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By Selwyn Gerber:
Global investing offers growth that may beat the U.S. market. The U.S. will rarely be the best performing market in the world, and the returns from well developed economies often dwarf U.S. Stocks.
Some would argue that tilting a portfolio toward a particular sector of the market like small company stocks or value stocks is the same as stock picking, which is a loser’s game. But if there’s more than one type of risk driving returns, and all studies agree that there are multiple risk factors impacting stocks, it is possible for investors to use a wider range of strategies to gain greater expected returns, while remaining within the bounds of indexing.
Newer indexes, available as ETFs, take advantage of these academic studies and allow for gains that beat the market. Equal weighted indexes provide broad exposure to all companies in an index such as the S&P 500 without allowing a small group of larger stocks to dominate the performance of the investment. An equal weighted index buys each of the 500 stocks in equal amounts, compared to the traditional index fund or ETF which holds each company in proportion to its capitalization within the index. By eliminating the bias toward large companies, an equal weighted index provides investors with the opportunity to outperform the index with lower volatility.
Figure 8-5 shows that the theory behind equal weighted index works. Frequent rebalancing to prevent one sector from dominating the index provides steadier gains, and increases the gains. Over five years, the equal weighted index provided an additional one percent a year, on average. In dollar terms, a $10,000 investment in a traditional cap-weighted index increased to about $15,000 over the five years in 2007. That same investment in an equal weighted index would grow to more than $18,000.
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An equal weighted index delivers higher returns in this example. This figure demonstrates the value of buying low, and selling high which is the discipline followed by equal weighted indexes.
Other ETFs have been developed to address the finding that value investment strategies generally outpace growth strategies in the long-term. The problem with traditional indexing is that as investing fads gain steam, the index over weights stocks that have become overvalued. This comes at the expense of underweighting lower valued securities, the ones likely to do best in the future. He results is that capitalization and float weighted indexes are at a disadvantage to equal weighted indexes. Equal weighting requires the manager to “buy low and sell high” enhancing future returns.
Research also demonstrates that fundamentally-based indexing, which is based on standard stock market measures, performs better than a cap weighted index. Fundamental indexing is proprietary technique of Research Associates and seeks to assign weightings within an index based ETF based on the actual economic footprint of the enterprise. A variety of accounting items, including sales, dividends, cash flow, and book value, offer the promise of increased returns. ETFs are available that select and weight securities using these fundamental values to break the long-standing limitations of standard indexing.
These returns demonstrate the benefits of a value indexing methodology.
As we can see in this figure, buying value stocks makes a difference. All approaches nearly double the total returns with about the same amount of risk. An ETF using these strategies would also hold fewer stocks than a traditional index ETF, resulting in lower transaction costs and greater tax efficiency.
Combining the latest in research with indexing strategies allows investors to improve on the market return without trying to pick the best stocks or the best managers. These techniques deliver on the promise of active management without the costs and the risks usually associated with the active manager.
Chapter 9: DIVERSIFICATION: THE KEY TO MANAGING RISK
Successful investors have a variety of investments in their portfolios, which can include ETFs based upon international and domestic stocks with varying styles. The well diversified portfolio also includes bonds. Asset allocation is driven by personal circumstances, not simplistic formulas. It is also important to regularly rebalance the portfolio to maintain diversification.
“Diversification is when the ice cream mans branches into selling ponchos”
- Rip Van Winkle Wisdom
Diversification means dividing your total investment portfolio into different types of investments, including stocks, bonds, real estate, and cash. Investors should also be diversified into different investment strategies within those broad categories. Using mutual funds or ETFs for the stock portion of a portfolio, this can mean owning a selection of growth or value funds, small cap, large cap, and/or sector funds. Geographic diversification can be achieved by owning a combination of domestic and international investments.
Diversification reduces the risk of a portfolio. This has long been known in the academic community. In 1952, Harry Markowitz published a paper called “Portfolio Selection.” He was later awarded the Nobel Prize in Economics for his work which began with this research. Markowitz developed the idea of selecting stocks to maximize returns given an individual’s tolerance for risk. He provided the math to justify the common sense notion that widows and orphans should hold more conservative investments than a multimillionaire in their early 30s.
Markowitz stressed the need to think of individual stocks as part of a portfolio. He demonstrated that performance depended upon balancing risk and reward. It was possible to balance risky stocks and safer stocks within a portfolio to provide solid returns with less risk than the overall market. In other words, with proper diversification an investor should be able to beat the market while holding a portfolio which is less risky than the market, despite the fact that within the portfolio there were individual elements that were relatively risky in themselves.
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