It is generally agreed upon in the investment community that small cap stocks and “value” stocks have higher expected returns, relative to large cap stocks and “growth” stocks – the suggested reasoning behind this is that smaller companies and value companies are perceived to be more risky, leading investors to demand a higher return on their capital. Most PWL portfolios are constructed with a heavier allocation towards these two known risk factors, which begs the question: How much riskier is a multifactor portfolio relative to a market-capitalization weighted index portfolio (otherwise known as a “Couch Potato” portfolio)?
I’ve created two model portfolios with ten years of index data to simulate the historical volatility of a balanced multifactor portfolio and Couch Potato portfolio. The multifactor portfolio has a 50% tilt towards the Dimensional Vector indices (which have a larger allocation to small cap and value stocks relative to the market).
As can be expected, the Multifactor portfolio had a higher standard deviation over this 10-year period relative to the Couch Potato portfolio (7.83% versus 7.38%, respectively), but probably not to the extent most investors would have guessed. In this example, approximately 90% of the additional volatility relative to the DEX Universe Bond Index was the result of the allocation to stocks, whereas the remaining 10% increase was the result of the small cap and value tilts. If an investor is looking for the most effective way to reduce risk, they could consider reducing their portfolio’s overall allocation to stocks before they consider reducing their small cap and value tilts (in order to get the most bang for their “risk bucks”).
This question was directed to me by an investor a few days ago – they had read a posting on PrefBlog.com that claimed investors should avoid holding bond ETFs and bond mutual funds in their non-registered accounts when the weighted average price of the underlying bonds are trading at a premium.
The disappointing answer is…yes, you can technically have a negative after-tax return on a bond ETF or bond mutual fund when holding either security in a non-registered account. I’ll illustrate this phenomenon using the iShares DEX Short Term Bond Index Fund (XSB) as an example (but it could just as easily be a bond ETF or bond mutual fund from another provider).
As of January 31, 2012, XSB had the following information available on their website:
Since the average coupon of the bond portfolio is higher than the yield to maturity (3.40% versus 1.49%), this would indicate that the weighted average price of the underlying bonds is above $100 or par (i.e. the underlying bond portfolio is trading at a premium). In this example, the approximate weighted average price of the underlying bond portfolio is $105.292*.
Let’s assume that we purchase $105,292 of XSB and that it matures in 2.84 years at $100,000 (this is completely theoretical, as bond ETFs never mature). This would result in a capital loss of $5,292 ($100,000 - $105,292) and total coupon interest received of $9,656 ($100,000 x 3.40% x 2.84).
The investor would also pay the fund an approximate MER of $787.09**, which would be deducted from the coupon interest before distributing it to the client, resulting in taxable coupon interest of $8,868.91 ($9,656 - $787.09).
If the investor is in the highest marginal tax bracket, they will pay approximately 46% of the interest to the taxman, or $4,079.70 in taxes ($8,868.91 x 46%).
So to sum up, here are the results (assuming the fund does not have any capital gains to offset the capital losses):
This would imply an annualized after-tax return of approximately -0.17%!
If the fund was able to offset the $5,292 capital losses against capital gains triggered by the fund, the investor would be able to save $1,217.16 in taxes ($5,292 x 50% x 46%), resulting in a total net dollar return of $714.37 (-$502.79 + $1,217.16), or an annualized after-tax return of 0.24%.
The main take-away from this analysis is to consider holding bond ETFs and bond mutual funds in registered accounts when the average underlying bonds are trading at a premium to par (as most bonds are today). If you must hold fixed income in your non-registered accounts, consider holding GICs (if you do not require the liquidity) or high-interest savings accounts if liquidity is a concern.
The helpful comments of Raymond Kerzerho are gratefully acknowledged.
In Larry Swedroe’s book, The Only Guide You’ll Ever Need for the Right Financial Plan,” Swedroe describes a strategy investors can implement in their own portfolio that can reduce risk while not reducing the expected return of the overall portfolio. His secret: Increase your allocation to small-cap and value (lower-priced) stocks while simultaneously decreasing your allocation to stocks in general.
Let’s say you have a rate of return requirement for your portfolio of 5.80%. Your long-term return expectation for bonds and stocks is 4.00% and 7.00% respectively. To achieve a 5.80% target return, you have decided to allocate 40% of your portfolio to bonds and the remaining 60% to stocks:
We’ll further assume you have just read the Credit Suisse Global Investment Returns Yearbook 2009 report and believe that over the long-term, small-cap stocks and value stocks will each return approximately 1.00% more than the overall stock market (as they are perceived to be more risky than large-cap and growth stocks). If you decide to tilt 50% of your stock allocation to small-cap and value stocks, you could be expected to earn 1% more than the overall stock market (resulting in an expected stock return of 8.00%). Since you are a firm believer in taking only as much risk as you have the ability, willingness, or need to take, you decide to lower your overall exposure to stocks to the point where the overall expected return of your portfolio equals 5.80% (in this example, this would be when your allocation is 55% bonds and 45% stocks):
The graph below shows the volatility of two hypothetical index portfolios over the past 10 years – as expected, the portfolio with the heavier allocation to small-cap and value stocks (but a higher allocation to bonds) had lower volatility:
Sources: MSCI, Dimensional Returns 2.0
As can be seen in the table above, the volatility of the portfolio has been reduced (6.06% relative to 7.25%) while the expected return has not. In this example, the expected rate of return of 5.80% was almost identical to the actual rate of return of 5.84% (please do not expect this type of result going forward...expected returns are just that...expected).
If you are a risk adverse investor (as most of us are), the strategy of reducing your stock exposure while increasing your small-cap and value exposure may be appropriate. The downside risk of loss is also reduced (as can be seen in the table above for the lowest 1-year return of Portfolio 2 relative to Portfolio 1), giving additional incentive to consider implementing a similar portfolio.