The last two posts (parts one and two) described a process for combining asset classes into simple portfolios. We did this using risk-return data from the Horizon Actuarial Survey and Excel’s Solver add-in to crunch the numbers. Below are the five asset allocation mixes we arrived at in part two, as well as our efficient frontier graph of their expected risk & return.
In the next two posts, we’ll implement our asset allocation, i.e. turn it into portfolios we can invest money into.
Remember from part one that asset classes are investment categories. It’s not possible to buy the “US Large Cap Stock” asset class for example. Since the allocations we created contain asset classes and not securities that can be bought/sold, the portfolios we created using SAA are more like templates, and the asset classes are placeholders for specific investments that can be purchased in the market.
Taking the next step involves identifying investment securities that represent the asset classes, selecting those that satisfy our criteria, and inserting them into our asset allocation template in place of the asset classes.
🚨DISCLAIMER – NOT INVESTMENT ADVICE
***THIS IS NOT INVESTMENT ADVICE ***
I’m not soliciting any action or transaction based on the information in this post. This is a hypothetical exercise purely for illustrative purposes. The goal is to describe the types of research that may help people evaluate the large number of investments in the market. You should not take any investment action without consulting your financial advisor. Past performance is not a guarantee of future results. Do your own research before investing.
Whether you are investing on your own or working with an advisor, I want to arm you with information about choosing investments to help you be a better investor. This is a thought exercise, and some broad assumptions and simplifications will be made.
We’re going to evaluate actual investments that are available to purchase in the market. The portfolios we create in this exercise may not be appropriate for you or any investor.
Financial professionals like me operate within a highly regulated environment. Before we can recommend investments to someone, we must understand their specific situation in order to have a sense of what may be best for that specific individual. This is an article on the internet that anyone can read, and it’s impossible for me to understand the unique circumstances of all potential readers. There are no investments that are universally appropriate for everyone.
You should always do your own research, evaluate prospective investments based on your specific situation (not the author’s), and consult with a financial advisor before taking investment action.
All that said, let’s jump in …. 👇💵
portfolio implementation
We need to find investments we can buy to represent our asset classes:
- US Large Company Stocks
- US Core Bonds
- Real Estate
Like before, we’ll break the process into steps.
The asset allocation process in parts one and two was based on forward-looking expectations of what return markets MIGHT provide for assuming different levels of risk. These expectations are theoretical, based on what professional investors observe in markets. No matter how smart you are, it’s not possible to perfectly predict the future. We know reality will be different from what we expect, even if those expectations were carefully formed.
Implementation involves evaluating specific investments to see if they are worth buying. What criteria should we use? Libraries have been written on the topic, and this post won’t cover them all. But let’s explore some that may be helpful.
VEHICLE
Should we buy individual securities or commingled funds where our money is managed alongside that of others? See thread explaining different investment vehicles below:
Example of an individual security: Apple Inc. stock (ticker: AAPL)
Example of a commingled fund: Vanguard Total World Stock Index Fund (ticker: VT)
Consider:
- How much investment knowledge you possess
- How much trading you expect/want to do
- How much research you want to do
- How much you want to pay
In this exercise, our asset allocation contains multiple asset classes. Each asset class is comprised of multiple sectors. Each sector, in turn, houses dozens if not hundreds of publicly-traded companies. For example, iPhone maker Apple Inc. is a large US company operating in the technology sector.
Layers of research
Thus, we can separate investment knowledge into three broad “layers”:
- Asset class: US Large Company (aka US “Large Cap”, short for “large capitalization”)
- Sector: Technology
- Company: Apple Inc.
Investing in individual securities can involve lots of research, diligent monitoring, and significant risks. It’s important to understand company-specific events, what’s impacting the sector in which the company operates, as well as the broader asset class. There are teams of professionals who spend all their time researching one specific sector, with some analysts devoted entirely to one specific company.
With individual securities, company-specific events can have a bigger impact than the risks that the broad asset class is exposed to. If your portfolio includes individual securities, expect to spend a lot of time and energy finding potential landmines before they blow up. You have to cover all three layers of research.
Coming back to the exercise, populating our asset allocation with individual securities would be the most research-intensive option. It would easily encompass all the working hours one person could handle, possibly even those of an entire team. Even then, research suggests it is extremely difficult for teams of professional investors to consistently outperform passive market benchmarks. [SPIVA DATA or thread]
For this exercise, let’s assume we don’t want to spend all our waking hours reading annual reports, listening to earnings calls and building discounted cash flow models in Excel (do you?). Let’s imagine we have a family we want to spend time with, or maybe travel the world. We have things to do besides investment research.
If we don’t want to spend as much time on research, or if we are new to investing, we can start by investing in mutual funds or ETFs. See the thread below for a discussion of the differences between mutual funds and ETFs.
Commingled funds are not devoid of investment risk. However, because they often hold hundreds (sometimes thousands) of securities, funds mostly (if not totally) eliminate single security risk – the third risk layer above. This allows fund investors to pay less attention (if any) to layer three risks, and instead focus on higher-level sector and asset class considerations.
For this exercise we’ll look for ETFs to represent our asset classes.
ACTIVE VS. PASSIVE
Would you rather take the return the market gives you, or try for higher returns and risk missing the mark?
Consider:
- How much you’re willing to pay
- How much risk you’re comfortable with
- How long you can tolerate underperformance
- How much volatility your financial plan can take
Passive investing, AKA indexing, has rightly gained popularity in recent decades. Passive strategies look to mirror the return of market benchmarks, like the S&P 500 or NASDAQ. To do this, they hold baskets of the same securities in similar proportions as the index they track.
