Every once in a while, I would see outrageously expensive portfolios that picked parts of the market to outperform, yet were all but destined to underperform. These portfolios were designed by either a broker’s gut feeling or a firm’s so-called research, just to be proven fallacy by academic research.
As portfolios evolve, unfortunately, I’m now seeing a lot of strategies that are supposedly based on science—though it’s more like science fiction if you ask me—and I think are even worse.
Take one portfolio I reviewed recently with the following funds sorted by annual expense ratios:
|Vanguard Intermediate-Term Treasury Index ETF||VGIT||0.05|
|DFA Tax-Managed US Eq||DTMEX||0.22|
|DFA T.A. US Core Equity 2 I||DFTCX||0.24|
|DFA Tax-Managed US Marketwide Value II||DFMVX||0.24|
|DFA TA World ex US Core Equity I||DFTWX||0.36|
|DFA Tax-Managed US Marketwide Value||DTMMX||0.37|
|DFA Emerging Markets Core Equity I||DFCEX||0.49|
|DFA Tax-Managed International Value||DTMIX||0.52|
|Bridgeway Omni Tax-Managed Sm-Cp Val N||BOTSX||0.55|
|DFA World ex US Targeted Val Instl||DWUSX||0.64|
|DFA International Small Cap Value I||DISVX||0.65|
|AQR Style Premia Alternative R6||QSPRX||1.68|
|Stone Ridge Reinsurance Risk Prem Interval||SSRIX||2.28|
|Cliffwater Corporate Lending||CCLFX||2.39|
|Stone Ridge Alternative Lending Risk Premium||LENDX||5.03|
In addition to these fees, the firm charged an ongoing management fee of nearly 1% annually.
Like other firms, the advisor claimed they constructed the portfolio based on a number of factors, including those derived from academic research and literature, commercially available software technology, securities rating services, general market and financial information.
Let’s examine some of the holdings. While I don’t use the Vanguard Intermediate-Term Treasury Index ETF (VGIT), I have no issues with the inclusion of this high quality, low-cost bond fund.
- DFA Funds
I’m on record as saying DFA is a good fund family, and completely agree with its position that factor tilting isn’t a free lunch. I don’t use DFA, as I feel I can develop a cap-weighted (dumb beta) portfolio of similar risk with far lower fees and greater tax efficiency. Still, I find the DFA funds overall to be the least objectionable funds in this portfolio—especially the ones with the lower expense ratios. I don’t know if this advisor is partially responsible for the fund outflows at DFA, but factor tilting has more risk, and this portfolio had nearly an 800% tilting toward small cap value versus market cap. Of course, this has been the worst style box in performance over the past five years.
- Bridgeway Omni Tax-Managed Small Cap Fund
I’m bothered by more than the 0.55% expense ratio. This fund’s holdings average under $1 billion in market cap versus $2.4 billion for DFA’s small cap value fund and $5.4 billion for Vanguard’s. This portfolio is not only heavily tilted to small cap value, it’s tilted to the smallest and most value oriented. So, over the past five years ending April 30, 2021, it underperformed the worst style box (Russell 2000 small cap value) by 2.67% annually. Not surprisingly, the Bridgeway fund family has seen fund outflows over the past several years.
- AQR Style Premia Alternative R6
An AQR fund seems to fit in perfectly with this science-based strategy. AQR claims a strategy of investment innovation at the intersection of technology, data and behavioral finance. And this fund seeks to provide long-term returns with a low correlation to traditional asset class returns by investing in a broad spectrum of asset classes and markets. It succeeded in wildly underperforming the index category of moderate to conservative target risk by 11.59% annually over the past five years ending April 30, 2021. That’s almost 10 percentage points worse than the 1.68% expense ratio would have predicted. This fund lost 3.61% annually versus the benchmark gaining nearly 8%. Not surprisingly, the AQR fund family has seen more than half of its assets yanked over the past few years.
- Stone Ridge and Cliffwater Funds
These three funds aren’t publicly traded and aren’t nearly as liquid as the other funds. The expenses are outrageously high, though they change quite regularly and vary depending on the source document. They have the right (and have exercised the right) to gate redemptions, meaning they can tell you when you’ll get your money back. I’ve been on record disagreeing with the Stone Ridge strategies and don’t know if Cliffwater will end any better. It’s true that some of these strategies have little to no correlation with stocks since insurance losses from events like weather aren’t correlated with stock performance. But fees make future returns low to negative, in my opinion. I’d rather take some money and go to Las Vegas—better odds, more fun and no correlation to stocks.
How Do We Get To These Science-Based Portfolios?
The first culprit is academia. To be published, one must come up with new research of new discoveries. These discoveries are based on “backtesting” performance and developing theories on why the outperformance will persist. This methodology is flawed, and underperformance typically follows as reversion to the mean takes over.
The second culprit is the advisor who is indirectly compensated for complexity. This is especially true if the advisor is a publicly held company or owned by one. They have their own shareholders as their masters.
The late Vanguard founder John Bogle stated “no man can serve two masters.” It’s hard for the advisor to charge much and retain the client for simplicity. Thus, complexity and costs become the advisor’s friends but the investor’s enemies.
To be clear, I think portfolios like these are often worse than those designed decades ago by many brokerage firms. At least those broker-designed portfolios weren’t claiming to be supported by academia and science, and weren’t necessarily based on past performance.
I define investing in eight words:
“Minimizing expenses and emotions; maximizing diversification and discipline.”
Whether designed by the broker from the last century or the advisor using so called science-based portfolio construction, violating these principles is likely to transfer your wealth to others.
Simple is superior. Stick to total U.S. stock ETFs like the iShares Core S&P Total U.S. Stock Market ETF (ITOT) or the Vanguard Total Stock Market ETF (VTI), and total international stock ETFs like the Vanguard Total International Stock ETF (VXUS) and the iShares Core MSCI Total International Stock ETF (IXUS).
For high quality bonds, consider the iShares Core U.S. Aggregate Bond ETF (AGG) or the Vanguard Total Bond Market ETF (BND). They have more holdings and two fewer digits in fees than some of the funds in this particular portfolio.
I love science fiction, but not in portfolio construction.
Allan Roth is the founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine. You can reach him at [email protected], or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter.