A Passive Approch to Implementing Asset Allocation

Why Indexing?

A large body of research from finance researchers at the University of Chicago, Dartmouth and other noted academic institutions strongly supports the position that there is very little, and quite possibly, negative value-added by the process of active investment management -- that is, by trying to pick 'good' stocks and avoid 'bad' stocks, or by trying to 'time the market.'

Additional research - some of it even produced by Wall Street firms themselves - indicates that, going forward, top performing mutual funds may be more likely to under-perform rather than out-perform the market. One study by investment firm Smith Barney covering 72 equity mutual fund managers with at least a ten-year track record concluded, 'The investment returns of the top 20% of managers tended to plunge precipitously while the returns of the bottom 20% tended to rise dramatically.[1] A similar study by Christopher Blake, associate professor of finance at Fordham University's Graduate School of Business, found that for the five-year period ending December 31st, 1997, funds that were ranked as 'five-star funds' by Morningstar at the beginning of the tracking period underperformed the S&P 500 by almost 4% per year going forward[2].

All of this research, and much more, points to the conclusion that active management doesn't necessarily only not add value, it may very well subtract value from the investment process.

So, What Matters Then?

Eugene Fama, the Robert R. McCormick Distinguished Service Professor of Finance at the University of Chicago Graduate School of Finance, and Kenneth French, the Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business at Dartmouth, using original research as well as incorporated research from other researchers, have made a compelling case that 95% of long-term investment returns come from just three factors. These factors are equity market exposure, and then - within the equity portfolio - small size exposure and value exposure.

Equity Market Exposure: If you were to use a very conservative investment, the one-month US Treasury bill, as a base standard, as you move out of that conservative investment into the equity markets at-large, you could expect - over a long period of time - to see both your risk and your potential return increase accordingly. So, to the degree that you increase your 'market exposure', you increase your potential returns. No terribly big surprise here, but a very important factor, obviously, in the construction of a portfolio.

Small Size Exposure: Once invested in the equity markets at-large, the next factor is size exposure. In a 1981 paper published in The Journal of Financial Economics[3], University of Chicago professor Rolf Banz showed that there is a higher potential return for investing in smaller companies as a class versus investing in the market at-large. For example, if you were to take all companies traded on the US markets every year (as represented by CSRP 1-10 Decile database 1926 - 1990) [4] sort them from largest to smallest (as measured by the total value of each company's outstanding stock or its 'market capitalization'), and then each year have held the smallest 20% of those stocks versus having held all of the stocks in the database, there would have been a statistically significant increase in return for having held the smaller stocks[5] Of course, with this potential for increased return goes the added risk and volatility of owning smaller stocks.

Value Exposure: Again, once invested in the equity markets at-large, the next factor is value exposure. A 1992 Journal of Finance paper by Professors Fama and French showed that there is also a higher potential return for investing in value companies as a class versus investing in the market at-large. Value companies are stocks whose prices are depressed relative to some common measure (such as earnings-per-share or book value) compared to other stocks. For example, the study showed that had you taken all companies traded on the US markets every year (again, as represented by CSRP 1-10 Decile database 1926 - 1990) [4] sorted them from most expensive to least expensive (as measured by the price-to-book ratio), and then each year have held the least expensive (or the most 'value-ey') of those stocks versus having held all of the stocks in the database, there would have been a statistically significant increase in return for having held the value stocks.

The common theme for each of these three factors is this: by increasing your exposure to a risk factor (e.g., equity market exposure, small size exposure, or value exposure), you increase your potential return over the long run. Another way of saying this would be to say that you are paying for higher potential returns with higher risk.

Why Should I Diversify?

An often asked question with the three factor model is, 'If small and value stocks have the highest historical and potential returns over time, why not just put all of my money into those categories?'

The answer is two-fold. First of all, these three factors have been shown to potentially increase returns over long periods of time; however, there can be very long stretches - five years, ten years, or longer - when any one investment category significantly underperforms its long-term historical average regardless of how it has performed in the past or how we think it 'should' perform in the future. Very few investors would be patient enough to sit through a 10-year stretch of significant underperformance of an investment category if all of their money was invested in that one category - even if we think that category has the highest 'potential return' over the long haul.

So, the first reason is that diversification is designed to increase the likelihood of intelligent, patient, and prudent investor behavior in difficult times! The second reason for not making huge bets on just one category is that in any one category - especially as exposure to the three risk factors increases - there can be significant volatility in both directions - up and down. By blending together several types of investments that have low correlation to each other, an investor can help minimize the overall volatility of a portfolio without sacrificing potential returns. So, for these two reasons, diversification should be part of the overall strategy. Remember, though, that no strategy can guarantee success or protect against loss.

What is 'the right' balance?

First of all, there is no perfect balance. The structure of a reasonable portfolio of asset classes is as much an art as a science, but there are definitely portfolios that offer higher return potential based on the three risk factors. Coming back to the Fama/French 3-Factor model, it is exposure to those three risk factors discussed above that historically has explained most of the difference in returns over long periods of time between different diversified portfolios.

However, there are also geographic factors to consider, which, by themselves, may not offer a potentially higher return, but which do help to diversify a portfolio, and thus help reduce its volatility. One study supporting the inclusion of international assets in a diversified portfolio was published in the Fall 1998 Journal Of Investing by David S. Laster [6]. This study concludes that the addition of international stock indexes (up to 40% of the portfolio) to an otherwise all-domestic portfolio can actually decrease potential portfolio volatility.

