As most advisors know, it is difficult to gain clients with strong performance but easy to lose them from weak results. Although most clients need equities to meet their financial goals, the asset class is full of traps that can be tripped. It is important to balance stocks’ long-term performance record with short-term movements that may scare clients.
Equity Returns to Individuals
Although stocks outperform every other asset class over long periods of time, the actual return received by individual investors don’t measure up to stated index returns. Putting aside the active vs. passive debate for another day, individuals investing in index funds receive reduced returns due to transaction costs and taxes. To not consider these costs will cause advisors to overstate expectations to clients, setting them up for disappointment.
Fortunately, Crestmont Research has created a returns database that takes these factors into account. There are four charts that are instructive:
The difference between the nominal and real returns is that the real data is inflation adjusted. The difference between taxpayer and tax-exempt data is that the taxpayer pays taxes on dividends received and capital gains realized. All the return series include the reinvestment of dividends and transaction costs. You may wish to review the assumptions utilized by Crestmont to create these datasets.
The Taxpayer Real chart is presented below. These returns are subject to the most restrictive assumptions (the payment of taxes and delated by inflation.) The diagonal presents the annual returns from 1900 to 2017. Each diagonal to the northwest displays returns for a longer period. The diagonal with the dark black line are all the 20 year returns since 1900.
Don’t try to read any specific number; you can do so by clicking on the link above. There are some interesting points to be made:
These numbers are presented to help advisors manage client expectations surrounding equity returns to be realized. Too many studies do not account for taxes, transaction cost or inflation. A thorough review of this piece’s linked charts will educate advisors on the actual history of equity returns.
Enhancing Equity Returns by Managing Downside Risk
Given the anticipated equity returns, advisors may wish to utilize a process that will better help clients meet their investment objectives. iSectors’ philosophy is that managing downside risk should be the primary advisor investment goal for the following reasons:
Below is a chart showing the return premia for Morningstar’s style factors each year from 2007 to 2017. These return premiums represent portfolios that are long securities with high exposures to a factor and short securities with low exposures. Please refer to Morningstar’s Global Risk Model Factor Exposure Methodology paper for detailed explanations of each of the factors.
Clearly, different factors have performed well in each year. Since we are looking to manage downside risk, we wish to focus on factors that are consistently positive and outperforming other factors. Two stand out:
Tilting Equity Portfolios to Smaller and Healthier Companies
In another study by Marie Brière and Ariane Szafarz, they found that alpha from investing in small stocks and companies with “robust profits” were significantly positive. The problem with investing clients in small stock-only portfolios is its volatility. Although small stocks provided more than significant additional return for the higher risk taken, they have still returned large negative numbers in individual months. Thus, advisors should own a diversified group of capitalization size portfolios but overweight them to smaller stocks.
The chart below shows the market capitalization weightings from a typical global equity portfolio an advisor may create. The portfolio is as follows:
The advent of factor-based exchange-traded funds (ETFs) has increased the choices advisors can utilize to invest in financially healthy companies. One needs to be wary of the number of engineered “high quality” ETFs that look attractive with back-tested data. Many of these ETF’s underlying indices have resulted from data mining that may not hold up in the next down market.
We prefer to use dividend funds as proxies for healthy companies. The payment of dividends, especially the growth of these dividends over time, indicates that management and directors believe in the company’s financial strength. Over the past 40 years, academic researchers such as Ray Ball, Eugene Fama and Kenneth French have found excess returns by owning dividend stocks. Advisors do not need to rely on back testing to receive confidence about this measure of corporate financial health.
We recommend that advisors add to mid and small cap in equity portfolios by moving 5% to 10% from large cap to each sector. Adding financially healthy companies, especially in the mid and small cap ranges can more than offset these sectors’ added volatility while reducing down-capture and increasing the alpha possibility in client portfolios.
Simple Implementation Utilizing iSectors Domestic Equity or Global Equity
To save you time and move you toward being an elite advisor, iSectors has equity allocations that incorporate more small and mid-cap stocks and emphasize financially healthy companies.
The iSectors Global Equity Allocation model targets a diversified basket of domestic, emerging market, and international equity index, low-cost ETFs. Fundamentally-weighted index ETFs (where the underlying indexes are based on dividends, or other fundamental criteria rather than capitalization-weighted indexes) are also incorporated into the portfolio to enhance return and reduce volatility. Approximately two-thirds of the Allocation is held in dividend funds. As the chart below indicates, the portfolio is tilted toward small and mid-cap stocks compared to the standard global equity benchmark.
For those advisors looking for a U.S. version, the iSectors Domestic Equity Allocation model is a strategic model comprised exclusively of U.S. equity securities. This model has a conservative, value-focused dividend overweighting (75% of the portfolio), which improves dividend yields while investing in financially healthy companies. Like the Global Equity Allocation, the portfolio is overweighted in small and mid-cap stocks which comprises 35% of the portfolio compared to 17% for the Russell 3000.
If you are a financial advisor that wishes to learn more about creating more effective equity portfolio, please contact Scott Jones at 800-869-5184 or [email protected]. Alternatively, you may wish to register, here, on our website, to review information on the iSectors Allocations described above.
Individual investors can contact Scott Jones for a referral to a recommended iSectors advisor that can help them determine the best iSectors asset allocation for their portfolios.