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Summary The author recommends using “David Swensen’s portfolio” as a key component of the Core Portfolio. Recommendation for the Satellite Portfolio will be covered in a separate article. Recommendation is in line with the implications of Efficient Market Hypothesis (EMH) and Random Walk Hypothesis (RWH). EMH and RWH imply that it’s impossible to consistently beat the market and suggest the utilization of passive investment approach. Recommended Portfolio Allocation The main goal of this series of articles is to introduce new stock investors to academic theories and help them develop their own approach to stock investing. Knowing academic theories and their implications should help investors gain confidence in their chosen path. That confidence is key in ensuring that investors consistently execute their chosen investment strategy. As we will discuss in the next articles, consistency is one of the main friends of stock investors. I will be suggesting an approach to stock investing that will be based on findings of Nobel laureates and market practitioners. With each article, we will be moving one step closer to developing an investment approach/portfolio that individual investors will be comfortable holding on to through thick and thin. We will start with David Swensen, CIO of Yale endowment since 1985, where he manages over $20 billion (as of Q3 2014, endowment assets were $23.9 billion). Over the decade (through 2009), the endowment realized an average annual return of 11.8 percent. It is an impressive performance given that this period covers the financial crisis of 2008. David’s consistent track record sparked debates if the new college building should be named after him. He is believed to be the alumni who contributed the most to the school through his management of the Yale endowment portfolio. David is credited with inventing the Yale Model (an application of modern portfolio theory that we will discuss in the next article). David Swensen suggests that individual investors should limit their portfolio to a handful, well-selected ETFs that will provide diversification across major asset classes (e.g. stock, real estate, and bonds) and geographies (i.e. developed and emerging countries) at a low-cost and tax-efficient manner. His recommendation is very much in line with the approach suggested by John Bogle (founder of Vanguard). David lays out the proposed allocation across asset classes as following: Asset Class Allocation Domestic Equity 30% Foreign Developed Equity 15% Emerging Market Equity 5% Real Estate 20% U.S. Treasury Bonds 15% U.S. Treasury Inflation Protected Securities 15% Source: David Swensen Strategy’s Strengths and Limitations MarketWatch developed a list of funds that closely resembles exposures that David Swensen proposed. The list of funds and its historical performance is presented in the table below. As you can see from the table, the proposed allocation has underperformed the S&P 500. As of 11/14/15 Fund Allocation 1-Year Return 3-Year Return 5-Year Return 10-Year Return Total Stock Market VTSMX 30% 0.62% 15.89% 13.05% 7.45% Foreign Developed VTMGX 15% -2.85% 7.67% 3.98% 3.73% Emerging Market VEIEX 5% -16.37% -3.49% -3.85% 4.44% Real Estate VGSIX 20% 0.36% 10.45% 11.04% 7.05% Long-term Bonds VUSTX 15% 2.99% 0.92% 6.82% 6.66% TIPS VIPSX 15% -2.17% -2.64% 1.98% 3.85% S&P 500 1.29% 16.18% 13.40% 7.31% Source: David Swensen, MarketWatch Main drivers of the underperformance are allocations to foreign developed markets, long-term bonds, TIPS and emerging markets. It’s not much of a surprise to see fixed-income instruments (i.e. long-term bonds and TIPS) underperform stocks (due to equity risk premium) over the long term. Analyzing the shorter period (up to 3-5 years), one can think of many reasons for the outperformance of US stocks vs. foreign developed and EM stocks. For long-term investors, arguments of mean reversion should make them comfortable holding on to diversified portfolio over the long term. As such, investors should not discard the model portfolio proposed by Swensen just yet. As mentioned, the list of carefully selected ETFs (must be low-cost and tax-efficient) should form the base of your portfolio. We will refer to this portion of the suggested portfolio approach as “Core Portfolio”. We will discuss the second portion of the proposed portfolio “Satellite Portfolio” in the future articles and share the rational for having such a satellite portfolio that might utilize a non-passive approach. Suffice it to say that EMH and RWH should provide