Broker Check

Active or Passive?

| August 22, 2016

My three favorite financial publications arrive on Saturday—the Wall Street Journal, Investor’s Business Daily and Barron’s. All three are excellent papers that feature well-researched investment articles. Many weeks, you can read highly convincing, yet incompatible, views of the same issue or event, which illustrates how complex investing can be. There is a wide consensus, however, that future investment returns are likely to be depressed for 10 years or more due to the current ultra-low interest rate environment and full equity market valuations. There is also mounting evidence that the most reliable predictor of future fund performance is low fees, and this month, we will review a very low cost and efficient allocation model that we use primarily in retirement portfolios.  We cannot include specific funds, but we are happy to share the details of the investments with you individually — just give us a call or email (see end of article).

 

If you Google “Lazy Portfolios,” you will find many examples of passive allocation models that typically contain anywhere from two to ten funds. This two-fund model is well diversified and also efficient and inexpensive when implemented using passive mutual funds or ETFs, available from a variety of providers:

—MSCI World Index — 70 percent

—Barclays U.S. Aggregate Bond Index — 30 percent

 

This portfolio is a very useful benchmark to compare any long-term portfolio to, but it has its shortcomings as well. The primary disadvantage is that it does not allow for effective ‘factor-based’ investing, where relative valuations are used to overweight asset classes with more attractive valuations and to underweight asset classes that are less favorable. This model provides the ability to manage 16 different dimensions instead of just two:

—Barclays U.S. Intermediate Credit Bond Index — 7 percent

—Barclays U.S. Long Credit Index — 2 percent

—Markit iBoxx USD Liquid Investment Grade Index — 6 percent

—Barclays U.S. Aggregate Bond TR USD — 7 percent

—Barclays U.S. Treasury Inflation Protected Securities Index — 3 percent

—ICE U.S. Treasury 20+ Year Bond Index — 2 percent

—JP Morgan EMBI Global Core Index — 3 percent

—S&P MidCap 400 — 7 percent

—S&P SmallCap 600 — 2 percent

—S&P 500 Value Index — 18 percent

—S&P 500 Growth Index — 12 percent

—MSCI USA Momentum Index — 6 percent

—MSCI USA Minimum Volatility (USD) Index — 4 percent

—MSCI Emerging Markets Minimum Volatility Index — 5 percent

—MSCI EAFE 100 percent Hedged to USD Index — 8 percent

—MSCI EAFE IMI — 8 percent

 

This 16 asset-class portfolio is a blend of passive and active strategies with the same overall asset allocation of 70 percent global equities and 30 percent global fixed income. Unlike some investors, who are almost religious about either the active or passive investment philosophy, we believe there is a place for both approaches, even in the same portfolio. Twelve of the asset classes are implemented based on static indexes, and four include active ‘smart beta’ factors such as volatility, momentum or currency hedging. The goal is to provide excellent risk-adjusted returns by keeping investment fees, transaction costs and taxes as low as possible, while still providing a very sophisticated solution that tilts the portfolio toward asset classes with higher expected future returns.

 

A good illustration of how these portfolios can differ is seen in the relative weighting of value and growth factors: the S&P 500 Value ETF is 18 percent of the portfolio, and S&P 500 Growth ETF is only 12 percent. This is because, as of July 31, 2016, the past 10-year performance of the S&P 500 Growth has outperformed S&P 500 Value by a large margin— 9.25 percent per year from Growth, and only 5.80 percent for Value. This relative weighting puts more of the large-cap U.S. equity investment into the value factor, which has higher future expected returns due to its recent underperformance—buy low, sell high. Looking at the fixed income investments, this finer grain portfolio also allows us to control the duration, geography and quality of the bond investments to maximize risk-adjusted returns.

 

We evaluate our portfolios at least on a quarterly basis and make adjustments based on asset class valuations and correlations. For the portfolio above, we shifted some weighting from U.S. small-cap to U.S. mid-cap, and also trimmed our emerging market equity exposure this last quarter.

 

Next month, I will write about how we construct hedged portfolios also using an asset class approach with both active and passive strategies. One of our favorite portfolios is designed to avoid drawdowns of over 10 percent in all but the worst 5 percent of market drops, and gain an average of 6 percent per year over a full market cycle—even in our current environment of lower expected returns.

 

As we mentioned last month, the best portfolio for you is the one that you can remain invested in through any market condition. Please give us a call at 303.900.4018, or email Jennifer@StewardshipColorado.com to schedule a complimentary initial consultation where we can review the efficiency of your current strategies and portfolios and provide you with our professional feedback on how well they match your goals and your ability to bear temporary losses. We are also happy to share with you the actual funds we use in our 16-asset class portfolio mentioned above.

 

Asset allocation and diversification do not ensure a profit or protect against a loss. Material discussed is meant to provide general information and it is not to be construed as a solicitation or a recommendation to purchase or sell any investment product or service and should not be relied upon as such. Individual needs vary, and require consideration of your unique objectives and financial situation. The market indices discussed are unmanaged. Investors cannot directly invest in unmanaged indices.