Passive Investing: When Selection of Index Truly Matters

Published January 2023

We all know it is very hard to outperform the stock market consistently over the long-run, which is why it’s hard to argue against passive investing. Even Warren Buffet claims to have instructed the trustee of his estate to invest 90% in the S&P 500 and 10% in US Treasury Bonds. A topic that is not often highlighted in the financial press, however, is the question of how to select the appropriate passive fund.

In the book Financial Fitness Forever, one of the key takeaways from author Paul Merriman is the long-term benefits of having a tilt to small cap value, which has historically had among the highest returns of any equity asset class. As it turns out, the selection of which passive fund or ETF to choose makes little difference for large cap equities, with the S&P 500 Index having very similar risk/return characteristics as the Russell 1000 index. However, within the small cap equity space, it can make a major difference over the course of an investing lifetime, and even more pronounced in small cap value.

Consider the Russell 2000 Value Index, the most popular benchmark in the small cap value universe. The Russell 2000 Value Index has underperformed the S&P 600 Small Cap Value Index by 1.59% annualized over the past 20 years. That may not sound like a big deal, but assuming an initial $100k investment, the difference in performance amounts to over $220k at the end of the 20-year period as shown in the graph below.

There are several potential reasons for the performance differential. For one, the S&P Index excludes companies that have had negative earnings for more than four consecutive quarters. This results in higher quality companies within the S&P Index. Indeed, a 2014 study performed by S&P Dow Jones Indices confirmed the existence of the profitability factor serving as a quality premium.

Construction methodology is an additional consideration in explaining performance differential between the two indices. The Russell Index is reconstituted annually at the end of June, when stocks are ranked according to their total market capitalization as of the last trading day of May. No new stocks are added throughout the year other than at the June reconstitution. The S&P 600 implements constituent changes on an as-needed basis. To be eligible for inclusion with S&P, companies must meet market capitalization, liquidity, public float, GICS sector representation, and profitability measures. Constituent deletions may occur for violation of one or more of the eligibility requirements. Since S&P does not follow a scheduled automated process, additions and deletions are less predictable and cannot be front-run by market participants. The table below summaries the difference in index methodologies.

Risk Parity For Late Cycle Investing

Published June 2019

With the stock market now surpassing the longest bull market in history, many investors are left wondering what they should do to prepare for the inevitable downturn, however many months or even years that may be from now.  Timeless advice from investing legends such as the late Vanguard founder Jack Bogle suggest the best advice is to do nothing, especially if you are a long-term investor.  It can be tempting to sell stocks and move to cash, but that strategy typically backfires as emotions get in the way and investors never know when to get back in the market, inevitably missing out on gains.  After all, typically only a few of the best trading days of the year account for the majority of the annual stock market’s performance.  But what if there was a better approach to preparing for a bear market?

In Money, Master the Game, author Tony Robbins interviews hedge fund mogul Ray Dalio, founder of Bridgewater Associates, the largest hedge fund in the world.  When Tony asked Ray about how to design an efficient asset allocation, Ray described a risk parity approach to investing, which in the book is referred to as the “all seasons portfolio.”  Before describing this approach further, it can be helpful to understand misconceptions about the traditional approach to asset allocation.

Many investors may think a standard 60%/40% stock and bond portfolio is well diversified.  However, when looking at the portfolio through a risk lens, Ray points out that the majority of the risk of the portfolio (over 95%) is being driven by the stock allocation.  Risk, which we will define as volatility, determines the dispersion of possible returns.  For example, the well diversified 60/40 portfolio was actually down over -14% in 2008.

Ray’s risk parity portfolio is designed to balance risk across all market environments.  There are four types of market environments: 1) higher than expected inflation 2) lower than expected inflation 3) higher than expected economic growth 4) lower than expected economic growth.   Certain asset classes perform well depending on which market environment we are in, but since it is impossible to predict which regime will come next, it is best to hold a portfolio which is prepared for any of the four market environments.  Instead of allocating on a dollar basis, like the 60/40 portfolio, Ray suggests allocating on a risk basis, so all the asset classes contribute approximately the same amount of volatility, or risk, to the portfolio.  Ray suggests the following asset allocation for the “all seasons” portfolio:

40% Long Duration Treasury bonds (performs well during falling growth, falling inflation)

30% Stocks (performs well during rising growth, falling inflation)

15% Intermediate Duration Treasury bonds (performs well during falling growth, falling inflation)

7.5% Commodities (performs well during rising growth, rising inflation)

7.5% Gold (performs well during falling growth, rising inflation)

(Money Master The Game p. 391)

The first thing that may jump out at you is the high allocation to bonds.  However, this is necessary given the fact that bonds have significantly less risk (volatility) than stocks, so for bonds to have approximately the same contribution to risk to the overall portfolio as stocks, a heavy allocation to bonds is needed, and in particular long duration bonds.

