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The Benefits of Elegantly Simple Portfolio Construction

Advisor Perspectives

By Scott MacKillop | July 10, 2017

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Do you get more by paying more? Is bigger really better?

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We all want to build the best possible portfolios for our clients. But we do it in different ways. Some use classic modern portfolio theory (MPT). Some prefer factor tilts. Others try to time the market. Whatever your approach, let me make a suggestion: Keep it simple.

Keeping it simple improves performance no matter what type of investment process you use. Our industry is in love with complexity, but complexity is costly to clients.

Here are some reasons why simple is good and some guidelines to help you stay simple.

The problem with optimization

MPT is a wonderful theory, but suffers from a fundamental problem. For it to work you need to know the future expected returns, volatilities and correlations for all the asset classes in your portfolio. Unfortunately, no one knows what they are. In addition to being mysterious, they are also ephemeral – they keep changing over time.

This is a problem for two reasons. Strict adherence to MPT causes us to build jumbo portfolios. We load up our portfolios with a laundry list of asset classes and sub-asset classes, many of which come along with high price tags. We think we are going to achieve diversification benefits that don’t materialize.

Our capital market assumptions don’t line up with what happens over the ensuing years. They are estimates (guesses) about the future that are often based on the past – a past that rarely repeats itself. Our assumptions are typically very long-term in nature. Even if they play out over 20, 50 or 100 years, they frequently don’t in a time frame that is meaningful to clients. Jeremy Siegel says the long-term real rate of return of the stock market is 7%, but it is unusual for that number to hold true for one-, three- or five-year time periods.

Meanwhile, we dissect the world into more asset classes, sub-asset classes and factors than we know what to do with. We bedeck our portfolios with these “diversifiers” like ornaments on a Christmas tree. Some of them are added solely for their theoretical diversification benefit, but have no long-term expected-return benefit. Each one has a cost and those costs add up.

Even Harry Markowitz, the father of MPT, knew better than to do this. He is reported to have allocated his retirement account at the RAND Corporation 50% to stocks and 50% to bonds, and left it at that. Was he also the father of elegantly simple portfolio theory?

The second problem is that once we’ve bought into the illusion that we have created an “optimal portfolio,” we can’t stop tweaking the poor thing, trying to reset it to its optimal mix. We revisit it weekly, monthly or quarterly trying to fine tune it like a prized race car. We can’t keep our hands off our perfect creation. Each tweak costs money. But does it add value?

The first step toward building elegantly simple portfolios is acknowledging the limitations of MPT. Do we really need all those ornaments on the tree? What would happen if we eliminated asset classes that have no long-term expected return, or only owned them when we had high conviction they were poised to provide a return benefit? Do we add value by owning separate funds to represent every nook in the style-box, or would a single all-cap fund do?

Then let’s acknowledge that no matter how hard we try, we can’t build a truly optimal portfolio, except in hindsight. If we admit that our diversified portfolios are not optimal, then we can be more relaxed in our fine tuning of them. What would happen if we let our portfolios drift a little more from their allocation targets? Probably nothing bad and we would save our client money each year.

Fees and expenses

Talking about fees and expenses is boring. It’s far more exhilarating to talk about your big macro call that paid off. But…

Both Morningstar and Vanguard have found that low fund fees correlate highly with strong performance. A 2010 Morningstar study concluded: “In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.”

In 2015, Vanguard did a study that measured the effectiveness of different factors in predicting mutual fund performance. They found: “The ex-ante expense ratio separated poorly performing funds from better performing funds more successfully than all other metrics…”

In another Vanguard study, they compared the returns of mutual funds in the lowest cost quartile with funds in the highest cost quartile in different asset classes over the 10 years ending in 2013. Again, the low-cost funds beat the high-cost funds in every asset class.

You clearly don’t get more by paying more.

This is counterintuitive. We are so used to associating high cost with high quality that we transfer this frame of reference to the investment world. But it doesn’t apply here.

