I’ll admit it. When I list all the ways investors have no control over portfolio performance, it does not make me the life of the party. I’m more the party pooper, telling investors they shouldn’t chase after hot holdings, dump declining ones, or jump in and out of the market based on whims and emotions.
I’m sorry there are so many things you cannot or should not do to your portfolio. But it also stands to reason: Since there are so few investment practices that actually matter, wouldn’t you want to milk the ones that do for all they’re worth? Asset allocation is one of the important ones – maybe the most important one – so let’s give it a thorough investigation.
Essential Asset Allocation: A Tale of Risks and Expected Returns
Asset allocation is the exercise of determining how much of each asset class you should hold in your portfolio. You have four broad asset classes to select from: stocks, bonds, Real Estate Investment Trusts (REITs), and alternatives. You’re already way ahead of most investors if you understand how to allocate your investments across these four asset classes. To really make the most of each, it also helps to know how to allocate your assets within them – especially in the stock category.
More on that soon, but first things first. How do we determine an investor’s broad asset allocation – i.e., how much to dedicate to stocks versus bonds, with maybe some real estate thrown in? (As I cover in my related video, current evidence suggests REITs may be unnecessary for effective diversification.) Except in hindsight, we can’t. The best we can do is take guidance from the academic literature, and keep an eye on it over time.
Our understanding of asset allocation began in the 1960s when academics William Sharpe and John Lintner built on Harry Markowitz’s earlier work to develop the Capital Asset Pricing Model, or CAPM. The first model to try quantifying the relationship between market risks and expected returns, the CAPM is a single-factor model. It describes the relationship based on one thing: a portfolio’s exposure to market beta.
In other words, CAPM helped explain the positive return investors expect to receive for accepting the risk of being in the stock market to begin with. This market-wide risk premium is very different from betting on specific stocks or market segments. Market-wide risks are there no matter how you go about investing in the market. Specific bets, on the other hand, introduce idiosyncratic risk, which a rational investor can and should diversify away from (typically using low-cost index mutual funds or ETFs). In competitive markets, nobody should expect to be consistently rewarded for being irrational, so idiosyncratic risk does not have a positive expected outcome.
Building a Tax-Wise Total-Market Portfolio
A total-market stock portfolio combines four, geographic stock asset classes: Canadian, US, international developed, and emerging markets stocks. Their sum is expected to offer improved risk-and-expected-return characteristics relative to the parts. This would be expected, considering the imperfect correlations between each asset class. That is, when one asset class zigs, the others often zag (negative correlation), or at least don’t move in equal measure with one another (low or no correlation). US equities are an exception, as they actually look better on their own over many historical periods. We know this in hindsight, but based on the academic evidence, we should not bet on it going forward.
At least with respect to raw returns, the optimal geographic mix is unknown; it’s more important that global exposure is achieved. That said, we’ve got to pick something. Most model portfolios (including those offered by PWL Capital, Wealthsimple, comparable Vanguard ETFs, and the Canadian Couch Potato) – have a heavy bias toward Canadian stocks, to the typical tune of about a third of the equity allocation. This, even though Canadian stocks make up only about 3% of the global market cap.
Why so much in Canadian stocks? Taxes. In the past, I have talked about unrecoverable foreign withholding tax on foreign dividends in registered accounts, which is an issue you’ll never have with Canadian stocks. Plus, in a taxable account, Canadian dividends receive preferential tax treatment. If geographic asset allocation is a somewhat arbitrary exercise anyway, favouring a tax-efficient asset class is sensible.
From January 1990 – July 2018, the Canadian dollar return for a portfolio equally split among Canadian, US, and international/emerging market stocks was 8.17% with a standard deviation of 11.92%. Again, there’s no guarantee we’ll earn the same returns moving forward, but these numbers suggest investors can employ sensible, broad market asset allocation, and expect to earn decent returns without overcomplicating things.
Adding Bonds and (Maybe) REITs
Now let’s talk about bonds and REITs. Over the long-term, bonds are much less risky than stocks, with correspondingly lower expected returns. That said, you may have noticed that Canadian bonds have almost matched the return of Canadian stocks for the last 30 years or so, with less than half the risk as measured by standard deviation.
Let me give you some context. During the past three decades, we’ve seen the greatest historical fall in interest rates ever. Falling interest rates make bonds look amazing. So, while these numbers need to be taken with a grain of salt, since 1990, adding a 10% Canadian bond allocation to our total-market portfolio barely reduced its return from 8.17% to 8.13%, while dropping the standard deviation more than 1%, to 11.83%. Evidence suggests the relatively high bond returns won’t last forever, but still, you typically add bonds to reduce a portfolio’s riskiness, not to increase expected returns. The allocation remains rational, regardless of future expected returns.
Next, there are REITs. Adding a 6% allocation to real estate investment trusts increases the annualized return since January 1990 to 8.32%, while lowering standard deviation to 10.60%. (This assumes 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.) Again, the latest research suggests there may be other asset allocations for achieving similar results … but that’s a down-in-the-weeds conversation for a future post.
There’s also the possibility of adding alternatives like hedge funds, managed futures, preferred shares, and high-yield bonds. While these potentially uncorrelated asset classes may look good in a back test, they come with other unfavourable characteristics I’ve discussed in detail in past videos and blog posts, such as here, here and here. Suffice it to say, I believe you’re better off without them.
In short, investors can build a strong portfolio by making relatively small allocations to bonds and (arguably) REITs. I think this is about as far as most people get. It’s certainly better than engaging in active stock picking or market-timing. But stopping here ignores the most up-to-date research on financial markets and portfolio management, and how we can use the additional insights to our advantage.
Advanced Asset Allocation: Additional Sources of Return
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 solely to market-wide risk, their model relates expected returns to three things: market exposure, small-cap stocks, and value stocks (whose price-to-book value is a relative bargain). Their model explains about 90% of the difference in returns among diversified portfolios.
This is important for investors. If there are multiple independent risk factors that explain returns, we want exposure to all them. More recent research has identified at least one other factor – profitability – which can be sensibly added to portfolio construction.
Beyond a hoped-for return premium, these four factors (market beta, size, value, and profitability) have added even more value by exhibiting 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. This should create a smoother ride over time, which further contributes to managing your portfolio’s long-term expected risks and returns.
You may be wondering whether you’re already exposed to these additional factors simply by holding the entire market. The answer is: Not really. If you have the same amount of small-cap or value stocks as the market, you only have exposure to market beta. You can only obtain added factor exposure (and thus increased expected returns) by increasing that exposure beyond the standard market cap weights.
Coming back to our hypothetical portfolio from January 1990 – July 2018, if we split each geographic region into one-third market, one-third value and one-third small-cap, we end up with an annualized return of 9.17% (versus 8.17% for a plain total-market portfolio) with a standard deviation of 10.36% (versus 11.92%).
Clearly, adding factor exposure was beneficial over the time period. As usual, there’s a catch. Obtaining cost-effective factor exposure can be a challenge, because there’s a lack of decent products for achieving this aim, especially for Canadian DIY investors.
What will future evidence reveal? At this point, I think total stock market exposure is a given in the asset allocation decision. Your mix between stocks and bonds is more subjective, based on personal circ*mstances and preferences. Added exposure to stock market factors is important, but often overlooked – and currently hard to achieve as a DIY investor.
This was an especially long post, but it’s an especially important subject. There are so few things investors have control over in the markets, you might as well make the most of the few you do. Are you employing asset allocation in your portfolio? Let me know how it’s working for you so far.
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