by WWM | Jan 28, 2021 | Uncategorized
Do you prefer to listen and watch your wealth management commentary?
If so, I am setting up many of my investment education blog posts as vidcasts on YouTube. Hopefully, in short enough time spans so that an episode may be easily consumed in one sitting.
Over time, I plan on using this channel for interviews with professionals in investing or other relevant industries. Where we discuss and debate wealth management topics of interest.
Investing basics, but also more complex wealth management issues. Specialized investment areas such as pensions, private equity, and wind farms. Topical issues such as FinTech, cryptocurrencies, and ESG.
Please check out the channel. I hope it adds some value in improving your wealth accumulation knowledge.
Wilson Wealth Management on YouTube.
by WWM | Jul 22, 2020 | Target Asset Allocation
Your asset allocation and investment strategy may work well in “normal” times. But how does it perform during a so-called Black Swan event? And what happens if you panic and reduce portfolio risk as the result of crashes?
An article by Jim Otar, “How asset allocation impacts portfolio recovery”, looks at this issue.
A few thoughts on the article from my side.
Markets are Overwhelmingly “Normal”
The media attention is always on the outliers and Black Swan events. Usually to the downside. So it appears huge corrections are fairly common.
Interesting to note that only 6% of the time, markets operated in a fractal mode. The other 94%, markets act in an expected, albeit often random, manner.
As the article points out, proper target asset allocation works well in normal times. You only have issues about 6% of the time. A good reason to “stay the course” and continue with a structured investing approach and plan.
Know Thy Risk Tolerance
True. I think this kind of gets glossed over in the article.
Investors should take a systematic approach to their risk tolerance. At times, this is difficult as emotions and behavioural aspects often intrude.
This is an area where a competent financial advisor can add value. Someone who is dispassionate. Who understands investing and how risk should be assessed within your portfolio.
Risk should not be about gut feelings. Though, they will play a part. If you are someone who is concerned about any minor loss, you will stay awake at nights if invested heavily in equities. So there is that to consider.
But if you learn about the risk-return relationship, portfolio diversification, how asset correlations can reduce overall risk, how time impacts riskiness, etc., that will (hopefully) alleviate some of the less rational concerns.
Asset Allocation and Life Cycle Phase
Part of one’s risk tolerance should be tied to time horizon and phase of life cycle.
If you are earning income and your main priority is retirement in 30 to 40 years, you have a relatively long time horizon. Ceteris paribus, you can invest in higher risk (with higher expected return) assets than someone who plans to retire in 3 to 4 years. Emotion is not involved. Just basic mathematics.
That said, most people have multiple investment objectives. Of varying time horizons. I am 30 and wish to retire at 65. I have a 35 year horizon. Perhaps my target asset allocation should be 80-90% equities.
But perhaps I wish to start a family and buy a home in 3 years. That changes the equation as I want greater certainty to ensure I have a down payment on the home. As well, maybe I want to start an education plan for my newborn. Or I need to consider personal insurance in case of health issues.
Your risk tolerance needs to reflect your investment objectives, their relative priority, and time frame.
Single, 30 year old me can sit tight and ride out any Black Swan events. Because I have a 35 year horizon and I will recover any short term unrealized losses. If I stay the course, I will do better than jumping in and out as the article’s examples show.
However, it is different for family starting 30 year old me. If I need $50,000 as a down payment on a home in 3 years, a Black Swan correction of 25% may not recover in 36 months. In the examples given, my behaviour and investing should be more like a 60 year old. At least for the portion of assets needed for near term objectives.
This is an area I often see problems. Individuals focus exclusively on retirement in 30 years and invest accordingly. But do not account for short term goals that require a different investment approach.
60/40 or 40/60 Asset Allocation Split
The article uses 60/40 or 40/60 equity to fixed income ratios in its examples.
Not too many years ago, a 60/40 split was often recommended for younger investors, with a move to 40/60 as retirement neared. Then, heavy into fixed income after retirement.
I think the author is simply using these splits in his examples. Not recommending them. Do not believe you should use either.
