How to construct a portfolio using simplified modern portfolio theory

How to construct a portfolio using simplified modern portfolio theory Travis Morien Compass Financial Planners Pty Ltd travis@travismorien.com http://www.travismorien.com

Before viewing this presentation: The presentation you are about to view on building portfolios is the “sequel” to a slideshow on selecting managed funds. Some concepts are carried forward from that presentation and are assumed knowledge. If you haven’t already done so, download the original presentation from http://www.travismorien.com/investment.ppt

Part One The asset classes

Basic principles • There are many asset classes out there and many of them are useful to investors. • Some asset classes are noted for their long term stability (low risk), others for their high returns. • Generally speaking, the higher the reward you are after, the more risk you’ll need to take. • Portfolios can be constructed out of multiple asset classes that exhibit superior risk and return relationships to any single asset, because diversification can significantly reduce risk.

A A B B Why risk and return are linked.. Investment A is the obvious choice… … but add risk, is the choice still obvious? B would die out through lack of takers! When two investments appear to offer identical risk, investors will prefer to buy the higher returning one. If the market is peopled by reasonably well informed investors, there simply won’t be any high returning low risk investments left and nobody will buy high risk assets with a low expected return.

Risk and return continued • In a portfolio construction context “risk” is usually measured with some sort of measure of price volatility. • There are other risks of course that need to be taken into account. • Inflation risk is a major problem with the more “conservative” asset classes such as fixed interest and cash. Many pensioners find to their horror that they can no longer live off their savings, despite the conservatism of their strategy, simply because their returns weren’t high enough to maintain the portfolio’s real value after inflation, costs and withdrawals. • It is necessary for all but the most short term oriented investors to consider at least some exposure to growth assets like shares and property, just to fight inflation.

Major asset classes: shares • Shares are part interests in businesses. How good a return you get on your share depends to a large extent on the fundamental business developments of the company itself and on the price you paid for the share. • Averaged out over many companies, shares as an asset class tend to respond to interest rates and the economy. • Although in the last few years many markets have fallen substantially, shares are still the highest performing asset class over the long term and by far the most tax efficient. • Shares generally go up in price over the long term because businesses don’t pay out 100% of their profits as dividends, they keep some to grow the value of the business itself. • Over the long term, shares have beaten inflation by about 6%pa.

Major asset classes: property • There are many types of property to invest in, each are different. • The highest income yield comes generally from commercial and industrial property, which often pay the owner as much as 10%pa in rent alone. • Residential property is an asset class that has really been booming over the last few years, but rental yields are now alarmingly bad by historical standards meaning that investors are highly reliant on capital growth. • Over the longer term you can expect property to grow in capital value at about the same rate as inflation (because the salaries with which we have to pay the mortgages only grow with inflation – there eventually comes a limit when growth above inflation just can’t be sustained), though local supply and demand issues mean actual returns could be higher or lower over a particular period of time.

Major asset classes: fixed interest • A “fixed interest” investment is a debt that can be bought and sold. • The borrowers are usually governments and companies. A typical fixed interest investment pays a regular “coupon” (interest payment) and will repay the principle on maturity. • Some fixed interest securities have a maturity of several decades, others are shorter term. • The actual price of a fixed interest investment will fluctuate in response to many things, most particularly interest rates. If general interest rates fall, the price of a long term fixed interest security will usually rise such that the “yield to maturity” is similar to those of other investments with a similar risk. On the other hand, if interest rates rise, fixed interest investments fall. • A typical fixed interest portfolio is yielding less than 5% right now, though falling interest rates over the last decade have helped bonds to deliver very strong performance which included a growth component.

Major asset classes: cash • “Cash” may mean currency, but in an investment context cash is just a really short term highly liquid fixed interest investment. • Longer term fixed interest investments are usually called “bonds”, shorter term fixed interest investments may be called “notes” and really short term ones are often called “bills”. • Cash management trusts usually invest in a portfolio of high quality short term fixed interest investments. Because of the short maturity, these fixed interest investments aren’t as sensitive to interest rate changes and thus don’t have a great deal of capital volatility. • Many cash investments are returning about 4% at the moment.

