A straightforward way for an investor to partake in capital markets is to own a diversified basket of stocks of companies from around the world, which can be achieved by owning a global equity fund. Perhaps a global market index tracker.
These days, this can be done cheaply and with ease. Consider this quote from Eugene Fama, often called the father of modern finance:
You have to talk yourself out of the market portfolio
This gives us a sensible starting point for building a portfolio. There are, however, a number of great reasons to talk oneself out of the market portfolio. All of these reasons are - as should always be the case - backed by a deep foundation of evidence.
Decades of evidence suggest that groups of companies with certain characteristics exhibit different returns, as a whole, to the market. The difference in returns can be explained by the different risks inherent in these groups of companies. Examples include value and smaller companies, or ‘small caps’.
The reason for holding exposures – or ‘tilts’ - to such companies is twofold.
1. Increase expected returns
On the basis of the higher risks involved with owning stocks in companies classed as value or small cap, it is reasonable to expect higher returns over the long term. This is – like most things in investing – by no means a guarantee. However, the longer an investor holds such portfolio exposures the greater the chance they have to enjoy the long term expected outcomes.
Over the same period as that in the figure above, a portfolio with moderate tilts to value and small caps enjoyed an annualised excess return of 1% over that of the broad stock market. For investors, this is an opportunity to increase the chance of achieving investing success and, ultimately, meeting one’s financial goals.
The expected outperformance of a tilted portfolio, however, is not delivered with regularity. There can be times whereby such exposures can leave an investor lagging the performance of the market. It could, perhaps, result in deeper declines in the short term in market downturns. The worst over the period above happened between Apr-37 and Mar-38, when the US market was down -49% and the tilted portfolio a further -7%. Investors with the patience and fortitude to continue with a disciplined approach of buying, holding and rebalancing during such times are rewarded in the long term.
2. Improve diversification
Another important benefit of moving away from the portfolio and tilting to value and smaller companies is improved diversification. In investing-jargon, this is owning exposures to imperfectly correlated asset classes. This can result in better ‘worst case’ outcomes, which is an important concern for any investor.
In global markets, the largest five companies comprise 17% of the market, at time of writing. Owning a tilted portfolio reduces this to 10%. For investors, this means lowering the concentration in a small number of companies, whilst still enjoying the returns such companies offer to investors as the largest in the world.
Have confidence in the approach
Investors should take comfort in the fact that they own a well-structured solution, grounded in evidence, built with an aim to deliver better outcomes. For many, owning short-dated bonds or cash also helps to smooth the investing journey.
When it comes to the growth engine of an investment solution, starting with the market portfolio is sensible. Moving away from this – with the guidance of a solid foundation of evidence – makes good sense. The difficult job an investor has – for which your adviser is always there to support you with - is to maintain confidence in their approach through time, whilst not concentrating too much on short-term outcomes.
