Tag Archives: iShares Russell 2000

Am I Effectively Diversified?

This is the sixth installment in our series on how individual investors can assess their financial health.

Diversified FolioDiversification is a perennial topic among investors, and if it seems controversial at times, that may be due to the fact that people don’t always share the same understanding of what it means. But diversification isn’t about investing in a certain number of securities or funds. And it’s not about investing in every possible security under the sun.

 

Diversification and Risk

Simply put, diversification is the process of combining investments that don’t move in lockstep with each other. For example, Treasury bonds tend to do well when stocks are falling, and vice versa.  Combining stocks and bonds thus helps to limit risk.  Bonds also reduce the risk of a portfolio because they tend to be less risky on a standalone basis than stocks.

This brings us to an important point: the aggregate risk/return properties of a portfolio depend not only on the risk and return of the assets themselves, but also on the relationships between them.  Determining the right balance among these three factors (asset risk, asset return, and diversification benefit) is the challenge of diversification.

A Diversification Self-Assessment

The starting point in the determining whether your portfolio is properly diversified is to come up with a risk level that matches your needs.  I discussed risk estimation in last week’s blog.  Assuming you have a target risk level for your portfolio, you can then attempt to determine how to combine assets so as to achieve the maximum expected return for this risk.

The word “expected” is crucial here.  It is easy to look back and to see, for example, that simply holding 100% of your assets in U.S. stocks would have been a winning strategy over the past five years or so.  The trailing five year return of the S&P 500 is 15.7% per year and there has not been a 10% drop in over 1,000 days.  Over this period, holding assets in almost any other asset class has only reduced portfolio return and risk reduction does not look like a critical issue when volatility is this low.  The problem, of course, is that you invest on the basis of expected future returns and you have to account for the fact that there is enormous uncertainty as to what U.S. stocks will do going forward. Diversification is important because we have limited insight into the future.

Many investors think that they are diversified because they own a number of different funds.  Owning multiple funds that tend to move together may result in no diversification benefit at all, however.  A recent analysis of more than 1,000,000 individual investors found that their portfolios were substantially under-diversified.  The level of under-diversification, the authors estimated, could result in a reduction of lifetime wealth accumulation of almost one fifth (19%).

Additional Diversifiers

Aside from a broad U.S. stock index (S&P 500, e.g., IVV or VFINX) and a broad bond index (e.g., AGG or VBMFX), what other asset classes are worth considering?

  • Because the S&P 500 is oriented to very large companies, consider adding an allocation to small cap stocks, such as with a Russell 2000 index (e.g. IWM or NAESX).
  • There is also considerable research that suggests that value stocks—those stocks with relatively low price-to-earnings or price-to-book values—have historically added to performance as well. A large cap value fund (e.g. VTV, IWD, VIVAX) or small cap value fund (e.g. VBR, RZV) may be a useful addition to a portfolio.
  • In addition to domestic stocks, consider some allocation to international stocks (e.g. EFA or VGTSX) and emerging markets (e.g. EEM or VEIEX).
  • Real Estate Investment Trusts (REITs) invest in commercial and residential real estate, giving investors share in the rents on these properties. There are a number of REIT index funds (e.g. ICF, RWR, and VGSIX).
  • Utility stock index funds (e.g. XLU) can be a useful diversifier because they have properties of stocks (shareholders own a piece of the company) and bonds (utilities tend to pay a stable amount of income), but have fairly low correlation to both.
  • Preferred shares (as represented by a fund such as PFF) also have some properties of stocks and some of bonds.
  • Another potential diversifier is gold (GLD).

 

Diversification Example

To help illustrate the potential value of diversification, I used a portfolio simulation tool (Quantext Portfolio Planner, which I designed) to estimate how much additional return one might expect from adding a number of the asset classes listed above to a portfolio that originally consists of just an S&P 500 fund and a bond fund.

Diversification

Risk and return for a 2-asset portfolio as compared with a more diversified portfolio (source: author’s calculations)

The estimated return of a portfolio that is 70% allocated to the S&P 500 and 30% allocated to an aggregate bond index fund is 6.4% per year with volatility of 13%.  (Volatility is a standard measure of risk.)  Compare that to the more diversified portfolio I designed, which has the same expected volatility, but an expected return of 7.3% per year, as estimated by the portfolio simulation tool.  The diversified portfolio is not designed or intended to be an optimal portfolio, but rather simply to show how a moderate allocation to a number of other asset classes can increase expected return without increasing portfolio risk.[1]

The process of analyzing diversified portfolios can get quite involved and there are many ideas about how best to do so.  But the range of analysis suggests that a well-diversified portfolio could add 1%-2% per year to portfolio return.

Conclusions

I have observed that the longer a bull market in U.S. stocks goes on, the more financial writers will opine that diversifying across asset classes is pointless.  We are in just that situation now, as witnessed by a recent article on SeekingAlpha titled Retirees, All You Need is the S&P 500 and Cash.

On the other hand, there is a large body of research that demonstrates that, over longer periods, diversification is valuable in managing risk and enhancing returns.  That said, a simple allocation to stocks and bonds has the virtue of simplicity and can be attained with very low cost.  Diversifying beyond these two assets can meaningfully increase return or reduce risk, but an increase in average return of 1%-2% per year is not going to take the sting out of a 20%+ market decline.  What’s more, a diversified portfolio is quite likely to substantially under-perform the best-performing asset class in any given time period.

But over long periods of time, the gain of 1%-2% from diversification is likely to increase your wealth accumulation over 30 years by 20%-30%.  This is consistent with the analysis of 1,000,000 individual investors cited above, from which the authors concluded that under-diversified portfolios were likely to reduce lifetime wealth accumulation by 19%.