Builders of elegantly simple portfolios pay attention to the internal expense ratios of the mutual funds and ETFs they use. They know that actively managed mutual funds are not always too expensive and ETFs are not always cheap. They look for the best combination of cost and value and focus on the blended expense ratio of the portfolios they build.

Transaction costs

The only thing more boring than talking about fees and expenses is talking about transaction costs. Yet transaction costs are every bit as important in building elegantly simple portfolios.

There are two ways to limit transaction costs: limit the number of positions you hold in your portfolio and trade less frequently. I already discussed how MPT can cause us to build jumbo portfolios with lots of positions. But there are two other causes: thoughtlessness and fear.

Here’s an example of thoughtlessness. You know that ETFs can have very low internal expenses and that buying them is usually less expensive than buying a mutual fund, so you decide to build your portfolios using only ETFs. But then you build a portfolio with 20 different ETF positions and trade them frequently.

If you have a good reason for holding 20 positions in your portfolios, do it. But most people could not articulate a good reason for doing so. They are not going to actively change allocations among those holdings, and if they are, they shouldn’t.

Fear is another reason people build jumbo portfolios. They fear that if they don’t, their clients won’t respect them or the sophistication of their guidance. There is some basis for this fear. People who don’t know any better equate complexity with sophistication. But truly it takes more sophistication to build elegantly simple portfolios. Fear not!

The other way to limit transaction costs is to limit trading. Hyperactive rebalancing strategies result in excess trading. It is common these days for advisors to employ quarterly or even monthly rebalancing strategies.

Michael Kitces and Michael Edesess have both written fine articles questioning the value of such frequent rebalancing. Take a good look at your rebalancing strategy. Would your clients benefit if you pushed the reset button less frequently?

Adopting the right attitude

Approach “good ideas” with skepticism, especially your own. They are a source of much woe. Initially, treat them like the sirens of Greek mythology. Their alluring voices will draw you to a rocky and jagged shoreline. Resist.

The urge to employ new research or the trend-of-the-day is very strong. Adopt a bias against making changes to your portfolio unless you have extremely high conviction that the change will add value. Build friction into your investment process.

In 2000 Terrance Odean and Brad Barber published an excellent paper in the Journal of Finance documenting the severe price that investors pay for active trading based on their “good ideas.”

Odean and Barber studied the trading activity of thousands of investors. They isolated transactions where investors sold one stock to buy another – their “good idea” stock. Overall, the stocks that were sold outperformed the “good idea” stocks by a significant margin. The more investors traded, the worse their results.

Similar research has been done in the institutional setting documenting the fact that managers who have been terminated by pension plans often outperform their replacements. Many “good ideas” don’t pay off.

If your good ideas persist, examine them closely. Step back and view them through a telescope. Slow down the decision-making process. Follow Warren Buffett’s lead: “A lethargy bordering on sloth is the cornerstone of our investment style.” Like some people, good ideas seem less wonderful the more familiar you become with them.

If they still won’t go away, discuss your good ideas with colleagues you trust. Listen carefully and don’t get attached to your good ideas. If there is any doubt remaining, walk away.

Simple is beautiful

Leonardo da Vinci said, “Simplicity is the ultimate sophistication.” He was right. If you save your clients even 1% annually by building elegantly simple portfolios, you will fund many years of additional retirement for them. They will learn to like simple.

You can hold 80% to 85% of the global market portfolio by buying three ETFs with a combined internal expense ratio of under .10%. The portfolio would include a global equity ETF, a domestic bond ETF and an international bond ETF. That’s an elegantly simple portfolio if ever there was one, and if you look at its historical performance, it’s done quite nicely.

What if you started there and only added positions or made allocation changes after a rigorous screening process? One that includes approval by a group of independent, outside advisors and a days-long “cooling-off” period for all “good ideas?” In managing this elegantly simple portfolio you always have the luxury of doing nothing. Would your clients be better off?