There are few things that we can control when it comes to investing;
asset allocation is one of them, and it may be the most important.
Asset allocation is the exercise of determining how much of each asset class you should hold in
your portfolio. In general, the asset classes that we have to choose from are stocks, bonds,
real estate investment trusts, and alternatives. Those categories can be broken down further,
but I will leave it there for now. Except in hindsight there is no optimal
asset allocation. The best that we can do is take guidance from the academic literature.
I’m Ben Felix, Associate Portfolio Manager at PWL Capital. In this episode
of Common Sense Investing, I’m going to tell you about asset allocation.
Building on the work of Harry Markowitz,
William Sharpe and John Lintner are credited with developing the Capital Asset Pricing Model,
or CAPM. If you have taken any finance courses you are at least aware that the CAPM exists. This
was the first model that quantified the relationship between risk and expected returns.
The CAPM is a single factor model. It sees risk and return as being determined by a portfolio’s
exposure to market beta, or the riskiness of the market as a whole. Market beta is
a priced risk. In other words, we expect a positive outcome for maintaining exposure
to market beta. This is very different from betting on a specific segment of the market.
That introduces idiosyncratic risk, which does not have a positive expected outcome.
To eliminate idiosyncratic risk we start our asset allocation journey with the
market portfolio. A total market index fund is representative of the market portfolio.
The next question is which stock markets do we need
exposure to? The answer, in short, is all of them.
Combining Canadian, US, International Developed, and Emerging Markets stocks into a portfolio
improves the risk and return characteristics relative to each of the individual parts. This
would be expected considering the imperfect correlations between each asset class. US
equities are an exception as they actually look better on their own over many historical
periods. We know this in hindsight, but should not bet on it going forward.
The optimal mix between Canadian, US, International developed,
and emerging markets stocks in a portfolio is an unknown. This makes the geographic
asset allocation choice mostly arbitrary, as long as global exposure is achieved.
Most model portfolios, including PWL Capital’s, Wealthsimple’s, Vanguard’s asset allocation ETFs,
and the Canadian Couch Potato portfolios have a heavy bias toward Canadian stocks, at about ⅓ of
the equity allocation. This might be surprising when it is considered that Canadian stocks make
up about 3% of the global market cap. Why so much in Canada? It comes down to tax treatment.
I have talked in the past about unrecoverable foreign withholding tax on foreign dividends in
registered accounts, which is an issue that you will never have with Canadian stocks.
Further to that, in a taxable account Canadian dividends receive preferential
tax treatment. With asset allocation being a somewhat arbitrary exercise,
assuming some level of global diversification, favouring a tax efficient asset class is sensible.
We have established that it is sensible to diversify globally to attain exposure to
the stock market, and it might make sense to be overweight Canadian stocks relative
to the market to reduce the impact of both foreign and domestic taxes.
As a point for future discussion, the Canadian dollar return for a portfolio
equally split between Canadian, US and International including emerging market
stocks from January 1990 through July 2018 was 8.17% with a standard deviation of 11.92%.
Now let's talk about bonds. Bonds are much less risky than stocks,
and they have correspondingly lower expected returns.
If you have noticed that Canadian bonds have almost matched the return of Canadian stocks for
the last 30 or so years, with less than half the risk as measured by standard deviation,
let me give you some context to understand those numbers. This time period captures
the greatest fall in interest rates in history. Falling interest rates make bonds look amazing,
so the numbers need to be taken with a grain of salt.
Canadian bonds have had a low correlation to our Canada-heavy global equity portfolio going back
to 1990, and adding them to the portfolio looks great. A 10% allocation to Canadian bonds barely
reduces the return, moving it down to 8.13%, while dropping the standard deviation more than 1%,
to 11.83%. Keep in mind that bond returns were uncharacteristically high over that time period,
so we might expect a bigger drop in returns for adding bonds going forward. Bonds would
typically be added to a portfolio to reduce its riskiness, not to increase its expected returns.