Your target asset allocation should reflect your unique investor profile. Not some cookie cutter approach.
For example, another “great” allocation calculation was to invest (100 minus your age) in equities. The rest in fixed income. If you were 30, that meant 70/30 split. At 40, 60/40. And so on.
Simple, yes. Useful, probably not.
See my comments above on the single 30 year old versus the 30 year old who wants to buy a home and start a family. Should they both have 70% in equities and/or identical portfolios? No.
Your target asset allocation should reflect your unique investor profile. Your financial position and realistic expectations. Where you are in your life cycle. Investment objectives by priority and time horizon. Constraints that may impact achieving your goals. And your personal risk tolerance.
All of these factors will determine the appropriate target asset allocation and drive your investing strategy. What might be optimal for you, may not be for a friend of the same age. As he/she will have a different investor profile. Perhaps similar, perhaps not. But not identical.
As your own personal circumstances change over time, then you will also differ from “past you”. Your investor profile should be updated to reflect those changes. And, as necessary, your target asset allocation and investment plan.
by WWM | Jul 16, 2020 | Diversification
In previous posts on diversification, I have mentioned that asset correlations are not fixed.
Typically, asset class correlations fluctuate within a range to some extent. For example, US bonds have been negatively correlated to US equities in the last 20 plus years.
But correlations may shift over time outside the expected norm. These shifts may be temporary in nature, based on short or medium term events. After which they revert back to the traditional range. Or they may be permanent due to longer term structural changes.
Investors need to monitor their inter-asset correlations on a regular basis to ensure their portfolio is optimally diversified.
“International Equities: Diversification and Its Discontents”, by Ford Donohue, provides a good example of a permanent shift. This one relates to diversification benefits of investing internationally, outside your domestic markets.
The article makes a few other useful points for investors, that I will also highlight.
Asset Correlation Reminder
Correlations between assets range from -1.0 (-100%, perfectly negatively correlated) up to 1.0 (100%, perfectly positively correlated). At -1.0, two assets move in completely opposite directions. At 1.0, they move in lockstep. At 0.0, there is no correlation between the two assets.
Any correlation below 1.0 provides some diversification benefit. But the lower the correlation coefficient, the more the risk reduction of adding the two assets together. A portfolio objective is to add low or negatively correlated assets into the overall portfolio as a risk management technique.
Historically, this is why relatively lower return fixed income is paired with higher return equities in portfolios. Over the last 20 plus years, US bonds have had a (mainly) negative correlation to US equities. The reduced returns of bonds versus equities is offset by the lower portfolio risk.
Since 1997, the traditional expectation is that bonds tend to be negatively correlated with equities. But even here, we see years where that does not hold true. Before 1997, there was not a traditional negative correlation. And from 2004 through 2007, there were also small positive correlations. Bonds were still a very useful diversifier, as positive correlations were relatively low. But short term economic events caused the correlations to shift in that period. Which may have lowered the efficiency of one’s portfolio.
Trading Return for Diversification
The article notes that, “Investors might be willing to sacrificing some returns in order to diversify a portfolio and reduce risk.”
True. And often a potential tradeoff for investors. Reducing risk is great. But if it comes at potentially hurting portfolio returns too much, that is an issue.
It is a constant balancing act to ensure you do an adequate job on the asset and investment mix. In this example, as asset correlations increased over time between US and EAFE (traditionally covering Europe, Australasian, and Far East) equities, this reduced the diversification benefits. And made the lower international returns less tolerable.
Irony and International Diversification
25 years ago, investing internationally provided excellent diversification benefits for equity investors. Prior to 1998, the asset correlation between US and EAFE stocks was under 0.50 for many individual years. Per the article’s rolling 10 and 20 year correlation graph, correlations averaged roughly 40-50% from 1980 to 1998.
Sadly, domestic investors typically stayed at home. Holding portfolios with very high home country bias.
Today, with a better understanding of diversification, international markets, and ease of access, more investors have gone global. Just in time for those great diversification benefits to have somewhat shrunk.
