the only option, but reasonable.
This is where experience and art combine. Some clients need a bigger safety net than others so we might lower our market exposure to allow for a bigger allocation to fixed income. In this case, we often increase the tilts to small and value in an attempt to counteract the lower overall market exposure.
Step 5 – Implementing the Allocation
If the new portfolio begins as cash or is tax deferred, we select the funds we believe will achieve the desired result. When the portfolio has existing holdings in a taxable account, we first identify any embedded capital gains or losses. Positions with losses we will sell immediately if they don’t fit the desired allocation. Positions with gains will be considered for sale. Normally we will avoid realizing short-term gains if we believe we can hold a specific security safely until the gains become long-term. Sometimes, we will incorporate existing securities into our asset allocation if the gains are very large.
In past years, a review of clients’ tax returns have provided capital loss carry forwards that we could rely upon to mitigate the tax cost of realizing gains, but many investors have never done tax loss harvesting on a regular basis or have used up prior losses.
Even though holding these securities might affect the tilts we are trying for, a large tax cost is an investment hurdle that must be taken into account when creating a reasonable portfolio.
While the considerations we use will not resonate will all investors, having a process we believe in and can effectively communicate is a good starting place.