For investors seeking to diversify beyond a low cost stock-bond mix, there are a number of simple portfolios that include a range of the asset classes discussed here and that have fairly long track records.  These are worth exploring as a template for further diversifying your own portfolio.

[1] For details on how the model estimates risk and return for different asset classes and for portfolios, see the whitepaper I wrote on the subject.

 

Related Links:

logo-folioinvesting

The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

Low Beta Market Sectors

With U.S. equity markets near their record highs and a bull market run that is starting its sixth year, the potential for a correction is a growing concern.  In addition, U.S. equity prices look fairly high when viewed in terms of the PE10 ratio.  Another factor that concerns some market watchers is that volatility (as measured by VIX) is at very low levels, reminiscent of 2007.  This type of complacency has historically been followed by increasing volatility, as levels return to their historical average, accompanied by a sell-off in higher-risk assets as investors adjust their portfolios to mitigate the effects of higher volatility.

Investors seeking to remain invested in equities at a target level but who want to reduce their exposure to market swings and to mitigate the impact of a rise in market volatility have historically been well-served by increasing their allocations to low-beta market sectors.  In this article, I will review the defensive value of low-beta allocations as well as examining the consistency of beta over time.

Beta measures the degree to which a security or a portfolio responds to a move in a benchmark index such as the S&P500.  A portfolio with beta equal to 80% (also written as 0.8) tends to go up 0.8% when the market rises 1.0% and vice versa.  Beta may be thought of as showing whether a security amplifies the moves in the benchmark (beta greater than 100%) or damps the moves in the benchmark (beta less than 100%).

How Beta Varies by Sector

The SPDR Select Sector ETFs provide a convenient way to break out the sectors of the U.S. equity markets by dividing the S&P500 into nine sectors.  These sectors illustrate how much beta varies.

Low Beta Market Sectors - 1

Betas and 10-year average annual returns for major sectors and indexes

The S&P500 has a beta of 100%, by definition.  Some readers may be surprised that emerging market stocks have beta of almost 140%, which means that emerging market equities tend to go up (down) 1.4% for every 1% gain (drop) in the S&P500.  Even before the market crash of 2008, emerging market stocks were high beta—this is not a new phenomenon.

There are three U.S. equity sectors with betas well below 100%: consumer staples (XLP), healthcare (XLV), and utilities (XLU).  It is often believed that low-beta equities have very low average returns.  In fact, a well-known but now widely-discounted model of equity returns (the Capital Asset Pricing Model, CAPM) assumes that beta of an equity or asset class corresponds directly to expected return.  High-beta asset classes have high expected return and vice versa.  Low-beta equities have historically substantially out-performed what would be expected on the basis of CAPM, however, and the past ten years is no exception.  These three sectors have all out-performed the S&P500 over the past ten years.  The return numbers shown here are the arithmetic averages, including reinvested dividends.

Low Beta Asset Classes in 2007-2008

The first question that is worth asking about beta is the degree to which beta corresponds to losses in really bad market conditions.  In the table below, I have tabulated beta calculated using three years of data through 2007 for each of the funds above, as well as the returns for each of these in 2008.

Low Beta Market Sectors - 2

Beta calculated through 2007 vs. 2008 returns

The three sectors with the lowest betas going into 2008 (consumer staples, healthcare, and utilities) had an average return of -22.3% in 2008, as compared to -36.8% for the S&P500.  An equity tilt towards these lower beta sectors could have reduced losses in that year.

Consistency of Beta through Time

The astute reader may notice that the betas calculated using ten years of data through May of 2014 (shown in the first table) are, in some cases, quite different from the betas calculated using three years of data through December of 2007 (shown in the second table).  Beta varies through time.  The betas calculated using three years of data through May 2014 provide an interesting contrast to the three-year betas through the end of 2007.

Low Beta Market Sectors - 3

Comparing betas for two 3-year periods

We are looking at two distinct 3-year periods, separated by almost six and a half years and, in general, low-beta sectors at the end of 2007 remain low-beta today and high-beta sectors back then are still high-beta.  The two most notable exceptions are international equities (EFA) and the technology sectors (XLK).  These changes notwithstanding, the three sectors with the lower betas in 2007 also have the lowest betas in 2014.

There are a number of factors that will determine whether any sector will weather a broad market decline better than others.  Beta is one important factor, but there are others.  In 2008, the financial sector suffered disproportionately large losses—well beyond what would have been expected on the basis of beta alone.  The underlying drivers of the 2008 market crash were most severe in the financial sector.  Small-cap stocks, by contrast, fell considerably less than the beta value of this sector would have suggested.

Low-Beta and Asset Allocation

Low-beta asset classes have historically provided some protection from market declines and increasing volatility.  There are a range of other considerations that potential investors should consider, however when creating a portfolio.  The selection of individual asset classes should be made with consideration of the characteristics of the total portfolio, including desired risk level, interest rate exposure, and income generation.  The target for total portfolio beta is primarily determined by an investor’s total risk tolerance.  A target beta level can be achieved both by choosing how to allocate the equity portion of a portfolio among sectors and by varying the balance between equity (stocks) and fixed income (bonds) investments.  Fixed income asset classes tend to have very low—even negative—values of beta.  In my next blog entry, I will explore these two approaches to managing beta at the portfolio level.

History suggests that low-beta sectors can provide some protection from market downturns.  The length of the current equity rally, and the substantial increases in equity valuations in recent years, are motivating some investors to consider their best defensive alternatives to protect against the inevitable reversal.  The question for investors to ask themselves is whether they are best-served by reducing portfolio beta by reducing their exposure to equities, by shifting some portion of assets from high-beta to low-beta sector, or both.

Related Links:

logo-folioinvesting

The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.