Since 1998, asset correlations have increased significantly. “Correlations between US and international equities over long-term time horizons now fall consistently between 80% and 90%.” Still some diversification benefits, but nowhere near the impact of 40-50% correlations from 25 years ago.
Cue Alanis Morrissette’s song, “Ironic”. Don’t you think?
The Increase in Correlations Impacts Asset Allocation
The article’s efficient frontier compares two portfolios. One assumes the 1970-2019 average correlation coefficient of 0.65. The second assumes 0.86 based on the most recent 10 and 20 year rolling correlations.
In scenario one, 60% of the portfolio could go into international equities. In the second, the international allocation is reduced to a maximum of 20%. Had the investor not monitored changing correlations, he/she would have continued with the 60% EAFE allocation in an inefficient portfolio.
Not too mention had they initially set up the portfolio when the correlation was under 0.50. That may have led to a 80% or higher international allocation. Much different from the maximum of 20% indicated today.
Why the Shift in Correlations?
The article mentions the “internet revolution”. True, to some extent. It has allowed for faster and more complete access to information and global trading platforms.
For example, I returned to Canada from Switzerland in 2007. In looking at the major banks in Canada, only HSBC offered online equity market access outside North American markets. There has been much change since then.
But the main reason for increasing correlations is globalization of business. Many companies operate outside their domestic markets for revenues. As well, large companies often outsource production to less costly locations. Apple or Nike manufacturing much of their products in China.
A good example of this globalization in the real world involves Starbucks.
“Starbucks began life in 1971. A single store in Seattle. In 1987, Starbucks finally expanded out of Seattle, to Vancouver and Chicago. What Australians or Swiss drank was of no concern. It was not until 1996 that Starbucks expanded outside the US, with a location in Tokyo. 25 years of revenues solely from North America. Yet by 2018, Starbucks had over 27,000 locations in 76 countries or territories. A good example of globalization and shrinking of borders business-wise. As the world changes, so too may inter-asset correlations.”
And in May 2020, Starbucks had over 31,000 outlets in 79 different countries or territories. Today, Starbucks cares very much about the caffeine choices and economic conditions in Australia, Switzerland, and many more locations.
Interesting how Starbucks’ global trajectory parallels the reduction in global equity correlations. McDonalds, Walmart, IKEA, BMW, etc. All have similar global expansion over the last 25 years.
Okay, a good article with some interesting points for investors. Always monitor your portfolio to ensure it is up to date. You may be able to ride out short term correlation fluctuations. But for permanent shifts, you will need to adjust your asset allocation to maintain portfolio efficiency.
P.S. If the diversification benefits of EAFE equities has reduced over the years, maybe investors need to look slightly further afield with their equity investments. Emerging and frontier markets, may be those fresh fields. For how long though, is the question.
by WWM | Jun 24, 2020 | Diversification
In “Diversification and Index Weighting”, we looked at how market capitalization weighted versus equal weighted indices can impact industry sector allocations in an index or investment fund. As well, simple measures to ensure your fund is diversified across sectors.
This was based on Morningstar Canada’s, “Is Your ETF Actually Diversified?”
A more realistic diversification problem with market weighted indices is the impact that relatively few holdings can have on the overall index performance. This is an area where I see investors get confused all the time.
Too Much Exposure in a Fund
You buy into a fund with 300 holdings. Way more than enough diversification. That is what we want, right? Yes, but …
The S&P 500 contains (roughly) 500 different companies. It deviates a bit in reality. 500 companies is a lot of diversification. In an equal weighted index, yes. Each holding will make up 0.2% of the index. The top 10 holdings will be 2%. The top (and bottom) 250 will be 50%. Each holding contributes equally to diversification, return, and risk.
But the impact differs greatly under market weighting.
Okay. But 500 stocks is a whole lot and that spreads out investment risk nicely.
But does it? At least to the extent it appears on the surface.