Finally, adding in a 6% allocation to real estate investment trusts increases
our historical annualized return to 8.32% while lowering our standard deviation to 10.60%. As
of now we have a portfolio consisting of 10% Canadian bonds, 6% US REITs,
28% Canadian stocks, 28% US stocks, 20% international developed stocks,
and 8% emerging markets stocks. I have some comments on REITs which I will save for later.
So far we have seen some big improvements by adding in relatively small amounts of asset
classes with imperfect correlations to stocks. I am not going to talk about adding in alternatives
like hedge funds, managed futures, preferred shares, and high yield bonds. While they may
be uncorrelated asset classes that look good in a back test, they come with other unfavourable
characteristics which I have discussed in detail in past videos and blog posts.
I think that this is about as far as most people get. Choosing some mix between stocks and bonds,
and maybe REITs, based on their ability, willingness, and need to take risk.
Stopping here ignores the most up to date research on financial markets and portfolio management. In
their 1992 paper the Cross Section of Expected Stock Returns, Eugene Fama and Kenneth French
summarized the body of research showing that the CAPM has substantial shortcomings. They
essentially concluded that the CAPM only explains about two thirds of the return differences between
diversified portfolios. So two portfolios with a beta of 1 might have had substantially different
returns, with no way to explain the difference other than attributing it to active management.
The following year, Fama and French proposed a new asset pricing model called
the Fama-French Three-Factor model. Instead of relating expected returns to market risk,
the three-factor model relates expected returns to exposure to the market,
exposure to small stocks, and exposure to value stocks. This
model explains about 90% of the difference in returns between diversified portfolios.
This is important for investors because if there are three independent risk factors
that explain returns, we want exposure to all three, not just to one. As we have seen,
adding in imperfectly correlated risks should increase our expected returns and
decrease our risk. More recent research has identified at least one other factor
that can be sensibly added to portfolio construction. That factor is profitability.
These four factors, market beta, size, value, and profitability have had low and
in some cases negative correlations with each other over time. The correlations of
factors with each other are even lower than the correlations between geographic regions
for stocks, and in some cases lower than the correlations between stocks and bonds.
I will quote a 2012 article published in the Journal of Portfolio management titled
the Death of Diversification has Been Greatly Exaggerated:
“ The argument that we make for factor diversification partly rests on the
expectation that the positive factor premia will continue to persist. But the
correlations (or lack thereof) these premia with each other are at least as important”.
One of the confusing things about getting factor exposure is that holding small cap stocks in a
total market index fund is not sufficient. If you have the same amount of small cap or value stocks
as the market, you only have exposure to market beta. It is only by increasing the exposure to
small cap and value stocks beyond market cap weights that factor exposure can be obtained.
Coming back to our hypothetical portfolio, if we split up each
geographic region into one third market, one third value, and one third small,
we end up with an annualized return from January 1990 through July 2018 of 9.17% with a standard
deviation of 10.36%. Clearly adding in factor exposure was beneficial over the time period.
This not just me cherry picking a data to make a point either. I can’t name all of
the studies that have demonstrated the benefits of factor exposure, but here’s one: In a 2017
study published in the Journal of Portfolio Management, Louis Scott and Stefano Cavaglia
examined the impact of factor diversification on the odds of retirees outliving their portfolios.
They found that terminal outcomes can be significantly enhanced through factor exposure.
The catch is that getting factor exposure is not always easy. It’s great if you can get it,
but it is a challenge, especially for DIY investors in Canada, due to a lack of products.
I said I would come back to REITs. Recent research has demonstrated that the return
of REITs is explained by the market beta, size, and value factors, in addition to the
term and credit factors which are factors that explain fixed income returns. Based on that,
a portfolio with exposure to the aforementioned factors may not need an allocation to REITs.
At this point I think that total stock market exposure is a given in the asset
allocation decision. The mix between stocks and bonds is more subjective based on personal
circumstances and preferences. Exposure to factors is important but often overlooked,
with the asterisk that even if you want it, it may be hard to implement.
Tell me about your asset allocation in the comments.
Thanks for watching. My name is Ben Felix of PWL Capital and this is Common Sense
Investing. I will be talking about a new common sense investing topic every two weeks,
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