· Fixed Interest Securities are Used to Reduce Portfolio Volatility - based on the history of the major financial markets throughout the 20th century, fixed interest and cash assets will under-perform property and shares over the longer-term. They help smooth your portfolio's results but they will not enhance your long-term returns.
In our opinion, there is little academic research to confirm any other reliable investment fundamentals that are not derived from the above. It is our further belief that most other concepts are based either on opinion, speculation or are yet to be proven in the longer-term.
Different Portfolio Construction Methods Considered
When analyzing the various investment approaches that you could utilize for your portfolio, we believe there are essentially three approaches that warrant consideration.
A. Traditional Active Management
Traditional Active Management generally involves the implementation of investment strategies that are designed to achieve improved returns through active stock selection and market timing.
This is the approach most frequently used to manage investment portfolios. That is, each of the managers adopted within a portfolio are trying to achieve excess returns through the active selection of assets that they believe will provide higher returns over time. This active selection of assets is usually implemented as a result of forecasting future asset prices and future economic events.
B. Passive (or Index) Management
Passive or Index Management is where the funds under management are designed to closely track the returns of an index, typically of one specific asset type.
Which of these is Best?
The question of whether to adopt an 'active' versus 'passive' approach to investment is a highly controversial issue. Indeed, each style of management has attracted a great level of criticism from the other side over the years.
We believe that all financial decisions should be made objectively and should be based on common sense and empirical research. On this basis, we provide a number of important considerations that we believe are relevant to the question of whether to implement or retain an active versus passive management approach to your investments:
Weaknesses of the Active Management Investment Process
Research overwhelmingly shows that:
· Active investment managers do not consistently outperform the index. In fact the majority of active managers often under-perform the index managers over time.
· Attempting to select fund managers that will produce above average returns in future has little scientific or academic basis, as such it is at best unreliable.
· Index funds, with low management fees and low turnover costs, always rank high in long-term performance studies.
· Managers with good past track records are no more likely to have good track records in the future than are managers with poor returns - in fact, research shows that managers with good track records are more likely to have poor future returns than are other funds in the future.
Based on our own experiences, we acknowledge that:
· Active managers are more expensive than passive managers - this is reflected in higher Management Expense Ratios (MERs) of actively managed funds.
· There are many cases of an apparent disregard for 'after-tax' returns for the investors in actively managed investment funds. Many managers pursue pre-tax returns that involve a higher level of turnover and subsequent realization of taxable capital gains.
Click here for more insights into why Active Managers Under Perform and the Failure of Forecasting
We also acknowledge common criticisms of index management
· There is no procedure to eradicate financially unsound securities from index funds.
· Index funds do not consider liquidity factors and market cycles.
· The index represents a relatively narrow and concentrated group of companies and does not reflect the greater number of companies and/or investment opportunities available. That is, companies which are not part of the ASX200 Index or MSCI International Index, for example.
· Indices are chosen randomly - for example, why the ASX200 and not the 250 largest stocks (by market capitalization).
If the disadvantages of Index Management could be overcome, we would strongly prefer Index or Passive Management above Active Management, given our concerns with Active Management. However, the criticisms of Index Management are also compelling.
Fortunately, there is another process of investment management - Asset Class Investing, which we believe captures the advantages of Index Management over Active Management, whilst also overcoming the main disadvantages of Index Management.
C. Asset Class Investing
Asset Class Investing is a form of investing that involves the purchase of specific asset classes, combined with active macro-economic condition filters, in order to enhance the returns on the index.
This also involves the targeting of companies within the equity component of your portfolio that may improve long-term returns, such as small companies or companies that are clearly suffering financial distress. (This concept is explained in detail later within this document.)
While Asset Class Investing is by no means a 'new' concept or style of management, its application to the management of individual investor's funds has not been readily accessible until relatively recently. In the past, such strategies were usually reserved for the large corporate superannuation funds.
Structuring An Efficient Asset Class Portfolio
Investment Portfolio Fundamentals
A. The Relationship Between Risk and Return
The most certain of financial concepts is that risk and return are related. Systematic differences in long-term returns must relate to differences in risk. After all, who would invest in shares or property if they expected the same return from a secure cash investment?
Investors expect markets to compensate them for increased uncertainty of returns and/or increased volatility in capital invested. Economists all over the world are unable to document any reliable way to add to returns without taking additional risk.
B. Portfolio Construction Process
We now believe that there are some essential criteria to consider when constructing an investment portfolio. These criteria can be summarized as follows:
· Broad investment diversification across a range of asset classes.