When Tony had his team back test the above asset allocation for the 30 year time period 1984 to 2013, it performed shockingly well.  The average return was 9.72% and the worst annual loss you would have experienced during those 30 years was -3.93% in 2008. (Money Master The Game p.393,394).  Keep in mind 2008 was a year when the S&P 500 was down -37%!  In fact, when back tested further, the book highlights that the allocation was significantly protected from stock market declines, as shown in the table below:

 

Year       S&P 500                All Seasons

1937       -35.03%                -9.00%

1941       -11.59%                -1.69%

1973       -14.69%                3.67%

1974       -26.47%                -1.16%

2001       -11.89%                -1.91%

2002       -22.10%                7.87%

2008       -37.00%                -3.93%

(Money Master The Game p.395)

The standard deviation of the risk parity portfolio during the 30 year back-tested time period was just 7.63%, which is another way of saying the volatility was low (for context the S&P 500 typically has a standard deviation of approximately 15% over the long run).  Tony is also quick to point out that the allocation did surprisingly well during the rising interest rate regime of the 1970s, as many critics claim that the risk parity approach to investing will get crushed when interest rates rise.  The main reason the strategy did well during the 1970s was the allocation to commodities and gold performed in the high inflationary environment.

I personally think the risk parity approach should be considered for three types of investors 1) very risk averse investors who emotionally overreact to the stock market volatility 2) those at or near retirement who want a lower volatility portfolio 3) investors looking to protect their portfolio in a late market cycle environment.  For young investors that have the goal of maximizing their account balance over the next 30+ years, I believe a heavy allocation to stocks (up to 100%) will likely have the better outcome over the long run, although with a much bumpier ride along the way.

Although I am not a believer in timing the market (i.e. tactical asset allocation), I do think it makes sense for investors today to consider switching to the risk parity approach and staying in the allocation until a significant stock market decline occurs.  I have decided to do this with my own portfolio, which was 100% stocks, and throughout 2019 have slowly migrated to the following asset allocation:

40% long duration Treasury

15% Intermediate Treasury

35% Stocks

10% Gold

I made some slight tweaks to Ray’s suggested allocation because I wanted to take a bit more of a defensive posture, so I included a higher allocation to gold.  This was also in part to offset the 5% higher allocation to stocks and not having an allocation to commodities.  Even though I admitted I do not believe in tactical assets allocation, I am using the risk parity allocation in an arguably tactical manner because I plan to stay in this asset allocation until we see a peak to trough drawdown of at least 25% in the S&P 500.  Considering the fourth quarter of 2018 experienced nearly a 20% decline in the S&500 with no signs of a recession, I’m convinced when we do experience a downturn in the economy eclipsing a 25% peak to trough drawdown is a highly probable.

The key to making this strategy work is twofold: 1) Sticking with it even when the stock market hits all time highs. 2) Following a rules based approach to get back to your normal target asset allocation (i.e. such as waiting for the 25% decline).  In regards to the first point, it is important to keep in mind that you are still participating in the stock market’s performance given you have an allocation to stocks.  Unlike investors that get out of the stock market and go to 100% cash, risk parity investors are still participating in the market.  The genesis of risk parity is the future is unknown, so its best to hold a portfolio with asset classes that can preform in any market environment, unlike a traditional stock heavy portfolio that is only designed to perform in a risking growth/falling inflation environment.  For point #2, it can be easier said than done to jump back into your stock heavy asset allocation when the market is selling off, so following an arbitrary rule can help. There is no doubt you will not perfectly time when its best to shift back to your more aggressive asset allocation, but at least you can take solace in the fact that your portfolio was much better off than being 100% in stocks.  Keep in mind a portfolio that is down -25% in a year requires a 33% return to just break even, so even if the market continues to sell off after you have switched back to a more aggressive stock allocation, you are still coming out significantly ahead.

The final, and most important component to making the risk parity approach work is that the negative correlation between treasury bonds and stocks needs to persist.  Many periods in history have shown this to be the case, including the 30 year time period in Tony’s backtest and the more recent example in the fourth quarter of 2018 with long duration treasuries up 5.32% and the stock market down -13.5%.  However, if you go back long enough, there have been periods in history where long duration treasuries and stocks are positively correlated, which would obviously be problematic for risk parity.  In my opinion, as long as the US dollar is still the world’s reserve currency, investors will have a flight to safety mentality and continue to buy safe haven assets such as treasuries and potentially gold during market sell-offs.

Shifting from an aggressive stock heavy allocation to risk parity in a late cycle market environment is certainly not for everyone, but may be worth considering.  Perhaps Jack Bogle’s advice will prove to be correct.  I’ve chosen to follow Warren Buffet’s advice to “be fearful when others are greedy and greedy when others are fearful” by shifting from a 100% stock allocation to a risk parity allocation, with the intention of switching back to my original allocation when the stock market sells off by 25%.  With 2019 seeing record highs in the stock market, a very strong IPO market, and a bounce back in bitcoin, now may be just the time to heed that advice.

The above article is presented solely for educational purposes and should not be considered financial advice.  You should seek the services of a licensed tax professional, certified financial planner, or tax attorney for counsel on your situation.  As with all investments, past performance is no guarantee of future results.

