“Build a better mousetrap and the world will beat a path to your door.”
-Ralph Waldo Emerson
The Basics of Portfolio Construction
The basic tenants of portfolio construction have been alluded to in previous newsletters, notably our Primer on Liability Driven Investing and our Primer on Alternative Investments, but they have not been directly addressed. We thought it was worth reviewing our worldview of portfolio construction, especially given the changes in the industry.
First, the basics: Modern Portfolio Theory is based on the combination of different asset classes (like cash, US large-capitalization stocks, or international-bonds) with different expected levels of risk, return, and correlations to each other. Using models, investors can select diversified combinations of these different assets to create “efficient” or “optimal” portfolios that maximize the amount of expected return for any given level of risk. Most investment products fulfill a need within this classic framework; for instance, you can buy a large-cap stock fund that mirrors (or attempts to beat) the S&P 500 index and consider this fund to be the US large cap stock component of your total portfolio.
Second, a little historical perspective: investments used to be the exclusive purview of only the very wealthy, but that has dramatically changed in the past 30 years. Even with the pullback following the 2008 financial crisis, more than half of households (54% specifically) have ownership in the stock markets - typically through sponsored retirement plans like a 401(k). Although 401(k) funds are relatively new (starting in 1981), the ability of everyday investors to have ownership in the stock market is the rule, not the exception.
A generation ago, primary access to capital markets used to come through stock brokers or broker -dealer offices. Today, with essentially ubiquitous internet access, investors can conduct high speed instant trading, nearly anywhere, for a marginal fee. There are still some environments where brokers and other service providers enjoy lucrative revenue sharing arrangements, but forthcoming regulations (e.g. - the looming ERISA 408(b)(2) disclosures) and legal precedent (e.g. – the Tussey vs. ABB decision) should significantly curtail these extravagant business arrangements. Access to the capital markets has become commoditized
Moreover, the tools and analysis available for everyday investors is unparalleled. Investors no longer have to be sophisticated experts in computing correlations, capital asset pricing modeling, rebalancing, or portfolio theory. There are a variety of inexpensive tools and products that do the heavy lifting for unsophisticated (or simply busy) investors. In other words, the essentials of portfolio construction are relatively simple to put together and no longer a distinguishing factor for most businesses. To summarize, once exotic services have become commonplace and the original innovative features are now standard.
The natural way for investment firms to compete – by lowering prices – is difficult given how low prices have already dropped. The value proposition for access is simply thinner for brokers, dealers, and investment managers.
So, how do investment managers compete in this new world? At the fund level, we expect sales professionals to advocate for their products. If you talk to a thousand different investment managers, you will hear a thousand different stories about how their product, or their underlying company philosophy, is the best option. We expect them to claim: “our US large-cap growth stock mutual fund is better than their US large-cap growth stock mutual fund”. That’s normal, but there is a limit to effectiveness of any salesmen given that the benefits of the product – investment returns - are perfectly quantifiable. The history of a product often sells itself or it does not.
New Trends: Additional Diversification
So, the basics of investment are relatively accessible and inexpensive, but investment firms have an incentive to advance and innovate away from the basics.
Recall that Modern Portfolio Theory is based on the idea of combining different asset classes to create an “optimal” portfolio. Mathematical analysis suggests a greater benefit to adding non-correlated or negatively-correlated asset classes to a portfolio. (A simple example, when Stock A goes up in price, Stock B tends to move down in price.) There are multiple studies to suggest that exotic securities have diversification benefits to portfolios that haven’t been fully exploited.
To this end, we have noticed trends where investment managers are creating new products to diversify portfolios with exotic, potentially underrepresented asset classes. For example, Real Estate Investment Trusts (REITs), convertibles, emerging market debt, and Master Limited Partnerships (MLPs) have been popular with investment managers trying to increase their product offerings. (Many of these alternative strategies, and the rationales for including them, are covered in Primer in Alternative Investments.)
Additionally, absolute return strategies which require active management (and therefore, higher fees) to implement are also popular with investment managers looking to expand their product line-up. For instance, some products focus on real return after inflation; whereas others focus on consistent, absolute returns that do not depend on the direction of the market. (Again, these strategies are described more fully in our Primer in Alternative Investments.)
