The beginning of 2016 had most people thinking that we were in for a rough one. There were some negative months to start things off, and a few more throughout the year, but all things considered 2016 was a great year to be in the market. That is not the story that you may have heard from the media, who were warning us to sell everything back in January. Despite Brexit and Trump, US and International markets continued to climb through December, and the Canadian market hit its highest 1-year return since 2009. Even bonds pulled their weight with a modest but respectable return.
It was small cap and value stocks that stole the show in 2016, delivering on return premiums that were starting to be forgotten or dismissed. Only emerging markets saw small caps underperform, while Canada, the US, and international developed markets saw small cap outperformance. Value stocks outperformed across the board.
The following is a breakdown of how the major asset classes that make up our portfolios performed in 2016 (in Canadian dollars).
After a slow start, the US equity market (Russell 3000 Index) continued to roll ahead through December, posting a final return of 9.41%. US small caps (Russell 2000 Index) posted a return of 17.73%, and US value (Russell 3000 Value Index) finished the year with a return of 14.91%.
International developed equity (MSCI EAFE IMI Index – net div.) posted a slightly negative return of -1.83%, but had a bit of a boost from international developed small caps (MSCI EAFE Small Index – net div.) with a return of 2.18%, and international developed value (MSCI EAFE Value Index – net div.) with a return of 1.93%.
Portfolios with an emerging markets allocation did get a further bump in performance. Emerging markets (MSCI Emerging Markets Index – net div.) returned 7.91%, emerging markets small caps (MSCI Emerging Markets Small Cap Index – net div.) finished with a -0.74% return, which was more than made up for by emerging markets value (MSCI Emerging Markets Value Index – net div.) which returned 11.52% for the year.
The end of 2015 and beginning of 2016 looked dismal for the Canadian equity market, but by the end of 2016 anyone that had dismissed Canadian stocks was kicking themselves. The Canadian market (S&P/TSX Composite Index) closed out 2016 with a 21.08% return. Canadian small caps (MSCI/Barra Canadian Small Index) posted a 27.16% return, and Canadian value (MSCI/Barra Canadian Value Index) ended the year with a whopping 32.38% return.
Fixed income seems to get a lot of negative attention, but continues to have decent returns. Global bonds (Bloomberg Barclays Global Aggregate Bond Index – hedged to CAD) still managed to post a return of 3.73%. It was a drop from the 6.43% YTD return that global bonds saw in July, but still nothing to complain about. Canadian bonds (FTSE TMX Canada Universe Bond Index) did not fare so well, posting a return of 1.66%.
The portfolios that I recommend to clients use products from Dimensional Fund Advisors, which aim to passively capture market returns with an increased weight given to small cap and value stocks. The funds are built this way based on the academic evidence that supports doing so. Dimensional funds do have higher fees than broad market ETFs. Is it worth it? I think so, and this year is a good example of why. I have compared a model portfolio of Dimensional funds to a model portfolio of ETFs by security, and by overall portfolio performance.
The obvious answer is small cap and value. When they outperform the market, a portfolio that holds more small and value than the market will also outperform. There are a few more edges that the Dimensional portfolio had over ETFs in 2016.
Dimensional’s fixed income is globally diversified, while the ETF portfolio holds only Canadian bonds; we saw above that global fixed income returns (hedged to CAD) more than doubled those of Canadian fixed income last year. The ETF model portfolio holds only short-term bonds with an average maturity of 2.92 years, while the Dimensional portfolio has an average maturity of 4.6 years – still short, but longer than the iShares Canadian Short Term Bond ETF. Longer bonds are riskier, but have higher expected returns. That risk paid off in 2016.
Currency hedging also played a role. Currency has no expected return, so over the long-term a currency hedge should not have a meaningful impact on performance. In the short-term, currency can add significant volatility to returns. The Dimensional portfolios partially hedge equities and fully hedge fixed income to CAD. The hedge resulted in a significant performance boost in 2016 as the CAD strengthened.
This post is not a victory lap. 2016 made Dimensional funds look good, but in past years that has not been the case. There is a risk to allocating more to small cap and value. Any given year may see underperformance, even over multiple years. We take the approach that it is optimal to follow the academic evidence that small cap and value stocks will outperform over the long-term, with the understanding that this does not mean higher returns every year.
Data sources: BlackRock Canada, Vanguard Canada, Dimensional Fund Advisors Canada, MSCI, S&P Dow Jones, Russell, FTSE TMX, Bloomberg Barclays, analyzed using Dimensional Returns Web
Academia points to some ways of investing that are likely to have better outcomes than others. The idea that value stocks will outperform growth stocks over the long-term is generally accepted by researchers and practitioners. The same is true for small stocks outperforming large stocks.
In an academic sense, capturing this outperformance is best achieved by going long small value stocks and short large growth stocks; an approach that might seem very reasonable to an academic who understands the research. In real world applications, though, investors are not usually comfortable with the concept of shorting, or the potential volatility that can accompany a long-short portfolio. Regardless of what academia says, the perfect investment strategy ends up being as much about the investor as it is about the research.