· Control over the asset allocation decision within your portfolio.
· Access to asset class returns that traditional portfolios often neglect.
· Tax efficient investment returns with a focus on your net of tax investment return.
· Cost effective investment approach.
· Ensuring that your portfolio structure matches your desired financial & lifestyle objectives and also your attitude to risk and reward.
Whilst these criteria form part of our overriding investment portfolio construction process, we then need to consider the most effective method of achieving these objectives. This involves a three-layered decision making process:
(i) Determine the allocation between growth oriented assets such as shares & property and interest bearing or defensive assets
- this asset allocation decision is the major determinant of the return you can expect to achieve. Academic research from the USA proves that 96% of the return that you achieve over time will be a direct result of the asset allocation you have invested in. As noted on page 1, this allocation must consider your income and capital needs as well as your risk profile.
(ii) Allocation between domestic assets and international assets
- this is a major diversification decision as different markets will perform differently at any given point in time.
(iii) Allocation across large, value, small shares
- this is where we have the opportunity to increase your expected return on your share portfolio by diversifying the portfolio away from the return of the ?broader' market.
Why Utilize an Asset Class Investment Approach
A. The Evidence
Before the mid-1960s, there was neither a generally accepted way to calculate a total return, nor a way to compare the returns of different funds. However, from the mid-1960s onwards, investors could calculate returns on a consistent basis and compare returns with those achieved elsewhere.
There is now over thirty years of research into fund performance, and the research is clear. In every time period examined, active management has lower average returns than would be expected from index funds (in other words, less than the broad market).
The results are the same for all equity styles and are also compelling with other asset classes such as fixed interest and property securities.
Upon hearing these findings, investors often respond that they are not concerned with the results of the average manager. Investors plan on hiring the above-average managers.
However, the research is clear again, managers with good track records are no more likely to have good records in the future than are managers with poor track records. Whilst not endorsing a pure index approach, index funds with low management fees and low turnover costs always seem to rank highly in long term performance studies.
Research in Australia, published in the Journal of the Securities Institute of Australia (JASSA Issue 4 - Summer 2000), provides evidence that Australian investment managers are unable to add value above passive strategies. These findings are consistent with previous studies conducted in Australia and also in the US, UK, and Japan. The research findings in all these countries send a clear message: Active management has lower returns than would be expected from passive management.
B. Defining Where Returns Come From for Equities and Fixed Interest Securities
There has been a tremendous amount of research and analysis performed on the issue of what drives stock returns. Whilst the initial research dates back to the 1950s, there was a ground breaking study released in 1992 from two well known economists, Professors Eugene Fama Snr from the University of Chicago Graduate School of Business and Professor Kenneth French from Dartmouth College, that drew on over 75 years of previous stock price analysis.
Fama and French tested many variables to search for traits that explained differences in share portfolio returns. Two variables stood out in this analysis, portfolios consisting of small companies and those with relatively high book-to-market (BtM) ratios have delivered superior rates of return. This lead to the development of the three-factor model, which found that three factors very reliably explain virtually all portfolio performance.
· The Market: any share portfolio will generally rise and fall in value in line with the same general direction as the whole market.
· Company Size: small company shares have higher expected returns than large company shares - the 'size effect'.
· Value or Company Health: relatively distressed, unhealthy or 'value' company shares have higher expected returns than healthy 'growth' company shares - the 'value effect'.
The results of Professors Fama and French extensive research suggests that performance of a share portfolio, as compared to the overall market, depends almost entirely on the amount of small companies and/or high BtM (value or unhealthy) companies that you hold. These two dimensions of stock returns rightfully appear in all of the stock markets around the world.
Whilst most people agree that small stocks are 'riskier' than large stocks (and hence the expected return from small stocks should be greater than large stocks), the notion that high book-to-market stocks are 'riskier' and have greater returns than low book-to-market stocks is tougher to accept.
However, the key to book-to-market lies in the denominator, the market price. High book-to-market stocks are lower priced stocks due to distressed earnings, other commercial risks or the like. Therefore, again we focus on the relationship between risk and return and these distressed companies have illustrated superior returns for investors over time due to their 'riskier' nature.
In essence, risk is related to distress in a very intuitively appealing way. Financially distressed companies have higher costs of capital than financially healthy companies. When they borrow from a bank, they pay higher interest rates. When they issue new shares, they receive lower prices. A firm's cost of capital is very similar to an investor's expected return.
The chart that appears next reflects the different return and risk characteristics of the three factors identified by Professors Fama and French.