New Trends: Optimizing the number of funds in a portfolio
In the previous section, we have suggested that there is an advantage to increasing the number of asset classes in a portfolio, but we did not discuss the reasons to limit the number of funds in a portfolio. Here are a few reasons to avoid over-diversifying a portfolio. First, there is the principle of diminishing returns: diversifying a portfolio from 3 to 4 asset classes will have a much larger effect then the subsequent diversification from 10 to 11 asset classes. Second, there is a finite amount of time for the required due-diligence on the part of plan sponsors, institutional clients, and their consultants. Evaluating an investment manager for additional diversification requires more time than replacing a manager since the client is evaluating the benefit of adding the asset class as well as scrutinizing the product itself. Third, over-diversification between products with competing philosophies may inadvertently counter-act the active bets within a portfolio, thus creating an unintentionally passive portfolio with the associated costs of active management. Fourth, there are often legal boundaries to contend with. For instance, the 404(c) safe harbor provision of ERISA specifies that 401(k) plans must have 3 materially distinct options – so that’s a minimum. Chris Carosa, of FiduciaryNews.com, references a June 2012 Department of Labor release that suggests that there may be maximum number of funds for 401(k) plans as well. Specifically, he notes that plans with more than 25 options may face additional liability. Fifth, adding more options can add to indirect costs (because of extra accounting, and error checking) and direct costs by preventing advantageous “breakpoints” often given for larger purchases.
So, what is the optimum number of funds? Of course, the answer is unique to each client. For instance, a 401(k) plan sponsor with a diverse array of plan participants (employees) will require more options than a singularly focused, purely risk-adjusted return driven, foundation or endowment. Also, as a general rule, larger clients tend to have more sophisticated needs and a larger ability to conduct the necessary due-diligence on their investment selections. Since they require greater flexibility in their approach, they may require a greater assortment of options.
New Trends: Risk Management Strategies
The 2008 financial crisis reminded investors a great deal about fear. The simultaneous collapse of the housing market (where a great deal of consumer wealth was stored) and the equity markets wiped out a tremendous amount of household wealth and investors are, understandably, more fearful than they had been. Investment managers, recognizing the fear, put out a bevy of products designed to placate anxious investors. This list includes risk-budget products, gold (and other hard assets) funds, VIX volatility trading strategies, absolute return funds, products with embedded insurance against deep losses (market “put-options”), and so on.
We see the value for many investors in a risk management approach, but we also have a bit of healthy skepticism. Let us explain why with an example: In 2010, there was a vocal group of investors that believed that a more substantial recovery was coming soon. Thus, they anticipated immediate recovery of Federal Funds Rates. As a result, many product managers were heavily promoting floating rate bond funds. Now that the Federal Reserve has, rather explicitly, announced that they won’t increase interest rates for several years, these products aren’t advertised anymore.
Human emotion is widely noted to be the key drag against the average investor as nervous sell at the bottom of markets and buy at the exuberance heights. (The school of thought called “Behavioral Finance” provides many examples on how our emotions lead us to make non-rational investment decisions.) We expect investment professionals to be sensitive to human emotion when promoting their products, but our worry is that undisciplined investors will take their money out of these products once they have sufficiently rebuilt their confidence and no longer fear the consequences of a sharp market pullback. We worry that inferring the future from the most shocking aspects of recent history is a reflex reaction to the past, rather a thoughtful analysis of where we may be in the future or over the long-term.
Risk management products have a place in a number of portfolios, just as they had a place in the portfolio prior to the market panic. Defensively oriented fund managers that have consistently practiced this philosophy may gain greater credibility rather than the more recent additions to the investment universe.
Trend: Re-examination of Passive vs. Active Investing
Passive investing, exemplified by index funds, is when a manager no longer tries to “beat” an index and instead tries to replicate the index. One key advantage of passive investing is cost. Since a simple computer model can take over much of the daily trading requirements of a passive product, the portfolio manager does not have to rely as heavily on human input. Most activity is automated, so it is usually cheaper to manage an index fund. Historically, index funds have also managed to beat most of their actively managed peers in long time periods, partially owing to the lessened “drag” of fees on investment returns. Index funds also have the advantage of following clearly explainable, transparent rules.
There are, of course, a number of advantages with active management as well. First, there are a variety of active products following a variety of investment philosophies and processes, some of which provide a better fit to the unique goals of an investor (e.g.- a low-beta, fundamentally selected, defensive fund). Second, some investors may be unsatisfied with a guarantee of underperforming their index; index funds do have fees, after all. Third, some plans have found it advantageous to arrange for revenue sharing between active managers to minimize other costs associated with plan management; this is quite common for Defined Contribution plans and these payment structures are acceptable, so long as the combined fees are completely and thoroughly disclosed. Fourth, some products and strategies simply aren’t possible to replicate with an index.
The debate between passive and active management has been going on more than a generation, but there are some interesting trends that involve hybrid approaches between the two types of products. For instance, the “Core-Satellite” theory argues that marketplaces are efficient in well-established markets and that the “Core” of a portfolio invests in broadly diversified, inexpensive, passively managed products. On the other hand, it allows that there are less liquid, less studied, inefficient marketplaces where savvy investment managers are more likely to extract extra value. Thus, the portfolio includes “Satellites” on the periphery of the marketplace, in the more exotic areas of the investment universe (for instance, micro-cap stocks, emerging market companies, etc.).
Another trend we’ve been following is that passively managed products have been using multiple techniques to adjust how they approach an index in order to differentiate themselves (on a factor other than lowest cost). An index fund might engage in security lending of their underlying holdings to boost returns, or they could add modest leverage to become an “enhanced” index product.