Dimensional Fund Advisors is currently one of the world’s leading investment firms with $585 billion in assets under management. All of their products are constructed based on academic research. As close as they are to academia, you will not find any long-short strategies in Dimensional’s product lineup. They are instead focused on building funds that take enough from the academic research to be beneficial, while remaining comfortable for investors.
But Dimensional takes another cautionary step: they only distribute their products through financial advisors who have shown a commitment to understanding the research. Finding the right investors is just as important as the quality of their products.
If an investor does not understand the reason that they are invested in something, it becomes extremely difficult for them to stay invested through any market turbulence. This is evident in the volatility of mutual fund flows. Nobody really knows what their actively managed mutual fund manager is doing, so they tend to pull their money out when markets are down.
Plenty of DIY investors are having success with the straight forward strategy of owning low-cost index funds and ETFs. When there is no active manager making decisions on your behalf, there is a lot less to second guess. Passively owning the market is an easy strategy to understand. For some, maybe this is the perfect investment strategy.
I tend to lean toward a research-based approach when I am giving advice, tilting market portfolios toward small cap and value stocks. Understanding the current academic research and how its implementation in portfolios impacts the expected outcome for clients makes it obvious advice to give. But whether or not this is the perfect investment strategy is harder to say. In the end, it depends on the client.
Actively managed investment strategies are not inherently bad, they just introduce a different kind of risk to the investment experience. A well-diversified passive investor chooses to own the market as a whole, taking on market risk. An active manager is making a promise to not own the market as a whole, but to instead select a subset of securities within the market that they believe will perform better than the market. The additional risk added by not owning the market as a whole is called active risk.
Active managers themselves are not bad people. They will likely work extremely hard to research securities and trends in their effort to deliver above-market returns. The problem that active managers have is that, statistically, it is extremely unlikely that they will be able to deliver on their promises. It is by no lack of effort or resources, but simple mathematics. Active investors invest in the market. In aggregate, the average return of all active investors will be the return of the market, less their fees. Based on this simple arithmetic, less than half of active managers should be expected to outperform the market after their fees.
Further to this, we know empirically that in any given year a disproportionately large portion of market returns come from a small number of the stocks in the market. This makes outperforming the market a greater challenge as it requires the identification of the relatively small number of stocks that can drive outperformance.
Fund performance data backs these assertions up. As at June 2016, the S&P SPIVA Canada Scorecard shows that only 28.77% of Canadian domiciled Canadian Equity mutual funds have outperformed their benchmark index (S&P/TSX Composite) over the trailing five-year period. In the Canadian domiciled US Equity mutual funds category, 0.00% of actively managed funds were successful in outperforming their benchmark index (S&P 500 in CAD) over the trailing five years.
This information is available to everyone, but, based on the dollars invested in actively managed funds compared to passive index funds, most Canadians continue to invest their money in actively managed strategies. The decision to invest this way is either driven by a lack of information, or greed. In either case, when Canadian investors inevitably suffer from poor investment performance and high fees, they are themselves as much to blame as anyone else.
The investment product landscape is a mine field. The most dangerous products on the market are the ones designed to appeal to the fear and apprehension of investors; active management promises higher than market returns and lower volatility, segregated funds come with various guarantees, and principal protected notes are pitched as offering upside potential with no downside risk. In reality, all of these products enable financial companies to charge additional fees for a sense of security. If investors selected their investment approach based on appropriate expectations, they would not be distracted by expensive promises of safety, and their investment experience would improve dramatically.
Investors in actively managed investment products should expect to underperform the market after fees in most years, with the potential for some years of outperformance. They should understand that their returns are not only affected by the performance of markets, but by the performance of their manager within the market. This can make it much more difficult to set realistic expectations, and adds another obstacle in sticking to a strategy. If the fund underperforms, the investor may wonder if their manager is making the right calls.
Segregated funds also tend to be actively managed, and the above commentary applies to them, too. They also have death benefit guarantees and maturity guarantees that protect the initial investment, in exchange for higher fees. Investors may find comfort in the guarantees, but they should expect lower returns due to the higher fees. They should also expect that over the 10 years that it will take for their maturity guarantee to take effect, the market will likely have increased in value. In other words, the maturity guarantee that they are paying for is not particularly useful unless the fund has been underperforming the market.
Principal protected notes combine a guarantee of the initial investment with the opportunity to partake in some of the gains of an asset or a group of assets. These products are usually locked in for 5 years. Investors should expect that if the market crashes, they will not lose their initial investment, and if the market soars, they will not fully partake in the gains. They should also understand that over a 5-year period it is unlikely that the market will have negative performance, making the guarantee less valuable.
Index fund investors should have the expectation that each year they will capture the return of the index, less fees. There will always be active funds that beat the index each year, and index investors may need to remind themselves of the body of evidence that reinforces an index-based strategy. If they want a smoother ride, they will adjust their asset allocation toward fixed income, while acknowledging a lower expected return for doing so.
Some indexes have different expected risk and return characteristics. For example, an investor may choose to follow the evidence that small cap and value stocks are expected to outperform large cap and growth stocks over the long-term, and increase the weight of small cap and value stocks in their portfolio. They would expect higher long-term returns, with the trade-off of slightly higher volatility.
There are many investment products and strategies to choose from. With appropriate expectations set for any investment, it becomes much easier to make an informed decision that will be more likely to result in a positive experience.