Other asset classes • Shares, property, bonds and cash are the major asset classes, but there are many others to choose from. • Hedge funds are sometimes called a distinct asset class as they pursue unconventional strategies that give them performance very different to the asset classes that they invest in. • “Private equity” is basically a shares investment, but in companies not listed on a stock exchange. • Agribusinesses are agricultural investments in things like tree farms and vineyards. • Some people also consider commodities like gold to be an asset class of its own, and many people consider collectibles, race horses and fine wines to be useful alternative investment asset classes.

The point of portfolio construction • A portfolio is often more than the sum of its parts. Because not all asset classes perform the same way over the short term, a portfolio of many asset classes usually offers a superior overall relationship between risk and return to any single asset. • A portfolio consisting only of shares would have done badly in the last few years since the US market crashed, but property and bonds have performed very well. This is quite typical, more “defensive” asset classes often do well when equities are falling. • A diversified portfolio has a reasonable long term growth rate because over time all asset classes offer a positive return, but being invested across different asset classes smooths out returns and offers a more predictable growth rate.

The last twenty years have seen very good returns for all major asset classes, well in excess of inflation, but the risk and return are highly variable.

Part Two Creating diversified portfolios

How diversification reduces risk There are two mechanisms by which diversification reduces risk: dilution and interference. • Dilution is easy enough to understand, if you swap half your shares for cash then you lose half your equity exposure and therefore half your equity risk. If the market crashed tomorrow you’d only lose half as much. • “Interference” (a term I pinched from physics where it is used to describe the way waves interact), is where negative movements in some assets are partly cancelled by positive ones in other assets. A good example is with property vs. shares, in the recent bear market in shares property did very well while shares tanked, the opposite may be true in the next few years.

Interference and correlation “Correlation” is the word given to the extent to which assets move together, this is measured with statistical formulae. Correlations can range from -1 (perfectly negatively correlated) through to +1 (perfectly positively correlated). If asset B tends to move in the opposite direction to asset A then these two assets are said to have “negative correlation”, and they can be highly effective at cancelling out each other’s volatility. If the assets both trend upwards over the longer term a combination of them will have a return equal to the average of the two assets’ returns but with substantially reduced volatility. Negatively correlated assets cancel the greatest amount of each other’s volatility.

Negative correlation isn’t essential • Assets don’t need to be negatively correlated to have some volatility smoothing. • As long as the correlation is less than +1 the assets will be at least a little bit different and at least some volatility will be cancelled. • Most real world assets are positively correlated because most prices are related somehow to important “macro” factors like global economic growth, interest rates, oil prices etc. • Even if negative correlations are rare, substantial volatility reduction is possible by using assets with a low positive correlation. • For example, the annual correlation of Australian listed property with Australian shares from 1982 to 2003 has been about 0.68, but the correlation of property with international shares was about 0.30, the correlation of Australian shares with international shares was about 0.64, so a mixed portfolio would be quite effectively diversified.

Return Efficient portfolios on or near the efficient frontier Risk Inefficient portfolios below efficient frontier The “efficient frontier” is the name given to the line that joins all portfolios that have achieved a maximum return for a given level of risk (portfolios that are “efficient”). If you programmed a computer to chart every possible portfolio that could be constructed out of a group of assets and plotted a point on a risk vs. return chart, the resulting plot usually looks much like the chart below. The top of the curve is the efficient frontier, anything below that curve is an “inefficient” portfolio, anything actually on the curve, or close to it, is an “efficient” portfolio.

Efficient vs. inefficient portfolios • It is impossible to predict in advance which portfolios will be the most efficient as this would require knowing in advance asset class performance and correlations. • A portfolio that has been diversified into a variety of asset classes should be close to efficient over the longer term, provided it is rebalanced regularly.

