Optimal Client Portfolios
There’s a little known investment fact: you can positively impact one important aspect of investment performance—your allocation of assets among broad asset classes. Stock or mutual fund picking and market timing, the things traditionally thought to be the most critical to investment success, turn out to be almost irrelevant. How can this be?
Several years ago, Gary Brinson, a noted finance academic and money manager, studied a group of pension fund managers. He found that he could explain over 90% of the differences in the results among these investment professionals just by classifying them according to how much of their funds they placed in stocks, bonds, or cash. Stock picking or market timing skill? As hard as he tried, Brinson found no evidence of either among these investment professionals. The significance of this for regular investors is profound—find the “right” mix of foreign and domestic stocks, bonds and cash, and your choice of individual securities becomes almost irrelevant in the long run.
How the investor arrives at the “right” mix is called “portfolio theory”, and is the critical component to long-term investment results. Until recently small investors had little guidance in this important area. Stockbrokers, investment newsletter writers, and mutual fund managers have a vested interest at keeping the investing public in the dark on portfolio theory. They do this by deluding the public into thinking that they, as professionals, can either time the market or select the right group of stocks that will be superior to the next guy…and certainly better than the average investor. This is how these professionals justify their high management fees and/or commissions.
Consider this, however: If over the past 5, 10, or 20 years you had simply held a portfolio consisting of one quarter each of the indexes of large U.S. stocks, small U.S. stocks, foreign stocks and high quality U.S. bonds, you would have beaten over 90% of all professional money managers and with considerably less risk. The fact is that over a long enough period of time, almost any reasonably balanced indexed strategy will outperform the overwhelming majority of “professional” managers.
Thus, long term portfolio returns are determined almost exclusively by the allocation of assets among broad based security classes. As noted before, one of the most important things we do is to work with our clients to create the optimal portfolio that best balances the client’s risk and objectives.
We further construct our client’s portfolios based on the Fama/French “3-Factor” research. Eugene Fama and Ken French took Modern Portfolio Theory deeper by discovering that there are three factors that explain, as previously noted, over 90% of a portfolio’s return:
- The “Market” Factor: The percentage invested in stocks versus fixed income securities (bonds)
- The “Size” Factor: The percentage invested in small company versus large company stocks
- The “Price” or Value Factor: The percentage invested in low-priced (value) versus high-priced (growth) stocks.
The Fama/French 3-Factor research showed a direct relationship between risk and return. Most investors accept that stocks have a higher expected return over time than bonds because they are riskier investments. The same is true of small company versus large company stocks and value stocks versus growth stocks. Research has shown these relationships to be common among foreign developed and emerging markets as well.
We, therefore, diversify the stock portion of a traditional balanced portfolio to include riskier small company and “value” asset classes. Consistent with the Prudent Investor Rule language, the result is a higher expected return with similar (or lower) risk.
All Glenmore Financial client portfolios start with a core, strategic asset allocation as the foundation to their investment plan. This is articulated in an individual Investment Policy Statement, which details the allocation to different asset classes. The strategic allocation is the model and baseline that is followed for ongoing portfolio management. Ideally, it represents the portfolio best suitable to reach a client’s needs based on all relevant assumptions, desired return and risk tolerance.
True to Modern Portfolio Theory, we will not attempt to “time” the market or try to achieve higher results than the overall market through individual stock or mutual fund selection for client portfolios. Especially since, as noted earlier, such efforts are not rewarded by the market in the long-run. We do, however, make minor adjustments periodically to keep the portfolio in the proper risk-return balance. We call this “re-balancing” and find this to be a proven way to heighten long-term returns. We meet regularly with each client to ensure the core portfolio is achieving the client’s objectives, and only after changes in one’s life or goals would the core portfolio asset allocation be revised.
In order to introduce the greatest degree of stability and predictability to the process, we are pleased to use select mutual funds from Dimensional Fund Advisors, as well as mutual funds and/or exchange traded funds (ETFs) from Charles Schwab & Co. and The Vanguard Group.
Compared to actively managed, high cost mutual funds, we have found these low-cost and high quality investment vehicles to be the best means to mirror the asset class to which they are intended. We believe that mutual funds and ETFs provide the best diversification for equities and fixed income securities in an asset class investment portfolio.
In today’s investing environment, the best investment strategy is not one focused on trying to “beat” the market. Instead, for the greatest long-term results, one is far better off having a diversified mix of key market indexes.
Let Glenmore Financial help you create the investment portfolio best suited to your individual goals and objectives!