Remember: passive funds can never perfectly match the index return, because funds must physically buy and sell securities, and face other “real world” implementation costs that indexes do not bear (indexes are just lists of securities).
Active investing involves holding a portfolio that’s different from the benchmark in search of higher returns. Research shows most active stock and bond managers underperform their benchmarks over time. Check out SPIVA for tons of data on this:
The data tells us that active investing is difficult. Successful active investing requires lots of research – both by the manager picking securities (the three “layers” discussed above), and by the investor researching managers. If you’re going active, manager selection adds a fourth layer of research.
- Investment Manager: Are they keeping up with their benchmark?
- Asset class
- Sector
- Company
To find a good active manager you need to
- Confirm the manager can outperform an appropriate benchmark
- Determine if performance was due to luck or skill
Either a manager has demonstrated the ability to earn above-average returns in the past or they have some competitive advantage that suggests they may be able to do so in the future (or both). Manager selection is challenging, and professional research teams spend lots of time here. You’ll need to monitor closely to verify the manager is meeting expectation, wait for the manager’s views to play out (why they think the market is wrong and they’re right), and pay more along the way. The additional research active managers do has a cost.
The active vs. passive decision can differ by asset class. Some assets like commodities don’t have benchmarks that passive investors can easily replicate. Unlike buying shares of common stocks, commodities markets involve futures contracts that must be rolled over periodically. For these, active may be the only option.
For publicly traded stock and bond asset classes, however, it’s often feasible to replicate market benchmarks. Managing index funds is simple; buy the securities in the index. Since it isn’t necessary to research company, sector, or asset class prospects (levels 1-3), passive index funds tend to be cheaper than those that are actively managed.
To summarize, passive investing seems attractive given its lower cost and effectiveness.
The estimates in the Horizon survey, which drove our asset allocation, are long-term expectations for what return professional investors expect from various asset classes in aggregate, without any active management. If we implement with active funds, we should expect to experience a wider band of higher or lower returns relative to those expectations.
Active management increases costs and uncertainty.
For this exercise we’ll look for passive ETFs to populate our asset classes.
iDENTIFY CANDIDATES
Ok, so we need passive ETFs representing US large cap stocks, US core bonds, and real estate to implement our asset allocation. Let’s explore different indexes and funds that track them.
Factors to consider when evaluating indexes:
- breadth; how well it covers the asset class
- how many funds available in the market track it
Factors to consider when choosing a passive ETF:
- which underlying index it tracks
- how well it tracks the index
- size of fund (total assets)
- expense ratio
- sponsor
We’ll start by finding an index that represents the exposure we want. Then we’ll find ETFs that track it.
US LARGE CAP STOCK indexes
The three most-quoted indexes for the US stock market are the Dow Jones Industrial Average, S&P 500, and NASDAQ.
“The Dow” is a basket of 30 large US companies. This is the oldest stock market index, with history back to the 1800s. This is cool, but also means the composition of the Dow tends to reflect what the economy looked like in the past. According to S&P Global, the largest sectors in the Dow right now are financial and healthcare stocks.
Source:https://www.spglobal.com/spdji/en/indices/equity/dow-jones-industrial-average/#overview
The Dow is a price-weighted index, so stocks with higher share prices have a higher weight. This isn’t an intuitive way to build an index. Companies can issue stock or do stock splits or buybacks to manipulate share price. Stock price is not necessarily related to company success.
The S&P 500 is a basket of 500 large US company stocks with history back to 1929. The S&P is weighted by market capitalization (“market cap” for short), which is simply the number of shares outstanding * the share price. Market cap is an approximation of the size or economic footprint of a company. This is probably a better measure of company success than its stock price. Let’s consider a hypothetical.
Company A’s stock price is $300. They have 10,000 shares that trade in the market. Their market cap is $300 * 10,000 = $3,000,000
Company B’s stock price is $100, but they have 100,000 shares that trade in the market. Their market cap is $100 * 100,000 = $10,000,000
Company B has a larger footprint and would be weighted higher in the S&P, but lower in the Dow.
The largest sectors in the S&P are IT (31%) and financials (13%). The S&P seems like a better reflection of the US economy.
Source: https://www.spglobal.com/spdji/en/indices/equity/sp-500/#overview
The NASDAQ is interesting.
Like the S&P, it’s weighted by market cap. NASDAQ was a stock exchange before it was an index. Exchanges are physical locations where stocks trade. The largest stock exchange in the US is the New York Stock Exchange (NYSE). There are strict requirements companies must meet for their shares to be listed on the NYSE.
Source: https://www.nyse.com/listings/resources
NASDAQ was originally a listing place for stocks not listed on larger exchanges like NYSE. As markets evolved NASDAQ ended up having a disproportionately large number of stocks in the technology sector compared to other exchanges. So the NASDAQ 100 index (and ETFs that track it) is a concentrated bet on the IT sector.
Let’s say we want the return of all 10 sectors of US stocks to be more evenly represented in our portfolio. So we’ll skip NASDAQ.
For this exercise we’ll select the S&P 500 index as our underlying US stock benchmark due to:
- Long history of data
- Widely quoted and understood benchmark
- Market-cap weights accurately represent economic reality
- Well diversified and not overly concentrated in a single sector
thank you for reading
In this post we decided to:
- Use commingled funds to populate our asset classes
- Use passive ETFs because we are ok with broad asset class expected returns.
- Find funds that track the S&P 500 to represent our US large cap asset class
In the next post, we’ll find specific funds and complete the exercise.
Subscribe to the blog and follow me on X for more posts about investing, personal finance, and business. 👇👇💵
Send me your money related questions via the contact page or email matt@empowermenttools.net
Thanks for reading!
-Matt