Rebalancing • Rebalancing a portfolio is the process of adjusting a portfolio to bring it back to its original asset allocation. • Since assets perform differently at different times, the portfolio is likely to drift from your desired asset allocation. • Failure to rebalance means that a portfolio can change risk profile over time and may no longer be appropriate.

A simple rule of portfolio construction • If you have two assets with roughly equal expected returns, putting 50% into each is a way to hedge one’s bets (and spread the risk) without compromising expected return. The lower the correlation of those assets, the more the risk will be reduced while not reducing expected returns at all. • Actually, this holds true with a greater number of investments as well. For example, if you have five equally attractive assets you could invest one fifth in each.

Since 1982 Australian shares (ASX500 index), international shares (MSCI world index) and property securities (ASX300 listed property index) have had roughly the same return…

So using our simple rule of thumb that if the three assets have similar returns we’ll use a third in each, we get the following portfolio which has outperformed all three with much less volatility! (Rebalanced monthly)

Diversifiable vs. undiversifiable risk • There is such a thing as “diversifiable” risk, as you add extra assets to the portfolio the volatility tends to decrease – but only up to a point. When a portfolio reaches a certain level of diversification the only way to reduce risk is to add lower risk assets which will reduce volatility by dilution, this usually reduces the return. • Risk which cannot be diversified away is “undiversifiable” or “systemic” risk. Holding every stock in the market (i.e. with an index fund) smooths out the maximum amount of diversifiable risk for shares, but you are still left with the risk of the market itself, that risk cannot be reduced unless you spread your portfolio across more asset classes. • According to financial theory, investors only get rewarded for taking on systemic risk. Having an under-diversified portfolio results in greater risk but no extra expected return. This is one definition of “speculation”. (There are others.)

Diversification can also increase returns A higher return may often be obtained from rebalancing the portfolio as a result of “reversion to the mean”. If you believe that at some point in the future two assets will give the same cumulative return then it would make sense to invest in the asset class with the worst recent performance and sell the one with the best performance! Rebalancing does precisely this, although it is normally seen only as a risk management technique. This is why the diversified portfolio did a little better than all three component asset classes. A small “rebalancing premium” is quite common because last year’s worst performing asset class often outperforms last year’s best performing asset class this year.

Improving the efficient frontier • Investors desire higher returns with lower risk. There is however a limit to what can be achieved with a particular set of assets, that limit is drawn on charts as the efficient frontier. • By adding more assets we can change the shape of the efficient frontier. Assets carry two items of interest to us, their returns and their correlation with the rest of the portfolio.

Refining our asset allocation • There is wide acceptance that so-called “value” stocks outperform “growth” stocks, and “small companies” tend to outperform “large companies”, at least over the longer term. • Their higher long term performance is very interesting, but so too is the fact that they often have a low correlation to large growth companies, the dominant stocks in the market. • They provide what asset allocation buffs call an “independent source of risk and return.” This may enable us to improve the efficient frontier.

Fama and French’s “Three factor” model Your returns mostly come down to asset allocation: • The mix of stocks vs. bonds • The average company size • The value characteristics of the stocks - how “cheap” stocks are compared to book value. Picture credit: Dimensional Fund Advisors

Over the long term value stocks and small companies have outperformed large companies. These are the returns of global value, large company and small company indexes calculated by Dimensional Fund Advisors from January 1975 – December 2003: Global value 19.70%pa Global small caps 20.29%pa Global large companies 14.98%pa

Adding value and small caps to a large cap growth equity portfolio gives a better return than a large cap only portfolio, but the volatility is actually lower, not higher. A mixed portfolio is more “efficient”. 20% Australian large 20% Australian value 10% Australian small 20% global large 20% global value 10% global small Data from Dimensional Fund Advisors DFA Returnw program, gross return of indexes tracked by DFA equity trusts. See http://www.dimensional.com.au *Annualised standard deviation is presented as an approximation by multiplying the monthly or quarterly standard deviation by the square root of the number of periods in a year. Please note that the standard deviation computed from annual data may differ materially from this estimate. 50% Australian large 50% global large

