We believe that asset allocation is the most important decision that an investor must make when creating a portfolio.
Numerous academic studies have demonstrated that asset allocation policy is the primary determinant of portfolio returns – security selection and market timing ultimately have a very small impact on overall portfolio results.
Although there are many asset allocation techniques, the most important asset allocation decision comes down to the split between stocks and bonds.
Stocks represent ownership in companies, tend to be highly volatile, have enjoyed relatively high returns historically and, theoretically, will have relatively high expected returns in the future.
Bonds represent loans to a government, corporation or some other entity that will repay their principal, plus interest. Bonds have generally had low volatility and correspondingly low returns, historically and theoretically in the future.
These two asset classes are distinctly different both in terms of what they represent (ownership versus a loan), the expected return and the level of risk. Looking at these factors along with how these two types of securities interact with each other form the basis for diversification across asset classes.
The two examples listed above are only two of many distinct asset classes. Among equities, we define asset classes by company size, geographic location, and other risk factors. In fixed income, we classify by duration (or term), credit quality, and structure.
Once we have established asset classes, identified their expected returns, expected volatility and relationship with each other (correlation), we use models to find the optimal mix of these assets for each client.
We expect stocks to serve as the growth engine of an investment portfolio.
At Acropolis, we seek to create value for our clients by finding high quality investments at reasonable prices. This combination should result in relatively good results over a full market cycle.
Beginning in 1926 and ending in 2013, large US companies have returned an annual return of 10.08 percent. Of course, those returns haven’t been earned in a straight line – returns have been as high as 53.99 percent in 1933 and as low as -43.34 percent in 1931.
Ultimately we believe that stocks will continue to deliver the highest returns because stocks represent ownership in businesses. However, we know that stocks can be very risky since the value of these businesses is difficult to assess and perceptions about value can change rapidly.
Given that stock investing has the most potential to earn substantial returns but can also result in the greatest losses, we believe that it is important to own stocks with a long-term time horizon and diversify across asset classes, sectors, and individual securities.
Once the asset allocation is determined, we equal weight our exposure in seven of the ten sectors so that no single sector becomes too large, like technology stocks during the Tech Bubble or financial stocks going into the 2008 Financial Crisis.
Within each sector, we seek to buy companies with what we believe are the best combination of high profitability and low valuation. Using techniques borrowed from academia, we use quantitative measures to identify the top 10-12 companies in each of the seven sectors with the strongest combined traits. With this short list of 10-12 companies in hand, we do a traditional, fundamental analysis of each company to cut the list down to six stocks in seven sectors.
We believe that it is essential to invest in high quality assets. When we invest in stocks, we are taking ownership in a business. As owners, we want to own high-quality businesses that will deliver returns to shareholders by growing their intrinsic values, engaging in share buybacks, or distributing dividends.
Our fundamental analysis includes a detailed review of the balance sheet, income statement, and statement of cash flows. In general, we are looking for companies with established competitive advantages as demonstrated by their financial strengths, profitability, and growth at both their top and bottom-lines.
Of course, it isn’t enough to simply find good quality businesses. It is critically important to pay reasonable prices for stocks. Ownership of the highest quality stock will result in poor performance if the purchase price is too high. Where the financial health of a stock is relatively easy to determine, figuring out the right price to pay is extremely difficult and requires substantial judgment.
Bonds serve as the ballast in a portfolio. Our goal is to find the best relative value and risk-adjusted return.
While stocks can earn terrific returns but also suffer significant losses, bonds have historically provided more stable, albeit lower returns.
Unlike stocks that represent ownership in a business, bonds are loans to entities like governments, municipalities, corporations or federal agencies. Like any loan, bonds pay interest and then return the principal to the investor.
Although the concept is straightforward enough, many investors are uncomfortable investing in bonds because of the jargon, math, and the fact that bonds generally don’t trade on exchanges like stocks.
Acropolis has substantial experience in the bond market. More than half the money we manage is invested in bonds.
If you’re unsure of the bond market, you can rest assured that you’re in good hands. Three of our founders were previously bond traders, and we have two dedicated bond traders continually reviewing market conditions and identifying securities that they believe will offer the best risk-adjusted returns.
Identifying Sources of Risk & Return
Many investors only consider the yield when selecting a bond. Like most things in life, there is no free lunch in the bond market and higher yields reflect additional risks. We generally break down the risks into four broad categories:
1. Credit Risk refers to the quality of the borrower and the likelihood that an investor will actually receive the expected interest and principal payments. Consider the difference between U.S. government bonds and corporate bonds issued by now-bankrupt Lehman Brothers. The government can print money to repay bonds where Lehman defaulted, stopped paying interest, and creditors are now fighting to divvy up what remains to former bondholders.
2. Duration, or term, represents the time that you are willing to loan your funds. It makes sense to demand more interest on a bond that will pay back in 30 years than a bond that pays back in three months. Duration is a major factor in the volatility of a bond – the longer the duration, the more volatile the bond.
3. Structure refers to the timing of interest payments and principal repayment. A bond can earn no interest and accrue in price, pay a fixed interest rate, a floating interest rate, or even pay interest and principal back each month. Structure is very difficult for individual investors to analyze and can be a source of risk and return.
4. Liquidity refers to the ability to sell a bond (or any security) without affecting its price. Imagine that you wanted to sell your house in 24 hours – you would expect to receive a substantial discount in exchange for selling a unique asset on short notice. If you were selling a diamond, you could expect to get market price for a diamond even on short notice because diamonds are pure commodities. Some bonds like U.S. government t-bills are commodities, while other bonds from a small issuer that trade infrequently will be illiquid. In exchange for the illiquidity, investors require a higher yield.
All of these characteristics and others play a role in our security selection. As we consider various opportunities, we constantly look at the potential risks along with the possible returns for our clients.
It is imperative to manage a portfolio that is subject to taxes in the most tax-efficient manner possible.
Many advisors say that they seek to minimize taxes. It is possible to minimize taxes by simply losing money year after year and never achieve any gains. This is hardly what investors have in mind!
The goal instead is to maximize returns after taxes are paid. To illustrate the difference, consider the hypothetical investor who has the choice to invest $1,000 in one of these two bonds:
|Municipal Bond||Taxable Bond|
|Taxes||$0||$320 (40% Tax Rate)|
While the investment in the municipal bond minimizes taxes, the taxable bond maximizes after tax returns. Of course, this stark example is designed to illustrate the concept and doesn’t reflect current interest rates or taxes.
At Acropolis, we employ three techniques to maximize after-tax returns.
1. Structural Efficiency
The first method is very simple: use tax-efficient investment vehicles. By using exchange-traded funds to achieve broad diversification, we avoid the pitfalls that are commonly associated with actively managed, open-ended mutual funds.
Exchange-traded funds are tax-efficient by design. Their unique structure allows them to track benchmarks with minimal tax consequences.
2. Tax Loss Harvesting
Tax loss harvesting is the process of selling a security at a loss and replacing it with a security with a similar (though not substantially identical) risk/reward profile. We can accomplish this with exchange-traded funds and with individual stocks or bonds in both up and down markets.
3. Asset Location
Asset location refers to the strategic placement of investments in different kinds of accounts. For example, a taxable bond should go into an IRA (or other deferred account) to shield it from taxes where a stock should be held in a taxable account since dividend and capital gains tax rates are low and tax harvesting can be efficiently employed.