enough confidence to individual investors to stick with the Core Portfolio allocations as long as the investors keep in mind that over the long run stocks provide positive real return. Actual Portfolio Allocations and ETFs Given the tax efficiency of ETFs, the author finds it more appropriate to use ETFs instead of mutual funds for the Core Portfolio. The actual list of ETFs and corresponding allocations is presented below: Asset Class ETFs Allocation Domestic Equity VTI 30% Foreign Developed Equity VEA 15% Emerging Market Equity VWO 5% Real Estate VNQ 20% Long-Term Treasuries TLT 15% TIPS TIP 15% There are a number of reasons for this recommendation: 1. The actual allocation to various asset classes is in line with David Swensen’s proposed allocations. Theoretical underpinning for passive investing is presented in the last section of this article. 2. The approach utilizes low-cost and tax-efficient ETFs. Typically, Vanguard ETFs are on the low end of fees. Also, ETFs are more tax-efficient than the mutual fund structure. A word of caution before you start implementing the recommendation – I’m not a tax advisor, and therefore, I strongly suggest you consult your tax advisor for any tax-related matters. Also, I would like to mention that this article is just the first one in the series. In the next articles, we will continue exploring the stock market theories and how they impact the way I invest. Next stop will be Harry Markowitz’s Modern Portfolio Theory and the need to diversify across a broad spectrum of asset classes. This article will be followed by Noisy Market Hypothesis, which should lift the spirits of investors who would like to “beat the market”. Appendix: Theory Dr. Eugene Fama, a Nobel Laureate, is thought of as the Father of Efficient Market Hypothesis (EMH). EMH suggests that current asset prices fully reflect all currently available information. To put it simply, stock prices should react only to news; and as you know, news is random in its nature. Due to this randomness, EMH implies that consistently outperforming the market on a risk-adjusted basis is impossible. In other words, don’t put your money into an individual “hot” stock or entrust to an active asset manager. Talking about randomness, one cannot skip mentioning the Random Walk Hypothesis (RWH), which traces back to Louis Bachelier. RWH argues that stock prices are random: chances that a professional analyst identifies a winning stock is similar to a flip of the coin. In a 1965 article, “Random Walks in Stock Market Prices”, Dr. Fama draws the parallels between EMH and RWH. As already mentioned, EMH and RWH imply that stock investors would be better off investing in passive index funds or mimicking such fund investments. On average, active investing (e.g. intentionally investing a higher portion of the portfolio in a specific stock or sector) is expected to yield similar risk-adjusted returns as passive investments. Some behavioral economists (note: we will cover behavioral finance and its implications in the future articles) would even argue that active investing should result in inferior returns, as emotions of investors will make them buy hot stocks just before these stocks peak and throw the towel just before the market bottoms. Industry practitioners, such as John Bogle of Vanguard, would further argue that investing is a zero-sum game: few basis points of alpha that one active manager generates come at the expense of another active manager. Furthermore, a typical individual investor who entrusted his/her funds to an active manager would come out short after receiving an average market return, less management fees and tax bill. Typical high turnover of active asset management mandates leads to higher transactions costs (e.g. bid-ask spread) and higher tax bill (i.e. short-term gains are taxed at a higher rate than long-term capital gains and dividends). All of the above suggests that low-cost, tax-efficient ETFs are optimal investment instruments for the Core Portfolio. References/Bibliography George A. Akerlof and Robert J. Shiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism , Princeton University Press, 2009 John Bogle on Investing: The First 50 Years , McGraw-Hill, 2000 Colin Read, The Efficient Market Hypothesists: Bachelier, Samuelson, Fama, Ross, Tobin and Shiller , Palgrave Macmillan, 2012 David Swensen, Unconventional Success: A Fundamental Approach to Personal Investment, Free Press, 2005 Next article: M odern Portfolio Theory: Introduce Alternatives To Your Portfolio Scalper1 News
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