Portfolio diversification/balancing

[laila]

Any advice on diversifying or rebalancing the following portfolio of shares:

20% in banks
10% in construction
20% in ETF - UK FTSE 100 and FTSE Dividend ETF
20% in Eurostoxx Dividend ETF
10% in managed growth equity fund
10% in cash
10% remains to be invested

With remaining 10% was thinking of Asia Pacific (mostly australian companies) Dividend ETF. I know I am over invested in banks but am hoping that other investments will make up some of the losses and that the banks may yet improve!

My objective is to build up a fund that will provide a dividend income stream to supplement my pension in 10-15 years time.
Any advice much appreciated. Thanks.

 

[Marc]

Hi Laila,

Firstly, I would always caution against speculating on any single company or sector of the market:

I have covered these points extensively on askaboutmoney

Please see these posts:

http://www.askaboutmoney.com/showthread.php?p=892699#post892699

http://www.askaboutmoney.com/showthread.php?t=112897

http://www.askaboutmoney.com/showthread.php?t=94076

According to leading Financial Economists, equity portfolios should be diversified by market capitalisation weightings across developed economies - so you should start from a position of holding about 40% in the USA, 10% UK and 10% Japan etc in every sector and every stock in every country.

If we want a higher expected return, you need to be willing to take more risk but not all risks are rewarded. It is now generally accepted that the most reliable way of capturing risk premiums in equity markets is by tilting your portfolio towards Emerging Markets where you have a higher expected return than from Developed economies.

Furthermore, by tilting the portfolio towards smaller companies and value companies you have a higher expected return than from large cap & growth companies.

You are sort of doing this with the Dividend ETFs, but not really if truth be known and there are better ways of doing this.

For example, an ETF has to trade along with a commercial index, it is therefore not indifferent about the prices paid to trade stocks - an ETF therefore subtracts value equal to it's trading costs and annual management charge.

According to Merton Miller 1990 Nobel Prize winner, the expected return of a stock is a function of its cost of capital and dividend policy doesn't matter. What this means is that money is money and it doesn't matter if you live on a dividend stream or sell stocks to realise capital gains - it amounts to the same thing.

Therefore targeting high dividend stocks is not the best way to allocate capital in an equity portfolio.

Finally, regarding the managed fund - it doesn't matter who its with, active investing is always a negative sum game. We often hear that now is a good time (or a bad time) for active investing. That does not make sense. In aggregate, active investors always underperform by their fees and expenses.

see an excellent explanation [broken link removed]

All the best,

Marc

 

[Rory Gillen]

Hi Laila,

Marc has given you a comprehensive answer and I would agree with nearly all of it with the exception of the comment on the Dividend ETFs you hold.

I think you are fine with your dividend-focused ETFs. There is ample evidence that, given time, dividend-focused portfolios (assuming they are well diversified which your dividend ETFs appear to be) deliver better returns than the standard market value-weighted indexes and ETFs that track them. Dividend-focused ETFs tilt their portfolio weighting towards a value factor, in this case the dividend yield. This provides an element of non-subjective discipline that works well in stock market investing (help us from ourselves and all that).

www.wisdomtree.com is the web site of the US based investment house that specialises in sponsoring (i.e. listing) dividend and other value-focused ETFs. You will find plenty of choice on that web site.

Rory

 

[praetserge]

You have a good diversification but can I advise you put more in cash (savings account), should make it about 40% as the markets are still volatile and you might need some cash in the bank. Also it would be a good idea to have some exposure to bond markets but it really depends on how much money you have to invest.

 

[Marc]

Sean,

These weightings are not at all related to where you live but rather to where we find the most companies. The US makes up about 40% of the world's market capitalisation, UK 10% Japan 10% etc. So, if we were to ignore these three markets say we would be basicially saying I just want 40% of the available capitalism please.

Sorting an equity portfolio by countries is not a reliable way to diversify since the free movement of global capital means that the expected return on any developed country is really the same as any other developed country. There is no reason to believe the Eurozone will have a higher expected return than either the USA, UK or Japan or any other part of the developed world.

[FONT=&quot]Efficient-market research conducted on exchange rates found the same random walk phenomenon found in stock returns. Exchange rates move unpredictably. Currency exposure tends to increase the volatility of a portfolio, but there is no reliable evidence to suggest that the expected return of exchange rates is generally anything other than zero. [/FONT]

The conclusion reached therefore is that the desire to hold a higher weighting in the home market simply reflects a home bias which is unjustifed when looking at actual market returns. UK investors put most of their money into UK companies, Americans into the US, Canadians into Canada and Australians into Australia. Who is right? None of them.

To illustrate the point consider the following stock market indexes over the period Jan 1999 to December 2008 with the results in Euro
FTSE All Share, MSCI Japan, MSCI Europe ex UK, MSCI Pacific ex Japan, S&P 500 and MSCI Ireland.

Following your logic, you would expect the MSCI Europe ex UK to offer what? the best returns? Better than average returns?

So, let's look at the best performing market in each year:
Year Market Return
1999 Japan 89.50%
2000 Europe -0.36%
2001 Ireland 2.59%
2002 Pacific -20.06%
2003 Pacific 22.32%
2004 Ireland 32.77%
2005 Japan 44.23%
2006 Ireland 32.34%
2007 Pacific 18.93%
2008 Japan -25.17%

Remember these returns are in Euro and have been adjusted for currency movements.

There is no pattern here from which an investor could expect to benefit and remember we are working on the basis of a sample of fairly broad regional indicies here. If we sort results by single countries it is even more pot luck....

