Busting the myths of investmentAdding small-caps to a global equity portfolio adds value without heightening the risk
If you are an investor you may have encountered these two adages. First, that in order to earn a higher return you must take greater risk. Second, that asset allocation is the most important contributor to performance
The first proposition at least sounds like it’s common sense. More formally it is known as the Capital Asset Pricing Model or CAPM for short. The only problem is that it doesn’t seem to work.
In 2012, Robert Haugen and Nardin Baker published research entitled “Low Risk Stocks Outperform within All Observable Markets of the World”. If you have not read it, maybe it’s because the title is not exactly the sort to catch your eye at the airport bookstand, that is a pity because its conclusions were startling.
To quote Nardin and Baker: “The fact that low-risk stocks have higher expected returns is a remarkable anomaly in the field of finance. It is remarkable because it is persistent — existing now and as far back in time as we can see. It extends to all equity markets in the world. And finally, it is remarkable because it contradicts the very core of finance: that risk bearing can be expected to produce a reward.”
Their findings can be illustrated by this chart of a subset of their data which covers 21 developed markets for 1990-2011 — in other words, a long period for much of the world’s equity markets.
Risk is defined as the volatility of the share prices.
For CAPM, or the old adage about risk and return to be correct, this chart would have to have the pattern of dots running up to the right, not down. The high-risk stocks have lower returns than the low-risk stocks. Something’s not right in the world of investment theory, it seems.
We have all been told that in order to make high returns we need to find stocks which are complex, difficult to understand, poorly researched, highly leveraged and risky. There is only one problem with this. As Richard Feynman, winner of the Nobel Prize for physics, said: “It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with experiment, it’s wrong.”
What about asset allocation? The seminal research on this was published in 1986 by Brinson, Hood and Beebower (or “BHB” as they are known in the industry). Their study of large pension plans entitled “Determinants of Portfolio Performance” is often incorrectly cited as concluding that asset allocation was responsible for 91.5 per cent of the portfolios’ returns.
Unfortunately, that’s not what BHB’s paper said. What it concluded was that asset allocation was responsible for 91.5 per cent of the variability in returns — not the returns themselves.
However, this mistaken conclusion has led a large portion of the investment industry to focus almost exclusively on asset allocation. If you attend enough meetings with investment advisers you will surely hear that asset allocation is more important than choice of individual assets, such as which stocks to own in an equity portfolio.
Another manifestation of this obsession with asset allocation is that many advisers focus on regional allocation of assets within equity portfolios and eschew investment in global funds. However, a research paper “The ‘New Classic’ Equity Allocation?” published in October 2010 by MSCI, the compilers of the Morgan Stanley Capital International World Index, looked at asset allocation within equity portfolios and found some glaring problems in this approach.
Among the most obvious is that many elements of business are now conducted globally rather than regionally or nationally, which makes regional asset allocation ineffective. In many cases, the country in which a company is incorporated, has its headquarters, or listing has little or nothing to do with its real exposure to geographic business and risk factors. The conclusion was that developed markets equities should be managed using global investment mandates, not regional ones.
Another issue identified by the MSCI study is “home bias” — the tendency of investors or advisers to overweight equity allocations to the market in which they are domiciled. In the UK, this leads funds not only to benchmark themselves against the FTSE 100 but to use it as a guide to portfolio construction given their desire to hug the index.
Why anyone would want to limit their investment choices to the UK economy is beyond my comprehension, even if they are UK domiciled. Moreover, the FTSE 100 is not even representative of the UK economy with more than three-quarters of its constituents’ revenues coming from outside the UK.
The MSCI study put forward the case for global equity allocation structured around three separate segments: developed world large/mid-cap stocks, developed world small-cap stocks and emerging markets.
It did so separately, since the small and emerging market segments have different liquidity constraints to global large-cap stocks and are influenced by particular macro factors and individual stock risk to a greater degree.
However, there is no doubt that adding a small/mid-cap element to a portfolio can achieve the seemingly impossible feat of generating additional return whilst reducing risk, as this chart shows:
This chart is an “efficient frontier” to use the jargon of the investment business. It takes the data for the past five years and shows the weekly return which you could have achieved with 100 per cent of your portfolio invested in the MSCI World Index and the risk of variation in returns you would have assumed in doing so.
It changes, with each blob indicating a 5 per cent shift in your portfolio from the MSCI World to the MSCI World Small Cap Index. What it shows is that if you changed 35 per cent (seven blobs) of your portfolio to MSCI World Small Cap you would get a higher return for the same risk. For any lower percentage, the higher return would be accompanied by lower risk.
I think Mr Feynman might conclude that we should all be managing our equity portfolios on a global basis and adding an element of small-cap exposure.
Terry Smith is the chief executive and chief investment officer of Fundsmith LLP. The views expressed are personal.