In a Dec. 23, 2011 article, New York Times columnist Ron Lieber wrote about my personal investment strategy, which can be described as a low-beta/high-tilt (to small and value stocks) portfolio. I want to circle back to it to illuminate important points about diversification.
Lieber called it the “Larry Portfolio,” or the “LP,” as we like to call it. My colleague Kevin Grogan and I recently published a book that provides the concepts and historical evidence demonstrating that the “LP” has earned superior risk-adjusted returns that produce a higher Sharpe ratio than that of a marketlike portfolio, with much smaller worst-case losses.
The following is from the introduction of our book, “Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility.”
“This book was written for those looking to expand their knowledge of the passive investing world. In this world, evidence and academia are used to design portfolios, not instincts, opinions, or ego. Whether you are an advisor looking to better serve your clients, an investor looking to become more knowledgeable on the workings of your portfolio, or, even a financial oracle, you will benefit from this book.
“While it is short in length, its content is heavy. It is data-rich and full of detailed examples. The empty rhetoric or the distracting noise often heard in the active investment world has no place here. Science and hard data make our case. There is no need for elaborate prose or the hyperbolic statements so often heard on the other side of the investing aisle.
“You are about to embark on a journey that we hope will be both informative and of great value. It is a roadmap to the Holy Grail of investing—the search for an investment strategy that can deliver higher returns without increased risk or the same return with reduced risk.”
While historically, the “LP” has delivered superior results to a market-like portfolio, one concern investors have expressed is that “it is not a well-diversified portfolio.” To address that question, there is a section devoted to the issue. The following discussion is derived from the book.
In one sense, that is a true statement [that the Larry Portfolio is not well diversified]. The “LP” does limit the stock holdings in both the U.S. and developed international markets to small value stocks, and in emerging markets to value stocks. That means there are no U.S. and international developed-market holdings of small-cap, midcap and large-cap growth companies, and no holding of midcap and large-cap value companies. And in emerging markets, there are no growth stocks, just value stocks.
To address whether the LP is well diversified, investors should think about diversification in a different way than they are probably used to. The conventional way of thinking about how well a portfolio is diversified is to think in terms of the number and weighting of individual stocks, asset classes and geographic regions. We want you to also think about diversification in terms of exposure to the factors that determine the risk and return of a portfolio.
As we have discussed, to understand how markets work, financial economists have developed what are called “factor models.” The standard model used is the Fama-French three-factor model. The three factors, by way of reminder, are beta (exposure to the risk of the stock market); size (exposure to the risk of small stocks); and value (exposure to the risk of value stocks).
To answer the question about how well a highly tilted portfolio is diversified, we will begin by looking at the exposure a total stock market fund (portfolio) has to the three factors.
A total stock market (TSM) fund has, by definition, an exposure to beta of “1.” However, while a TSM fund holds small stocks, it has no exposure at all to the size factor. This seeming contradiction confuses many investors. The reason for the confusion is that factors are long/short portfolios. The size factor is the return of small stocks minus the return of large stocks. In other words, small stocks provide a positive exposure to the size effect, and large stocks provide a negative exposure to it.
Thus, while the small stocks in TSM provide positive exposure to the size factor, the large stocks in TSM provide an exactly offsetting amount of negative exposure. That puts the net exposure to the size factor at 0.
The same is true for value stocks. The value factor is the return of value stocks minus the return of growth stocks. Value stocks provide a positive exposure to the value effect and growth stocks a negative exposure. While the value stocks within TSM provide positive exposure to the value factor, the growth stocks in TSM provide an exactly offsetting amount of negative exposure. That puts the net exposure to the value factor at 0.
We now turn to looking at the exposures that the “LP” portfolio has to the factors. The exact answer depends on which funds are used to implement the strategy. In other words, the smaller the weighted average market capitalization of the stocks in the fund, and the lower their weighted average price-to-book ratio, the greater the exposure to the factors.
The funds in the portfolios we use to build the “LP” create a portfolio with loadings (exposure to the factors) on the size and value factors of approximately 0.6. And like most well-diversified stock portfolios, the equity portion of the portfolio has a beta of about 1.
Now consider a portfolio that uses the high-tilt, low-beta approach of the LP and chooses to have a 30 percent allocation to stocks. The portfolio will have a beta of about 0.3, a size loading of about 0.18 (0.6 x 0.3) and a value loading of about 0.18 (0.6 x 0.3). And the portfolio’s bond holdings will give it exposure to term risk as well; that is, how much will depend on the maturity of the bonds used for the bond portion of the portfolio.
Thus, the portfolio has exposure to four factors, each of which has low correlation to the other factors. Contrast that with a TSM portfolio with a 100 percent allocation to stocks. It has a beta of 1, and that is the only factor it is exposed to.
Thus, while TSM is more diversified when you think about diversification across asset classes—holding more equity asset classes and filling in more of Morningstar’s style boxes, the “LP” portfolio is more diversified when looking at exposures to risk factors.
Again, TSM has all of its eggs in one risk basket—beta, while the “LP” portfolio diversifies its risks across three stock risk baskets—beta, size and value, as well as the term factor of the bond holdings.
The “LP” portfolio is also just as diversified in terms of economic and geopolitical risks across countries.
And it certainly holds a sufficient number of stocks. Using the international small value and emerging market value funds of Dimensional Fund Advisors and Bridgeway’s Omni Small Value Fund [the only two funds needed to implement the equity portion of the LP], it holds the stocks of about 4,800 companies from 43 countries—certainly more than enough to diversify away any idiosyncratic risks.
In fact, it holds just about the same number of stocks as Vanguard’s Total World Stock Index Fund (VT | B-100), which holds about 4,900 stocks from about 41 countries.
The bottom line is that the “LP” portfolio is a well-diversified portfolio, just not so well-diversified when thought of in a traditional asset-class approach. And while that leaves the investor subject to that dreaded psychological disease known as “tracking error regret”—the portfolio’s returns will look very different from those of the market—the benefits in terms of reduced tail risk are large in comparison.
Accepting the risk of tracking error is the “price” an investor must pay in order to benefit from the risk-reducing characteristics of the strategy.
Larry Swedroe is a director of Research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.