What if I told you that the top 10 holdings in the S&P 500 make up 26.6% of the total assets under instrument (AUI)? Or that the top 20 and top 30 holdings represent 35.9% and 43.2%? Out of 500 stocks in the portfolio, only 30 make up almost half the AUI.
Is that as diversified as you thought a 500 stock portfolio would be?
Looking at it another way, Microsoft (5.67%), Apple (5.65%), and Amazon (4.19%) are the largest holdings in the S&P 500. These three companies make up 15.51% of the index.
In comparison, the smallest 150 companies of the 500, combine for 4.49%. 150 companies equals a single Microsoft, Apple, or Amazon in clout.
Going farther, the smallest 250 companies, fully half the index, only account for 10.52% of the total. And the smallest 400 companies only achieve 29.14% of the index.
Versus the top 12 largest companies that weigh in at 29.60%.
Yes, an S&P 500 fund may provide you with 500 different companies. But how many companies in that index actually impact annual performance? Probably fewer than 50.
50 different companies is still pretty good for diversification (at least if we do not factor in industry, geography, etc., that impact correlations). But if you think you are getting the diversification benefits of 500 companies, this is not true due to the use of market weightings.
Not Just an Index Fund Issue
The same problem often is true with most actively managed mutual or exchange traded funds.
In Canada, consider some of the largest mutual funds.
The Pimco Monthly Income Fund is primarily a bond fund. It has 2224 holdings and CAD 22.3 billion in AUI. Lots of holdings. Yet its top 5 account for 34.1% in AUI.
The RBC Canadian Dividend Fund has 83 holdings and CAD 16.4 billion in AUI. Yet, the top 5 holdings account for 30.3% of all assets. The top 10, 46.5% of AUI.
The Fidelity Canadian Growth Company mutual fund has 92 holdings and CAD 6.9 billion in AUI. Its top 5 holdings are 27.3% of AUI. Its top 10 holdings make up 46.0% of all assets.
Again, you may think you have a ton of diversification when you invest in funds with a relatively large number of holdings. But it is important to look beneath the surface.
Always review the top 10, 20, and 30 holdings as a percentage of overall AUI. That will help inform you as to how many holdings truly impact that fund’s performance and diversification.
by WWM | Jun 17, 2020 | Diversification
Is your investment fund as diversified as you think it is?
Morningstar Canada considers this question in, “Is Your ETF Actually Diversified?”. And yes, the same question applies to mutual funds and other investment products.
The article does a good job of analyzing this issue. The focus being on how the method of index weighting can skew sector diversification. Worth a read.
But there are other lessons contained within, which are not considered by Morningstar.
Today I want to address how market weighting an index may distort sector diversification. And, more importantly, how to reduce this risk. We will cover other lessons in subsequent posts.
Index Weightings
Market indices (and related investment funds) may be created in different manners.
The two most common are market capitalization weighted and equal weighted. You may also occasionally see factor weighting and price weighting. But we will just look at the most common weightings.
Market weighted indices are created based on relative market capitalization of the holdings. If we use the S&P 500 as an example, behemoths like Microsoft, Apple, Amazon, and Google dominate based on their sheer size. While still large companies, relatively smaller stocks like Union Pacific, Danaher, and NextEra have minimal weightings.
Equally weighted indices do not factor in market capitalization. Microsoft is included in equal amount as Union Pacific. 500 companies in the index. Each carries 0.2% weight.
Index Investing May Not Provide The Diversification You Assume
The focus of the article is on how market weighted indices overweight certain industry sectors. This is true. Good to understand. I am just not sure it is that crucial for investors.
As the article points out, which overall market (e.g., country) the index covers will pinpoint the potentially over (or under) weighted sectors. What do I mean?
The iShares Core S&P 500 ETF (IVV) is a market weighted index proxy. Given the size of Microsoft, Apple, Google, Amazon, and Facebook, it is unsurprising to see that Technology is by far the largest market weighted S&P 500 sector at 26.7%. Trailing this is Health Care (14.4%), Communication (10.8%), Consumer Discretionary (10.7%), Financials (10.6%), and Industrials (8.0%).
