Advisors: How to Create More Effective Equity Portfolios

By iSectors Chief Investment Officer, Chuck Self on May 15, 2018

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:

  • The upper right corner is the average annual equity return from 1900 to 2017 after inflation and after taxes. It is 3%! This is probably a lower number than most readers would have guessed. If inflation averages 2% over the next 10 to 30 years as implied by Treasury breakeven rates and tax rates stay where they are (current tax rates are at around the long-term averages,) after-tax real equity returns will average 5% over the long-run.
  • Focusing on the colors, there has been great variability in after-tax real returns over this 117-year period. In fact, looking at the 20-year return line, 10 of the 97 periods have had negative returns (in red)! But the last one was 1965 to 1985. In more recent years, the 1989 to 2009 period earned the lowest after-tax real return, which averaged 2%.
  • There has not been a 20-year period where equities earned a 10%+ average after-tax real return (in dark green). There have only been 12 periods that earned greater than 7% (light green). Therefore, it is not likely that stock will return 10%+ on a nominal basis over the long-run going forward.

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:

  • Over time, if downside risk is minimized, strategies can be top performers in their asset class
  • Reducing downside risk will smooth volatility of returns clients receive. We call this giving a client a “smooth ride.” Most importantly, not presenting large portfolio losses decrease the probability that clients will force advisors to sell at the bottom and reinvest in the market at much higher levels.

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:

  • Size: The amount of premium earned by owning small capitalization stocks compared to large capitalization stocks. During the positive and negative volatility of the past eleven years, this premium has been positive each year and the lowest relative position was fifth in 2014. Many other researchers, most notably Eugene Fama and Kenneth French, found a significant positive size premium. The Morningstar work indicates that small cap outperformance continues to persist.
  • Financial Health: This premium accrues to companies with stronger financial health and lower risk of bankruptcy. There are many ways to asses this measure. Morningstar computes a proprietary score related to equity return volatility and leverage. 2012 is the only year in this period where less healthy companies outperformed and it ranked 9th that year.

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:

  • US Large Cap Growth: 23.5%
  • US Large Cap Value: 23.5%
  • US Small-Mid Cap: 12.1%
  • US REIT: 4.8%
  • International Developed Market: 25.3%
  • International Emerging Market: 10.8%

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.


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