Best performing developed country (in UK Pounds)
1983 Norway 100.61%
1984 Hong Kong 84.16%
1985 Austria 121%
1986 Spain 115%
1987 Japan 12.41%
1988 Belgium 59.93%
1989 Austria 130%
1990 UK - 8.22%
1991 Hong Kong 54% etc

Again there is no reliable pattern here.

So, the rational approach is to initially sort your portfolio broadly by market cap weightings across all developed countries and then ask yourself, how should my portfolio differ from this "market" portfolio.

Do I want more exposure to Emerging Markets - which are more risky and therefore have a higher expected return as compensation.

What is my preference for a size tilt - do I want more exposure to smaller companies which are more risky and therefore have a higher expected return than big companies.

What is my preference for a value tilt vs Growth - do I want to tilt to value companies which are probably showing more risk in their price right now relative to the market (like the banks) and so I will have a higher expected return if I load up on distressed stocks compared to growth stocks.

Hope that helps.

All the best,

Marc

 

[PMU]

Marc, it’s difficult to see what your market cap approach has to offer over MPT /MVO / efficient frontier / CAPM, etc. broadly, the use of diversification to optimize portfolios. Also, about 50% of the world’s total investable assets are in bonds and property and you don’t appear to suggest that all portfolios sholud contain that allocation.
I would suggest that, unless you have a particularly long investment horizon to accommodate currency fluctuations, putting 60% (based on market cap) of your portfolio in foreign developed market equities exposes a euroland investor to currency risk for which he or she is not rewarded. So a rational euroland investor should first decide what percentage of his portfolio should be in foreign developed market equities and then decide on appropriate allocations between US, UK and JP. You would also expect this allocation to change over time with a rational investor moving from foreign developed market equities to euro equities as he approached retirement. As you say, currency risk does even out over time, but that can be a very long time period, so a rational euroland investor should reduce this risk by re-balancing his portfolio to euro-denominated equities as he approaches his investment horizon.
Also sorting a portfolio by countries doesn’t make sense. Countries are not asset classes, and while there is a diversification benefit by spreading your investment in foreign developed markets between US, UK and JP equities, if you plug the figures into any of the ‘Markowitz’ calculators you end up with an allocation that is different from a market cap based allocation, because the market cap approach does not take into account the volatility of returns in different markets and also that markets are not perfectly correlated.
Wrt countries, you say: “There is no pattern here from which an investor could expect to benefit”, which is correct but you can benefit by allocating between asset classes that are not 100% correlated. For example, if you were invested in commodities (commodity futures) in addition to developed market equities, you would have suffered less volatility and had lower loss than if your portfolio was 100% in equities:e.g.:
http://uk.finance.yahoo.com/q/ta?s=LCNE.L&t=1y&l=on&z=m&q=l&p=&a=&c=^STOXX50E,^FTSE
So the rational approach is to invest in different asset classes, and allocate on the Markowitz model. If you don’t believe in efficient frontier and all that you should just allocate equal amounts to each asset class. Forget about countries, in themselves, they are not asset classes.
[Disclaimer: The above is comment / observation and is not a recommendation to follow any particular investment strategy or to buy / not buy any particular fund.]

 

[Marc]

Sean,

You are not buying countries, you are buying stocks in countries.

So, the market weight approach just means that you are buying ALL the stocks that are out there, roughly in proportion to their Global market capitalisation. So, you are buying more Microsoft than Kerry Foods for example.

This is, by definition, "the market". There is more Microsoft out there so one view is that you should hold more of it relative to other stocks.

The disadvantage of this approach is that in reality when an investor tries to do this, they suffer from the way that funds offer partial replication of the markets.

The MSCI World Index for example is just 933 Shares with Exxon making up 1.84% of the index. But there are 5000 shares listed on the New York Stock exchange alone.

This means that you have to be missing out on a lot of stocks. The MSCI Index is mostly Large Cap and Growth Stocks hence you need a multi-factor model to create an index that ensures you are allocating your portfolio appropriately.

 

[Marc]

PMU,

The OP was looking for advice on a portfolio of shares. We are not considering recommendation for a diversified multi asset class portfolio. This question specifically relates to a diversified Equity portfolio.

But I'll pick up on one of your observations since it is relevant to my comments.

Asset Pricing
Bill Sharpe developed the Capital Asset Pricing model (CAPM) back in the 60s. This is a specialised field of finance - looking at segments of capital markets with their own risk return characteristics or equity asset classes. I agree that countries are not asset classes and if you read my post, you will see that I am not arguing that they are.

CAPM is a single factor model, which essentially said that all performance is driven by how much relative risk you take to the market so if the market is up by 1 on average and you are up by 1.2 then you were 120% taker of market risk - so your expected return is 120% of the market's average return.

The problem with the CAPM is that it doesn't explain all of the variations in a diversified equity portfolio.

The Fama/French multi-factor model is essentially the same concept but it captures more of the risks that investors care about. In addition to how much stock market risk an investor takes, there is a risk associated with size (small companies are riskier than large companies) and stocks with low relative prices by some accounting measure are riskier than growth stocks and have a higher expected return as compensation.

97% to 98% of returns in a diversified equity portfolio are explained by these three factors.

Of the part that is left over is generally attributed to the choices made by fund managers - and that number is negative and taking money away from the portfolio.

So, this analysis of a diversified stock portfolio is consistent with everything in modern portfolio theory.

For the avoidence of doubt I'm not arguing that investors shouldn't consider other asset classes - although I have argued that commodity futures don't offer most of the benefits that are often claimed of them.