Archive | May, 2012

Inside the DFA Global Balanced Fund

Long-time readers will know that I’ve written before about Dimensional Fund Advisors, an innovative investment firm that builds low-cost, widely diversified funds. I enjoy keeping an eye on DFA, because their strategies are based on academic research (there are a few Nobel laureates in the family) that all investors can learn from.

The one downside of Dimensional funds is that they’re not available through discount brokerages: the only way you can get them is through a small number advisors who have been schooled in DFA’s strategies. This helps the company control fund inflows and outflows from performance-chasing retail investors that would make executing those strategies impossible.

But that doesn’t mean Couch Potatoes can’t pop the hood on these funds and take a look. Just shy of a year ago, the firm launched the DFA Global Balanced Fund in Canada: it’s a fund of funds that includes the standard 60% equity and 40% bonds. [Note: This fund's name has been changed to the DFA Global 60EQ-40FI Portfolio. There are now also versions with different allocations to equity and fixed income.] The I thought it would be interesting to compare it to my own Complete Couch Potato.

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Why Isn’t Everyone Beating the Market?

Sometimes I wonder why everyone isn’t getting better returns than a simple Couch Potato portfolio. Spend a little time and you’ll discover all kinds of strategies that beat the market. And I’m not talking about the nutbars who promise 5400% gains on penny stocks—no one takes those seriously. I mean reasonable strategies that have been studied by academics—or at least serious practitioners.

Really, why would anyone use cap-weighted index funds when equal-weighted indexes, fundamental indexes and value-weighted indexes all crush them over the long run? And why buy the whole market instead of zeroing in on small-cap stocks, value stocks, and low-beta stocks, all of which have outperformed the broad indexes?

Why stay invested at all times when you can reduce your risk and earn higher returns by market timing with technical analysis, or even with a less fussy technique like “sell in May and go away.”

If you want to keep your volatility low and still pull in 9% a year, just put half your money in gold and cash with The Permanent Portfolio,

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Ask the Spud: Does Home Bias Ever Make Sense?

Q: The Global Couch Potato has one-third of the equity allocation in Canadian stocks, but Canada makes up only about 4% of the world markets. Aren’t you guilty of home country bias? – Jeremy D.

I’m actually pleased that I’ve received this question several times in the last few months. Not long ago, it wasn’t unusual for investors to ask why anyone would invest in any country but Canada. Our domestic market was one of the world’s top performers during the first decade of the new millennium, but that’s changed: Canada has now lagged the MSCI All Country World Index by 3.4% annually over the last three years, and we’ve trailed the US over the last five.

That’s a reminder that the long-term expected returns in any developed country are more or less the same. (Since 1970, the average return on Canadian, US and international stocks are almost identical.) However, since each country’s stock market moves along a different path, a globally diversified portfolio should have lower volatility than any single country, and it should boost returns by providing opportunities for rebalancing.

It makes theoretical sense to build an equity portfolio that assigns weight to every country based on the size of its stock market.

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Why I Have No Faith in Market Timing

Earlier this week I described the market timing strategy outlined in Mebane Faber’s book The Ivy Portfolio. I chose not to editorialize too much, preferring instead to simply explain the strategy to readers who may have been unfamiliar with it. So let me make my opinion on this clear now: I do not recommend this strategy or any other form of market timing. I simply don’t believe it will help investors improve their long-term returns.

Let’s start with the obvious point. The performance numbers in Faber’s book (which show a 1.5% boost in returns and much lower volatility since 1973) assume that costs and taxes were zero. But as Larry Swedroe is fond of saying, strategies have no costs, but executing them does. Trading commissions and bid-ask spreads would likely be low with Faber’s strategy, but they will certainly reduce that outperformance. More importantly, in a non-registered account taxes would severely cut into the returns of a timing strategy. (Obviously, in an RRSP this is not an issue.)

Do you have the discipline?

But the real problem with timing strategies is not the costs: it’s behaviour. Faber freely acknowledges that the most important factor in any quantitative strategy is the discipline to pull the trigger,

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Market Timing Goes to College

In recent years, the so-called Yale Model has been extremely popular with investors. The model is an attempt to mimic the investment strategy used by Ivy League endowment funds, which have an outstanding track record of beating the market indexes. David Swensen, the superstar manager of the Yale endowment fund, delivered returns of 10.1% annually from 2002 to 2011, a decade when stocks returned 3.9%. The Harvard endowment returned 9.4% over the same period and has grown 12.9% annually over the last 20 years.

The Ivy Portfolio, by Mebane Faber and Eric Richardson, describes how Yale and Harvard use an asset allocation model that is broadly similar the Couch Potato strategy. The key difference, however, is that the endowments include a number of asset classes that are not available to retail investors, including private equity, hedge funds, and direct ownership of timber resources and commercial real estate.

The first half of Faber and Richardson’s book is a fascinating look at how individual investors can mimic the Yale Model. The authors quote both Swensen and Jack Meyer (Harvard’s former endowment fund manager), both of whom recommend building diversified portfolios with low-cost index funds.

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Can You Protect Your Portfolio From Drawdowns?

If your portfolio loses 1% today and gains 1% tomorrow, are you back to even? Not quite, but you’re awfully close. You actually need a gain of 1.01% to get back to where you started.

While that difference seems trivial, it gets magnified when the ups and down of your portfolio get larger. A loss of 5% requires a 5.26% gain to recover, while a 20% loss needs 25%. As for a 50% drawdown like we saw in 2008–09, well, that’s even worse than it appears. Your portfolio needs to double (a 100% gain) to return to its starting value. Stocks do recover from devastating declines like this, but it can take many years: the Canadian and US markets are still well below their 2007–08 highs.

Some investors simply don’t have the ability or the stomach to endure drawdowns of 20% or more. As index investors all know, the most straightforward way to protect your portfolio from catastrophic loss is to adjust its asset allocation: a 50-50 mix of Canadian stocks and government bonds lost just 12% in 2008.

But as I wrote about last week, markets are filled with uncertainty.

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Risk and Uncertainty in Stock Markets

When we consider the risk in investing, we’re often thinking about volatility: that is, the sometimes dramatic movements in equity prices. But as Alan Fustey explains in his book, Risk, Financial Markets & You, there’s a big problem with equating volatility with risk.

One of the biggest shortcomings in financial models is the reliance on standard deviation (SD) as a measure of risk. SD is a measure of volatility—or more specifically, how much returns vary around the average. About two thirds of all returns will fall within one standard deviation of the average, and 95% will fall within two standard deviations. In theory, annual returns that vary by three standard deviations should happen only once in a century, while a six-SD event would occur about once in a billion years.

This idea makes more sense when you use some real-world numbers. According to Credit Suisse, from 1900 to 2011 the average annual return on equities was 8.5%, with an SD of 17.7%. That means two years out of three should see returns between –9.2% and 26.2% (the average +/- one SD). In only one year out of 20 would returns be lower than –26.9% or higher than 43.9% (the average +/- two SDs).

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