Considering the above information, the basic construct rule I generally use in the equity portion of a portfolio is a 60-40 weighting ratio for Domestic vs. International; and a 67-33 weighting for Developed Markets vs. Emerging Markets and for Large Cap vs. Small Cap. This means, for example, that within a typically constructed portfolio, exposure to large stocks will be twice that of the exposure to small stocks; exposure to domestic stocks will be one-and-a-half times that of the exposure to international stocks; and within the international portion of the portfolio, that exposure to developed markets will be twice that of the exposure to emerging markets. This approach seeks to produce a fair weighting toward the important size and value factors, as well as international diversification.

How to Implement?

If the critical decisions of portfolio construction are market exposure, size exposure, and value exposure, then how do we implement the strategy?

Going back to the first section, the preferred answer would clearly be to NOT use actively managed funds, since active management has been shown to account for less than 5% of portfolio success, and generally comes at a higher cost in terms of costs - both management fees and tax costs.

An alternative, then, is to use index funds. Index funds are large pools of money that make no effort to 'beat the market'; rather, they just try to 'be the market.' This means that if you want to invest in the US stock market at large, don't own a fund that is attempting to hold the 'good' US stocks; instead, own a fund that owns all or a representative sampling of the US stocks. If you want to invest in small foreign companies, again, don't invest in a fund that tries to own just the 'good' ones; rather invest in a fund that owns all or a representative sampling of the small foreign companies.

The potential benefits of the index approach are three-fold: first of all, carefully chosen index funds can lower internal costs relative to similarly styled actively managed funds. Secondly, lower turnover index funds often result in lower taxes for those with taxable accounts. Third, index funds offer the possibility of increased control over portfolio decisions, since active managers can 'drift away' from their stated investment style objectives. Index funds may eliminate or reduce some or all of these problems.

Do keep in mind the following points: 1) Mutual fund investing - including the use of index funds - is subject to market fluctuation such that, upon redemption, shares may be worth more or less than original purchase price; 2) That investing in international and emerging markets involves specific risks such as political instability and currency fluctuations; and 3) That small cap stocks are more volatile than large caps and may be subject to illiquidity.

Which Index Funds to Use?

In implementing the indexing approach outlined above, there are three major investment sources I choose from: Vanguard Funds, Exchange Traded Funds (ETFs), and Dimensional Fund Advisors (DFA). The variables I consider in selecting an index fund are costs, depth into category (or 3-factor risk factor exposure as discussed above), investment category selection within the family, and internal diversification within each fund.

My primary choice for an index fund provider is Dimensional Fund Advisors (DFA), a quantitative index fund family in Santa Monica, California. I believe DFA has two strong appeals. First, they have a broad selection of index funds, including five tax managed funds, and among their choices are fund categories that are difficult to find elsewhere in the index fund marketplace. Such categories are important because they allow us the opportunity to better diversify among many investment categories that may have low correlation to each other. This, in turn, allows us to construct portfolios which seek to lower overall volatility.

Secondly, in some investment categories, such as the Morningstar's US small cap 'blend' category, DFA's US Small Cap fund has more holdings (3,354 stocks) than either Vanguard's Small Cap Index fund (1,771 stocks) or the Barclay's exchange traded iShares Russell 2000 fund (1,910 stocks), thus further increasing diversification within the category[7] Third, DFA attempts to go deeply into the value and small categories. For example, DFA's US Small Cap Value fund has a price-to-book (P/B[8] ratio of 1.4 versus Barclay's exchange-traded iShares Russell 2000 Value index's P/B ratio of 1.8 and Vanguard's Small Cap Value Index's P/B ratio of 2.0. (Note that the lower the P/B ratio, the deeper into the value category a fund is considered to be.)

DFA also has strong affiliations with some of the leading minds in finance-related academia (e.g., Eugene Fama at University of Chicago's Center for Research in Security Pricing and Kenneth French of Dartmouth, among others). As a result, their funds tend to seek a pure implementation of the most current research in the field of investment finance.

For links to articles about Dimensional Fund Advisors (DFA), click here. To visit Dimensional's website, click here.

Finally

Keep in mind that neither asset allocation nor index investing is a magic bullet that guarantees short-term success, but what you can say about a well-diversified, intelligently allocated portfolio is this: over time, your returns should be in proportion to your exposure to the three risk factors outlined by Fama and French - i.e., equity market exposure, small size exposure, and value exposure. The most critical portfolio factors over long periods of time have been shown to be the ones outlined above AND your willingness to adhere to the chosen investment allocation, during market ups and market downs, regardless of the emotional difficulty of doing so. And so, in closing, I'll add this: although Fama and French have shown that 95% of portfolio returns are driven by the three risk factors, I believe that, ultimately, 95% of investor returns are driven by investor behavior. Therefore, what is really important is to select an appropriate allocation, one that you can live with, and then do just that - live with it.

Footnotes

1. Registered Investment Advisor magazine, September 22, 1997
2. New York Times, April 4, 1999
3. Banz, Rolf, 'The Relationship Between Return and Market Value of Common Stocks', 1981, The Journal of Financial Economics
4. The CRSP Database provides access to NYSE, AMEX and Nasdaq daily and monthly securities prices, as well as to other historical data related to over 20,000 companies. The data is produced, and updated quarterly, by the Center for Research in Security Prices (CRSP), a financial research center at the Graduate School of Business at The University of Chicago.
5. Fama and French, 'The Cross-Section of Expected Stock Returns', Journal of Finance, 1992
6. Laster, David, S., Measuring Gains from International Equity Diversification: The Bootstrap Approach, David S. Laster, Journal of Investing vol. 7, no. 3 (Fall 1998):52-60
7. All of the statistics for the DFA, Vanguard, and iShares index funds provided in this paragraph are based on data obtained from the Morningstar Principia Pro database.
8. Price-to-Book ratio (P/B) is one of the common measures of investment value. The lower the ratio, the greater a fund's exposure to value is considered to be.