Asset Allocation and Market Factors

Asset Allocation and Market Factors

There are times when I get involved in an investment discussion on another investment site.  The debate frequently involves the very basics of portfolio construction.  Does one use individual stocks, mutual funds, or ETFs to populate portfolios?  This is a fundamental question.  Here at ITA Wealth Management we use, almost exclusively, ETFs to build our portfolios.  Is there a logical reason for this approach?  Why not select individual stocks as all one needs to do is select the best stocks and stay with them?  Leave the “dogs” to the indexers.  If only it were this easy.  I see nothing wrong with building portfolios around individual stocks, so long as one has the analytical skills to evaluate companies.  Stock selection is a skill not given to many investors.

If you have never read William Sharpe’s article, “The Arithmetic of Active Management” now is the time to do it.  Keep in mind that managing portfolios such as the four ITA Dual Momentum™ accounts runs counter to the Sharpe article.  Therefore, we are not completely “clean” here at ITA.

Many years ago I cut my investing teeth by searching through Weisenberg Reports (no longer published) for well managed no-load mutual funds.  This was long before the Internet so I spent quite a bit of time in our wonderful local library.  As I began to learn more about the importance of Asset Allocation I found myself drawn to the business library at Portland State University as they carry the most academic journals on finance and investments.  Many of the articles were so statistically oriented I was only able to understand the abstract and conclusions.  Those abstracts and conclusions guided me to writers such as William J. Bernstein who is excellent at laying out the basic principles of portfolio construction.  Of Bernstein’s three most critical investment books, I would begin with the third volume, “The Investor’s Manifesto.”

Here are a few more logical reasons why we advocated index securities here at ITA.

If you follow portfolios such as the Gauss, Einstein, Kepler or Millikan you know that the investment quiver includes ETF arrows that cover critical asset classes as well as market factors.  Here is a bit more on the lesser known market factors, now known as the Fama-French Five-Factor model.

The Fama-French factor model began with three market anomalies. Those three were; size risk , style risk, and market risk. The three-factor model evolved to include momentum, the least understood (Why does it continue to work?) market anomaly.  Here at ITA we are big on momentum.  It is used in all but a few of the ITA portfolios.

Currently the F-F model is the Five-Factor model which includes Profitability. This last market anomaly was discovered by a former high school student of mine.

Getting back to the importance of Asset Allocation, I now build portfolios around ten to fifteen asset classes and add in the five market factors.  We are not invested in all at any single time.  The ETFs are there to be plucked for activity when a Buy signal is generated by the Kipling spreadsheet.  Obviously there is overlap between the Asset Allocation and Market Factor models.  One classic overlapping example is Size where VBK fits both an Asset Allocation and Market Factor requirement.

While one can develop a Buy-Hold-Rebalance portfolio using Asset Allocation and Market Factors, I continue to experiment by applying momentum principles to a basket of ETFs. The Dual Momentum™ model is a classic example.  Portfolios classified as Relative Strength or Momentum Strength such as the Kepler and Gauss are examples.

Having written all the above, one should never get too cocky as in the background there lurks the Schwert Rule!  “After they are documented and analyzed in the academic literature, anomalies often seem to disappear, reverse, or attenuate.” How true! Of the five factors, the one that seems to have “nine lives” is momentum and that is why we apply it to all the actively managed portfolios.

While on the topic of active management, one does need to be aware that active management leads to more market churning and therefore is subject to higher taxes.  Several years ago I performed a back-of-envelope calculation and for an investor in a “middle” tax bracket, they need to add approximately a 2% gain/year in order to offset the higher taxes.  That is not at all easy to do.  Once more, this reverts back to the Sharpe article.

Investing can be quite simple and at times complex, depending on your personal interests.  Here at ITA we strive to provide portfolio examples on both ends of the spectrum with a few in the middle.

Lowell