Be Happy First

Published April 2019

“Life moves by pretty fast.  If you don’t stop and look around sometime, you might miss it.”  That quote from the classic movie Ferries Bueller’s Day Off is advice we could all take to heart once in a while, especially given the fast pace of life.  In the book The Happiness Equation, author Neil Pasricha challenges readers to question the notion that most people have when it comes to happiness: “We think we work hard in order to achieve big success and then we’re happy.”  Instead, Pasricha suggests we should focus on being happing first, which will then lead to to great work and big success. 

So how does one focus on being happy first?  The author gives some ideas such as exercise, meditation, random acts of kindness, and gratitude, but since happiness is very individualized, I think it makes sense to take the time to write down the ten things that make you happy in life.  Chances are you’ve probably never taken the time to do an exercise like this before.  To help get the creative juices flowing, I’ll share with you my ten, in no particular order:

Running in the park

Skiing

Family

Friends

Going to the gym

Hiking

Reading

Writing

Playing guitar

International travel

Intentional Living

Once you have analyzed your list, ask yourself how much of your time each week do you allocate to the activities that make you happy?  If you are like me, the answer is likely much less than you’d like.  However, when you stop and analyze what you spend your free time doing and what is on your list, you may find some opportunities to be more intentional about how your spend your time and perhaps squeeze in some items from your list on a consistent basis.  Netflix, for example, is not on my list, but yet I was spending over five hours a week watching it.  If you make a concerted effort to find time to pursue items on your list, even if its as simple as getting outside and going on a 15 minute walk (if that’s on your list), then you will eventually develop a habit of incorporating this into your daily or weekly routine. 

Relationships

If you are dating someone and wondering if this person could be the one you tie the knot with, it could make sense to try this exercise to assess compatibility.  It is certainly not necessary to find someone with all the same items on your list, but having at least a few overlapping activities would be beneficial in  fostering a long-term relationship.  It does not even matter if the activities are specific overlaps, but general categories that overlap is a good sign, so don’t panic if you’re already married and your partner’s specific activities don’t overlap with your own.  For example, my list of ten could be summarized as outdoor activities, social, and creative/cultural pursuits.  At the very least, you will have a better understanding of the person you are dating or sharing your life with and what makes them happy. 

Motivation For Financial Independence

Another conclusion that may be reached from this exercise is it may surprise you that many things on your list cost next to nothing to pursue.  In fact, outside of skiing, international travel, and the gym membership, the vast majority of the items that make me happy are free or nominal expenses.  However, if you analyzed your spending habits, are they congruent with the things that make you happy?  Perhaps you are spending money on items simply for their short-term benefits, but yet they have no impact on what truly makes you happy.  Research shows spending on experiences instead of material possessions creates longer-lasting happiness.    

The controversial FIRE movement, which stands for Financial Independence Retire Early, in many respects was formed out of the motivation to give people another avenue out of the corporate grind so more time could be spent with loved ones or pursuing interests that have been neglected over the years.  People in pursuit of FIRE save and invest a large percentage of their incomes to eventually have an investment portfolio that can cover their living expenses in perpetuity, achieved significantly before the traditional retirement age.  Critics of the FIRE movement point out all the pitfalls that could derail one’s life, such as prolonged recessions/bear markets, medical emergencies, and other unexpected expensive life events.  However, there are many positive aspects to the media attention this movement has gained, such as an emphasis on saving and investing, which sadly the majority of people are not doing.  For me personally, I’m not a fan of the “RE” portion of FIRE, as I would get bored not having a defined plan for how I would want to spend my time.  In fact, “never retire” is one of the nine pieces of advice given in the Happiness Equation because it is important to have a reason to get out of bed in the morning.  But if you are in a job you do not enjoy, achieving financial independence could give you the confidence to pursue work or volunteer opportunities that truly motivate you to get out of bed each morning, regardless of the pay. 

Despite the drawbacks of FIRE, I think using your list of ten things that make you happy as motivation to pursue financial independence is a very worthwhile endeavor.  It’s unfortunate our consumerism society places such a high emphasis on our careers we are often defined by them, leaving little time or energy left over to pursue the things that make us truly happy in life.  Many retirees lack a sense of identity when they retire because their identity was tied up in their careers.  If they had taken the time to write down the ten things that made them happy in life early in their careers, perhaps they would have had a better sense of their own identity and what they truly want out of life, not to mention life would have been a whole lot more enjoyable along the way.  After all, as far as I know, nobody on their deathbed has ever stated they wished they would have spent more time in the office.  So you might as well take ten minutes out of your day now and write down your list of ten things that make you happy and dedicate some time each week to make sure you are intentionally pursing them.              

Be Happy First

If the above reasons for trying this exercise were not enough to convince you, at the very least do it for you.  How would your energy level and attitude change if you intentionally made the effort to do more things that made you happy?  There is nothing selfish about focusing on your own happiness.  It is analogous to the announcement you hear on airplanes that state “put your oxygen mask on first before helping a child.”  To show up everyday and be the best version of yourself at work, at home, and in life, focusing on incorporating more activities that make you happy in your day- to- day life will make you a more productive employee, spouse, parent, or human being.  Not to mention, you will be a whole lot more enjoyable to be around and people will notice your positive energy because it’s contagious.  Be happy first.