Total stock market vs. “slice and dice” • The stock market is dominated by what would be classified as “large growth companies”, also known as “blue chips”. As a portion of market capitalisation, the very largest companies dominate the market and so an exposure in market weightings tends to have a very small amount of small company and value exposure. • Many asset allocators believe a portfolio should have more small company and value exposure than the market gives. Although small companies might only make up 5% of the market by capitalisation, they make up the vast majority of listed companies by number. Despite the tiny market weighting, asset allocators often allocate a larger amount of 10 to 20% to small caps and similarly overweight value companies.

Computer backtest optimisation • A common tool used is called a “mean-variance optimiser” or MVO, a computer program that backtests portfolios to find the ones that lie on the efficient frontier. It looks at historical correlations, mean returns and volatility. • The idea isn’t as good in practice as it sounds in theory because past performance is no guarantee of future results. The program usually only does what inept investors have always done – chase past performance, wags have dubbed MVO’s “error maximisers”. • A non-technical approach goes back to the basics – try to build your portfolio from many “independent sources of risk and return”. This simply means you should diversify into many different asset classes.

So how do you go about constructing a portfolio? • The usefulness of historical correlations and returns is usually overstated, but can form a crude guide as long as we don’t take them too seriously. • Don’t get too hung up on quantitative data, but try to find assets that are very different (e.g. property vs. shares.) • Our first example of a diversified portfolio had a one third allocation to Australian shares, one third to international shares and one third to property. Since over the longer term these asset classes deliver approximately the same returns but operate on somewhat different cycles, that isn’t a bad allocation to start with for a high growth portfolio.

Decisions, decisions… • Active funds or passive/index funds? • How much to growth assets, how much to income assets? • Balance of value stocks to growth stocks? • How much large cap shares, how much small caps? • How much money to put in developed markets vs. emerging markets? • Currency hedged or unhedged international shares? • Listed or unlisted property? • Short or long maturity fixed interest?

Within the one third allocated to Australian shares in our simple starting portfolio, we can allocate money between large cap growth, small cap growth, large cap value and small cap value. We can also allocate along the lines of industrials vs. resource stocks. • Within the one third allocated to international shares we have the same asset classes above, but we can also allocate to developed markets or emerging markets. • One might even consider allocating some of the shares investments to private equity (unlisted shares), which may often provide a very high return yet at substantial risk. A small allocation to a risky asset with low correlation to other asset classes can actually reduce the volatility of the overall portfolio. • Long/short managed funds can also be useful as they usually have a very low correlation with the indexes.

Risky assets vs. risky portfolios. • It is important to think about risk in a portfolio context, not an asset context. Portfolio building should be seen more like cooking – we are more concerned with the final product than the taste of each ingredient. Pepper tastes great on a steak, but makes a lousy meal by itself. • Small percentage allocations to riskier assets like emerging markets, private equity, commodities, hedge funds and agribusiness can actually reduce the risk of the overall portfolio because they don’t operate on the same cycles as major asset classes. Small allocations to such assets can have a great impact on the efficient frontier.

Are risky assets like emerging markets too risky for conservative portfolios? • Emerging markets are by themselves a very risky asset class, their monthly volatility is about 50% higher than global large companies (DFA indexes). On the other hand, their correlation with the global large caps indexes is quite low. • Despite the high volatility of emerging markets, their low correlation with global large cap equities means a small percentage allocation of emerging markets to a global portfolio can actually reduce the volatility of a portfolio while potentially increasing returns. January 1988 to January 2004, DFA Emerging Markets index plus Global Large Company index.

A little volatility can go a long way • In a sense, the high volatility of the riskier asset classes is one of their most valuable attributes for a portfolio. • The high volatility of asset classes like emerging markets and commodities means they punch well above their weight in contributing risk and return to the portfolio. • A 5% allocation to a risky asset class with low correlation to “mainstream” asset classes might contribute as much diversification as a 20% allocation to a less volatile asset class, so only a small amount needs to be invested to improve portfolio diversification.

