Using SCV and EM

[Roy]

I believe TSM is too LC weighted to obtain the risk I want for the Prosperity portion of the PP.

Guys,

I find I am thinking about the Stocks component much more than I had. 

Aggressive Stocks:  the original mandate for Prosperity
As others have done, I too wondered if there is a better approach to achieve the "aggressive" mandate suggested by HB in the Stock portion for "Prosperity".  Whatever that word "aggressive" means, it seems to imply higher returns than less aggressive securities.  I don't think it means this must come from "Growth Stocks". I think it is the behavior of the security type that is the issue.  Remember, any benefits from SV derive not from the class itself but because of the migration of a few its stocks into a Larger and/or Growthier direction.  Now, many of us do not believe higher returns possible without higher risk.  So what Stock types do provide this sort of "aggression" in "prosperity"? 

I know many of us have looked at this repeatedly.  And for different reasons, many of us (me included) have settled on TSM as being the best representation of what the Stock component ought to be, just as HB might agree.  Further, many of us agree that the greatest diversification and explanatory power of the PP comes from its quartile composition.  But since this site permits a more focused analysis of the PP, and because 25% of any portfolio is still a large amount, I've been thinking on Harry's original mandate a bit more.    Since the OP and others mention Small Cap Value, and Craigr mentioned the Aggression issue, I decided initially to look again at the SV class. 

The following yearly analysis (going back as far as I could find stocks data, around 1927 up to recently but not sure the endpoint) shows the powerful effect of Beta exposure—that which is common to all stock types.  (I did not look at Emerging Markets or International Small Value yet.)  I believe Larry discussed these findings before.  I mention this data simply to offer some framework other than pure CAGR and Risk calculations.


• TSM and SV both had 24 years where the returns were Negative.

• 18 of those 24 years both TSM and SV were Negative (same time).

• There were 6 years where TSM was Negative and SV Positive.

• There were 6 years where SV was Negative and TSM Positive.

• There were NO extended periods where SV was Negative and TSM Positive.

• The years where SV was Negative and TSM positive = 1939,1948,1953,1960,1987,1998.

• The years where TSM was Negative and SV positive = 1970,1977,1981,2000,2001,2007.

• There were no 2 consecutive years where SV went down and TSM up.

• There was 1 string of 2 years where TSM went down and SV up (2000-2001).

Over the period examined, Small Value had higher returns, much like what Fama showed.


Tracking Error  and other concerns
Speaking only about Stocks for the moment, any allocation is making a bet on its composition.  Past returns may not assure future returns, but that applies to everything.

The nature of CAPM means, necessarily, that a massive weighting will be to Large Caps (which always dominate "the market").  That is not indifference;  it matters.  CAPM may called "neutral" owing to its structure, but that structure defaults to a huge commitment to a particular market segment.  (Madmoneymachine indicated this, above.)

Those who fear Tracking Error understandably want to own "the market" in its CAP weight.  With conventional portfolios, that argument makes lots of sense.  But the Tracking Error issues would not concern me in the PP.  First, the PP—as a portfolio— already has enormous Tracking Error, and it is doubtful that the low Beta exposure of the PP stock component would alter that significantly, but over time, returns may be improved without incurring significant risk (measured partly by Standard Deviation, which clearly is not the only risk). 

My concern has not been losing out on higher expected returns that SV (in some addition) might provide.  My concern was the periods of under-perfomance (even months) where additional SV losses may test my resolve especially when the other PP asset classes are also tanking (I'm thinking short term acute periods not just whole years).  As the PP concept is conservative, the Large Cap domination made some sense.  But consider the Stock component was originally supposed to be "aggressive and growthy". 

But, if the Beta exposure within the PP is low (and it is pretty low), this may be less a concern than I imagined.  My other reason was the past success of the PP, using TSM (an indexed version of HB's original active funds).  But if looking back matters at all, we can see any number of Stock arrangements could have increased portfolio returns without sacrificing much in Standard Deviation or  drawdown.  Thus, "aggression" paid off.  And if one believed an adjustment in the Stocks component were justified, should the adjustment be absolute or relative to where an investor is in their own retirement picture?  That is, would a younger investor feel better with a "more aggressive" portion than one already in retirement (More SV in the former, less, if any, in the latter)?

(I have not looked back to 1972 to see how SV would have impacted the PP in each year.  And I plan to look at pure Large Growth Stocks too)

Now if looking back does not matter, then strike every mention of past from all obelisks, remove the yearly returns charts, etc.  But I think each part of this (how to view past correlations, risks, and returns) holds some portion of the truth without any part being absolute.


No answers here, but for the moment, I think TSM is likely the best choice.  Though, I am less sure of that than before, even as I am certain the basic PP quartile approach is the factor with the greatest impact.  And maybe at day's end the Stock type does not matter much. But the Aggressive Stocks mandate is something I'd want to discuss a bit more.


Roy

[craigr]

No answers here, but for the moment, I think TSM is likely the best choice.  Though, I am less sure of that than before, even as I am certain the basic PP quartile approach is the factor with the greatest impact.  And maybe at day's end the Stock type does not matter much. But the Aggressive Stocks mandate is something I'd want to discuss a bit more.

Great post, Roy.

I think that the above is basically where I am. I feel the diversification in the portfolio comes from the core assets chosen. We can debate about whether gold is best for inflation vs. alternatives (I think it is). We can also debate if US Treasury LT bonds are best for deflation (I think it is). We can debate if ultra-safe Treasury Money Markets are best for cash (I think it is). So it is a perfectly rational debate to look at the stocks. Is TSM the best of our choices?

