Larry has often said that increasing a portfolio tilt to small and value stocks, while reducing beta (equity exposure) can help achieve the same ‘expected’ return but with lower volatility (reduced tail risk) relative to a market portfolio. This helped significantly reduce the downside in 2000-02 and 2008. His own portfolio is structured in a similar way. In addition, Bill Bernstein in “The Ages of the Investor” also presents a portfolio with a significant value and small cap tilt for the young investor.
I think there is some merit in a factor tilted approach, but with a big caveat – tracking error risk.
This post is to highlight the magnitude of tracking error risk, and possible ways to address some of it for those wanting to consider a factor tilted approach.
So where’s the catch? Tracking error risk
- The data from 1982-2012 illustrate the downside benefit. A 100% holding of S&P500 had an annualized return of 11.1 %, with cumulative losses in 2000-2002 of -37.6%, and in 2008 of -37.0%. A 50% RAFI pure small value: 50% T-bills portfolio had a similar back-tested annualized return of 11.2%, but had a cumulative gain in 2000-2002 of 29%, and a much lower downside in 2008 of -17.9%. So where's the catch? In my view it is tracking error risk – which can be huge and for long periods. For those considering this approach, I would suggest considering tracking error risk before taking the plunge. If we rewind to 1984, and compare performance of the above mentioned portfolios from 1984 to 1999.
- 1984-1999 – growth in $1.
S&P500 = $14.3
50% RAFI Pure Small Value: 50% T-bills = $5.4
Obviously this underperformance at a portfolio level is lower if an investor only has a small equity allocation (eg. 25% equities), but for those in the accumulation stage with higher equity allocation, the underperformance can be significant. It is probably as hard to stick with a strategy when everyone else is outperforming for such a long period (1984-1999), than it is when everyone loses money in a crash (2008). In this respect the greatest risk with these strategies may be tracking error risk (capitulation). While the same case could be made for underperforming a value and small cap tilted portfolio, most people in the broader finance community, right or wrong, measure performance against beta (the market), and underperformance against the market may be harder to stick with, as there would likely be more noise around it. There’s a trade-off then in this case between downside risk, and tracking error risk. Greater downside protection came with greater tracking error risk (which can be significant). - 1984-1999 – growth in $1.
- Two options are:
- 1. Add more S&P500 back to the tilted portfolio. This would both increase the downside a bit, but also reduce tracking error. Stop adding when you find the balance between downside protection and tracking error risk you can live with – both are important (some prefer lower beta e.g. Larry Swedroe, some prefer higher beta e.g. Rick Ferri – no right answer for everyone).
2. An alternative is to consider adding a large cap momentum fund (in place of adding back S&P500) – which tends to amplify returns when the S&P500 does well as in 1984-1999, off-setting more of the lag in small value. In addition, the low average correlation between momentum and value (Asness) can add a diversification benefit.
- Annualized return 1982-2012
MSCI momentum index = 13.5%
AQR momentum index = 12.8%
S&P500 = 11.1%
Correlation coefficient between MSCI momentum index and the RAFI fundamental pure small value index = 0.41, and between S&P500 and RAFI fundamental pure small value = 0.62.
Just to note that adding the MSCI quality index to the mix did not add much. This may be due to the fact that the RAFI Pure SV already has a positive load to “profitability” whether using the Novy-Marx profitability factor or the Asness, Frazzini, Pedersen “quality-minus-junk” factor. This seems a bit counterintuitive, but perhaps its the result of weighting/sorting of stocks by cash flow and sales (re: Larry’s earlier blog on this). The MSCI momentum fund also has a small but positive profitability load. So using MSCI momentum and RAFI pure SV in a portfolio already provides a significant portfolio "profitability load" and in this sense adding the MSCI quality index does not add much to this, but subtracts from the portfolio value tilt as the MSCI quality index had a -0.15 value load.
- 1. Add more S&P500 back to the tilted portfolio. This would both increase the downside a bit, but also reduce tracking error. Stop adding when you find the balance between downside protection and tracking error risk you can live with – both are important (some prefer lower beta e.g. Larry Swedroe, some prefer higher beta e.g. Rick Ferri – no right answer for everyone).
- The bottom line seems to be that heavily tilting a portfolio to small and value stocks while reducing beta has reduced downside risk relative to a market portfolio without giving up much return over 1982-2013. The cost was significant tracking error in 1984-1999 – needing some fairly incredible staying power. For those wanting less tracking error risk, adding a momentum fund would have reduced this more effectively than simply adding back the S&P500 (resulting in a higher Sharpe ratio).
Just some due diligence on momentum, now that investable options are available. Hope its useful.
Robert
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