Review of the return vs. volatility of major asset classes from January 1988 to January 2004.

Obviously some asset classes have been more efficient than others over this time frame, but which asset classes will be best over the next 10 years is another matter entirely. • Australian value stocks for example continued to provide strong gains over the last few years as the rest of the stock market, especially international stocks, did poorly. In 2003, Australian small caps rose 40% (nearly twice what large companies returned) despite underperforming over the previous decade. • There really is no way to forecast which assets are going to outperform, although that doesn’t stop people from trying!

Adding conservative assets • So far we’ve only shown what happens when growth assets of the various flavours of shares and property are added together. • Although we can substantially improve on large cap growth share portfolios in terms of risk and return there are limits to how conservative a portfolio of growth assets can be, to push the efficient frontier more toward lower risks the income asset classes (bonds, cash, mortgages) will need to be added. • We have to accept that over the longer term this will probably cost the investor money due to a lower expected return, but the risk reduction potential is tremendous and this may be more suitable for conservative investors.

Half the risk doesn’t mean half the return! • Risk to reward ratios get more favourable for conservative portfolios. • Putting half a share portfolio into cash will basically halve the risk, but since cash doesn’t return 0% you won’t halve the return. • If you gear a portfolio though you do double your risk (if you use 50% leverage), but because you have to pay interest on the loan you won’t double your return. • Conservative portfolios therefore can greatly reduce risk without necessarily having the same amount of reduction in the return. This can be seen on the efficient frontier, which is usually curved instead of straight.

A property of efficient frontiers is that the left side of the chart is usually a lot steeper than the right side. Addition of even a small amount of cash to a share portfolio (here we have used the ASX500 All Ordinaries share index from January 1980 to January 2004) can significantly reduce volatility with very little impact on returns and the addition of a small amount of shares to a cash portfolio can significantly increase returns without increasing volatility much. All cash All shares

Part Three Risk profiling and portfolio design

So why not always use a medium risk portfolio? • If diversification makes it relatively easy to substantially reduce risk for only a small cost in return, why not do it all the time? • The answer lies in compounding interest. Over a long period a small increase in returns makes a big difference to the final portfolio value. • The difference between a portfolio that returns 8% over 20 years and a portfolio that returns 10% over 20 years is very substantial. Ten thousand dollars invested at 8% for 20 years will grow to $46,610, one thousand invested at 10% for 20 years will grow to $67,275 - a very significant difference! If you are young then your time frame on retirement assets is likely to be 30 years or more. • Growth assets are also generally more tax efficient and therefore the gap between aggressive and conservative portfolios widens after tax.

Over a short period of time there is very little difference so it may not be worth taking a risk, but if you do have a long term horizon then serious thought should be put into ways to get an extra percentage point or two out of the portfolio. An extra point of risk is often hard to notice without a computer, but an extra point of return makes a very big difference in the long term! Risk is important but being overly conservative can be a costly mistake over the long term.

Choosing a level of risk vs. return • “Risk profiling” is a tricky business that depends on the time horizon, risk tolerance and return requirements of an investor. • As a financial planner I spend a lot of time working on this with clients, but it is a complex area and it is outside the scope of this presentation. • Some model portfolios with different levels of risk and their risk/return profiles are shown on the next few slides.

Three dimensional approach to risk profiling Most advisors discuss risk tolerance in terms of potential volatility only, often using short multi-choice questionnaires. In my opinion, this is inadequate and doesn’t really address the client’s needs. I think there are actually three dimensions to risk profiling: • Time frame – when is the money required? • Volatility tolerance – how much volatility? • Conventionality – given the different cycles of value and small cap shares and that they may underperform large growth companies for extended periods of time, how much of a value and small cap tilt is acceptable?

How to construct a portfolio using simplified modern portfolio theory