If we compare that to Invesco’s S&P 500 Equal Weight ETF (RSP), Technology falls to second spot at 14.3% of the fund. Instead, in equal weighting, Industrials actually is the largest sector at 14.8%. A substantial redistribution versus the same companies under market cap weighting.
That is Morningstar’s point. By market weighting the S&P 500, you end up with an overweighting in Technology. This can negatively impact portfolio diversification. True.
Depending on how you calculate, your index may change the relative exposure to market sectors. However, changing relative sector weights by equal weighting, may or may not increase diversification. It depends, at least to me, on many other factors. Not simply weighting.
As well, should Union Pacific or NextEra carry the same weight in an index as Apple or Amazon? Does equal weighting better represent the large cap US stock market? I would argue that market weighting better reflects US equity reality. But your own mileage may vary.
Global Diversification
Part of the reason investors should diversify globally is to smooth out potential sector over-weightings in market indices. Different countries have different areas of dominance. By investing across markets, you can equal out your sector exposure and keep that diversification intact.
We saw in the S&P 500, that Technology dominates. But that is the US market.
In Canada, Financials (33%) rule the TSX Composite, with Basic Materials (14%), Oil and Gas (14%), and Industrials (11%) following. In Canada, Technology is only fifth, at 10%.
In Europe, consider the index fund, iShares Core MSCI Europe ETF (IEUR). Its top sectors are Healthcare (16%), Financials (15%), Consumer Staples (14%), and Industrials (14%). Technology is ranked seventh, at 7%.
In China, index fund iShares MSCI China ETF (MCHI) largest sector exposure is in Consumer Discretionary (27%), Communication (22%), and Financials (19%). Technology ranks seventh at 4%.
Canada offers significant Oil and Gas exposure versus relatively little in Europe or China. In turn, Europe is heavy in Healthcare, which is not a major sector in Canada nor China. And in China, Consumer Discretionary is a big sector. In Canada and Europe, much less so.
By investing in different geographical markets, your relative exposure to specific sectors changes. As well, you can allocate more to sectors or markets you think have upside. Whether that be overweighting a specific country index or in adding niche funds to your portfolio.
For example, if you are worried about not having enough Technology in your Canadian equity fund, you can add iShares S&P/TSX Capped Information Technology Index ETF (XIT) to complement your TSX Composite fund.
With so many ways to offset sector skewing, the concerns raised in the Morningstar article become less an issue.
Market Cap and Style Diversification
The same argument can be made for investing across different market capitalization indices (e.g., mega, large, mid, small, micro) or style (e.g., Value, Growth).
In the US equity market, mega cap companies (capitalization typically over USD 200 billion) dominate the S&P 500 index. The Apples, Amazons, Facebooks, Microsofts, Googles of the equity world.
The Russell 2000 tracks US small cap companies (capitalization typically USD 250 million to 2 billion). In this market segment, Healthcare (21.5%), Industrials (15.2%), and Financials (15.1%) exceed Technology (15.0%) for sector exposure. A marked difference from the S&P 500 breakdown.
With style, let us compare two mid-cap indices (capitalization typically USD 2 and 10 billion). We will use iShares S&P Mid-Cap 400 Value ETF (IJJ) and iShares S&P Mid-Cap 400 Growth ETF (IJK).
IJJ’s top five sector weights are Financials (23.1%), Industrials (13.7%), Consumer Discretionary (12.4%), Real Estate (11.7%), and Technology (10.0%).
IJK’s top five sector weights are Technology (22.0%), Industrials (17.9%), Consumer Discretionary (14.9%), Healthcare (14.5%), Real Estate (9.1%).
First, we see variation in sector weightings between US market equities of small, mid, or mega capitalization. Second, even within the US mid-cap market, there are different sector weightings based on whether the companies are Value or Growth stocks. Both findings make sense and are expected. And a reason to diversify into asset subclasses.
It is useful to understand the differences between market and equal weighted indices. And that market weighting can skew sector allocations. That said, there are many ways to adjust sector weights on your own. Then create the allocation you desire.