Many new passive products coming out have changed their rules on weighting the underlying holdings to differentiate themselves. Consider, most passive products are market capitalization weighted. That means that the largest companies have the most weight in an index. Alternatively, there are also equal weighted products, where every stock in the index has the same weight. There are also revenue-weighted funds (top-line), profit-weighted funds (bottom-line), & dividend-weighted funds. Let’s look at an example: General Motors is the 5th largest Fortune 500 Company in terms of revenue (earnings), but only the 20th largest in terms of profit. At roughly $35 billion in market capitalization (stock price x number of shares outstanding), General Motors does not even make it into the top 50 in terms of Market capitalization. So, these readjustments of the rules can sharply affect the weights within a product and its performance.
New Trend: Strategic vs. Tactical Approach
An efficient portfolio often represents the long term strategic allocation for the client. Depending on the desire for opportunism, there may also be short term tactical leans embedded into products. For instance, a client with a 50% stock, 50% bond strategic allocation may decide to rebalance their portfolio to a 55% stock, 45% bond tactical allocation after sharp equity market downturns to take advantage of potential overselling. Investment firms may manipulate a portfolio’s orientation on several axes including credit vs. interest-rate-driven fixed income, emerging market vs. international developed exposure, growth vs. value stock, dividend vs. capital appreciation driven, high vs. low quality, and so on.
New Trend: Challenging the Basic Inputs of Risk, Return and Correlation
At an even more fundamental level, investment firms have challenged the original inputs of Modern Portfolio theory as an inadequate tool for investors. The 3 key components for determining an optimum portfolio – risk, return and correlation of each asset class- must also be subject to prudent examinations.
Risk - classically defined as the standard-deviation of investment returns - may mean different things to different investors. For instance, we have described in our “Primer on Liability Driven Investing” newsletter that “risk” for a pension plan is not best defined by standard deviation, but by unfunded liability risk. For individual investors, “risk” may be better reflected by worst case scenarios: so called “black-swan” events. These investors may be better served by computer models that are optimized to reduce a portfolio’s “Conditional Value at Risk” (i.e. CVaR) instead of simple standard deviation.
Returns are not equal for every investor. In the Primer on Liability Driven Investing, we’ve pointed out that there is limited benefit for Defined Benefit plans that are overfunded and that returns are simply less useful beyond a certain point. On the other hand, foundations and endowments face unique challenges when their returns fall under the 5% required spending rules necessary to maintain their favored tax status.
Finally, financial analysts have noticed that the correlation between different asset classes gets a lot stronger in times of stress. For example, in most time periods, there may be only a weak correlation between stock prices for US and Canadian companies. However, when the whole US stock market is crashing by more than 20%, it is significantly more probable that the Canadian stock market is falling by 20% as well. There are alternative computer modeling techniques that adjust for the variability of correlations over time or during times of stress (like a market crash).
So, what can you expect from Westminster Consulting? As fiduciaries, we are always driven by the application of the legal interpretations of the prudent investor rules for our clients. As interpreted through most laws (such as the Uniform Prudent Management of Institutional Funds Act [UPMIFA] and related legislation [NYPMIFA, UPIA, ERISA, MPERS]), we are generally required to diversify assets to appropriate portfolio risk/return profile specific to our clients. Beyond that, documenting the procedures and consistently implementing your plan (in accordance with your Investment Policy Statement) is required, but implementing any particular trends in portfolio theory are, as yet, not required as a best practice. Utilizing the basic tenants of Modern Portfolio Theory is required by existing legislation, but the constant reconsideration of new trends, investment innovations (or marketing fads) is not. Most legislation recognizes the inherent risk in investing and allows for thoughtful implementations, so long as they are well-reasoned and well documented.
In plain English, let’s get the basics right and we can adjust our view from that starting point. Each one of our clients at Westminster Consulting has unique needs and may each require a different set of solutions to meet those needs. We retain an agnostic point of view toward portfolio construction as we customize our approach for every client with an eye on their unique needs, the types of risk they are most sensitive to, and - always - an eye on cost. Studies demonstrate that the majority of an investor’s return is ultimately a function of basic investment selection – the ratio of equity to fixed income. Refinements to investment strategy with diversification, and through selection of the most prudent investments have measurable, positive effects, but the primary requirement for success may be the discipline to adhere to an investment strategy once it has been selected. For a defined contribution plan participant, this may equate to retaining a well-diversified, automatically-rebalancing, target-date-fund. For a defined benefit plan, this may equate to the closely controlled implementation of a liability driven investment glidepath. For a foundation or endowment, this may equate to rebalancing their portfolio to meet strategic targets as the markets move.
In short, there is room for reasonable disagreement on the best approach, even for similar clients. The reality is that portfolio construction is as much of an art as it is a science at sufficient levels of optimization.