Well, let's back up a bit. I am quite certain that of stock fund types, an index fund is the best choice. Active management is very spotty and not likely to beat the market over the long run. This has been decisively shown. So we know we want the stocks to be an index. This is a change from the original portfolio that Browne also made.

So what index then?

TSM is my way of basically throwing up my hands in a true "I don't know" fashion. My main reasons for using it is because it may not be the best, but I'm unlikely to have any serious regrets.

In the past I was on the SV side of things and did slice and dice my (non-Permanent) portfolio. But after running it for a few years I found that the funds were expensive and the tax costs of rebalancing a bunch of different assets was very high. Finally, the funds sometimes had higher turnover increasing internal capital gains that spilled out. My own analysis showed that for a taxable investor much of the surplus gains (if any) went to the Govt. In essence, I was taking the risk but Uncle Sam was getting the rewards from my value tilting.

Now I think there is an argument though that for those that can stomach the extra volatility that maybe an SCV fund is fine for the stock portion. Or perhaps it's best as a mix with TSM as many like to do. It's possible. And in fact I really don't have any serious objections other than the ones above about tracking error and possible higher costs. But with new SCV index funds the costs have been going down and in a tax-deferred location it may not matter.

My advice overall is if someone wants to do it that they should only use an index fund. Of the primary indices available for SCV (S&P 600 Small Cap Value and Russell 2000) I think that the S&P 600 is better. They use a stricter screening criteria for companies entering the index and have lower turnover than the R2000 index. This makes the fund tolerable for taxable investors but also boosts returns vs. the R2000 index. I do know that the R2000 index criteria had been re-swizzled the past couple years so perhaps they fixed the other problems. I have to research it more. The criteria specifically would be:

1) A passive index
2) Low cost
3) Low turnover
4) Best tax-efficiency possible
5) Offered from an established index fund provider
6) Not a specialty index
7) Good liquidity and asset base size (see #6)
8) No gimmicks (e.g. Fundamental indexing)

But I use TSM basically because it is simple, cost efficient, and theoretically the best diversified as it captures all the market segments. If someone wanted to go the SCV route and use an index fund to do it it would probably work out fine if they stick to the plan.

[Roy]

Well, let's back up a bit. I am quite certain that of stock fund types, an index fund is the best choice. Active management is very spotty and not likely to beat the market over the long run. This has been decisively shown. So we know we want the stocks to be an index. This is a change from the original portfolio that Browne also made.

Now I think there is an argument though that for those that can stomach the extra volatility that maybe an SCV fund is fine for the stock portion. Or perhaps it's best as a mix with TSM as many like to do. It's possible. And in fact I really don't have any serious objections other than the ones above about tracking error and possible higher costs. But with new SCV index funds the costs have been going down and in a tax-deferred location it may not matter.

1) A passive index
2) Low cost
3) Low turnover
4) Best tax-efficiency possible
5) Offered from an established index fund provider
6) Not a specialty index
7) Good liquidity and asset base size (see #6)
No gimmicks (e.g. Fundamental indexing)

But I use TSM basically because it is simple, cost efficient, and theoretically the best diversified as it captures all the market segments. If someone wanted to go the SCV route and use an index fund to do it it would probably work out fine if they stick to the plan.

Craigr,

Wholly agreed on the requirements for a proper fund of any sort. 

Your last point is can not be overemphasized.  It is the sine qua non Fama himself makes for those who choose to "tilt".  He says they should be prepared to "ride their decision to the beach."  (Remember too, Fama sees "tilting" as possible in any direction, not just SV!  It's just that Tracking Error Regret applies when deviating from only the broad market—TSM or S&P 500)  So Fama's admonition would apply powerfully in 1998 when the broad market was up big and SV was down. And Gold would not be helping then either.  Now, as we see, that sort of up/down disparity with SV did not happen much, but the severe lag lasted 2 years, which in today's information age may feel like eternity for those who actually track the movements of their portfolio.  In recent years, anyone following discussion boards, saw how REITS went from "must haves" to dogs;  Like SV, REITS are influenced strongly by economic cycles.

Are you ("you" meaning anyone) prepared to ride your allocation to the beach?  This is true for all portfolios, but especially when specific class sectors are involved.  I'm guessing that no matter which Equity division produces technically superior outcomes (and one can apportion that 25% in many "logical" ways), the one that may be emotionally superior is TSM.  And for me, the biggest appeal for the PP proper lies there.

Roy

[MediumTex]

Are you ("you" meaning anyone) prepared to ride your allocation to the beach?  This is true for all portfolios, but especially when specific class sectors are involved.  I'm guessing that no matter which Equity division produces technically superior outcomes (and one can apportion that 25% in many "logical" ways), the one that may be emotionally superior is TSM.  And for me, the biggest appeal for the PP proper lies there.

Roy

Just to make this point explicit, I don't like getting upset, and losing money that I have already earned upsets me.  I like the PP because I know I am unlikely to get upset as a result of choosing this allocation.  Tracking error is, to me, an abstraction that is basically meaningless and tends not to upset me in the least (though I understand that it does upset some people).

As simple and obvious as these points sound, I think there are a lot more people like me out there who also don't like getting upset, but who have portfolios that are going to upset them if they stick with them long enough.

I think that deep down most investors are conservative--many of them just haven't figured it out yet, and the time they spend being upset about their investments slows down the process of discovering their own nature.

[hrux]

After much consideration, deliberation, research, etc.  in my personal opinion one should have a 50/50 US-International equity exposure as well as an equal mix of small to large cap.  The following is my suggestion:

For taxable accounts:
25% VV (US large blend)
25% IJS (US small value)
15% EFV (Int'l large value)
10% VWO (emerging)
25% VSS (international small to mid for both developed and emerging)