Every so often, I like to explore alternative and what I think are innovative, strategies outside of the large broad indexes to enhance return but also to keep investors engaged.
The Core-Satellite Strategy
For people who take an interest in their investments like myself, I like to break my portfolio into what is called the core-satellite strategy. What this means is that 90% of my portfolio is dedicated to those most boring of investments: index funds in various market segments and strategies. The more important it is to my future well being, the more boring it is. For example, much of my retirement funds are in a target retirement index fund that automatically adjusts from more stocks towards bonds as I get older. Since I am an investor that’s inclined to take a little more risk, my target date goes beyond the typical retirement age of 65 by a few years and I keep my Roth IRA investments in equity strategies that diversify away from the large cap nature of the target funds such as a small cap IS focused ETF as well as an international small cap ETF.
My non retirement assets consist of real estate that I own and manage and my brokerage account consisting of my after tax savings. I evaluate my portfolio as a whole, meaning I count retirement, real estate, and my brokerage account as my whole portfolio. Of this overall portfolio, I carve out 5%-10% to try alternative and risky strategies which I think may beat the market.
Of course, many investment theses prove to be wrong and in the worst case scenario I could lose all my principal on those investments. However, I take comfort in the fact that even if this unlikely event were to happen, I would still maintain 90% of my overall portfolio and would live to fight another day.
There is also a psychological aspect to this strategy. It keeps me feeling engaged with the market and gives me a sense of control over at least a portion of my investments. This need for control can be dangerous for some investors, especially if their investing ideas turn out to be completely wrong. If I were to test my ideas on my entire portfolio it could leas to financial ruin to to overconfidence and stubbornness not to sell my losers to try and “see an investment through.” I am well aware of these mental biases, which is why I cede control of much of my portfolio to an automatic and indexes strategy which I know is likely to have a boring yet predictable outcome in the long run.
There are spillover benefits as well. Rather than just stashing the money away in indexes and letting my investment skills get stale, this strategy helps keep me up on the latest news and trends. Since I already work in finance, keeping up with these topics is part of my job and adds value for the people around me. I can’t tell you how many times keeping up with this blog or doing my own research has randomly benefitted me in the workplace. My role entails having comfort with a wide range of different products and market knowledge and even though the paths don’t always cross in terms of my personal interests and my job, some times they do and it gives me an opportunity to stand out from the crowd.
CAPE and Value
I am a long term investor by nature. One simple reason for that is taxes. Short term gains are so heavily taxed, if I can’t hold something for more than a year to get the benefit of much lower taxes, then the investment becomes much less attractive for me. I look at net pay, not just gross.
If you read this blog regularly, you also may know that I am very internationally focused. This is not just because I used to work in emerging markets but has been a theme in my life since the beginning. Although I did not live in other countries or travel too much when I was young, what was going on in the world outside of the US was always closely followed in my household. This is likely the consequence of having parents and extended family that had spent a significant amount of time outside the country. My mother had spent some time living in Africa after college and my father grew up the son of a diplomat for the US government, which meant part of his childhood was spent overseas.
International investing has not been en vogue lately. Both emerging markets and stocks outside the US in other developed markets have lagged the US in the last 10 years mostly due to the run up in big tech. We tend to be backwards looking when it comes to returns and people like to assume just because some stocks have done well in the recent past, they will continue to have similar performance in the future. This line of thinking doesn’t take into valuation though and although I am invested in tech through my index funds, I don’t have an appetite to lever up my exposure via my “fun” 10% of my portfolio. Just looking at how big tech is dominating is enough to give me pause. The top 5 tech stocks in the S&P 500 are worth as much as the bottom 288 stocks as was visualized below.
Source: Cadence Wealth Management
Tech is tough for me to call, so I focus on long term value. Here, one ratio that I like to use to gauge the long term invest ability of the market is the cyclically adjusted P/E ratio or CAPE. This basically averages earnings of an entire market over the last 10 years. The idea here is that it takes into account earnings fluctuations due to market downturns as well as higher growth periods, it smooths out the earnings.
If we look back at over 100 years of earnings the long term average CAPE for the US stock market is about 16 times earnings. Currently, even after the downturn to to the coronavirus, the CAPE for the S&P 509 sits at 23.8 times as of the end of March 2020. The media loves to look at long term averages as an absolute measure of value but this isn’t always the case. Demographics, savings rates, capital markets access, national pension structure and education levels all have an influence over who tends to hold stocks directly out of a population. These in turn can affect the price that that segment of the population is willing to pay for a given level of pricing. Since 1993, stocks have consistently traded above their long term average P/E ratio.
This phenomenon isn’t in a vacuum and it isn’t hard to understand why. While interest rates in the US have been in long term decline towards the 0 level they are at now, the equity risk premium or the excess return compared to bonds which investors demand to hold stocks, has fluctuated but sits near its long term average. Taken another way, when future earnings or dividends are discounted by a risk free rate, if the rate moves lower, equity prices move higher. Over time lower interest rates have pushed investors more and more into stocks due to this phenomenon.
So to marry the value factor with the international factor, we could look at CAPE ratios across different stock markets internationally to see if there is overall value in other markets outside of the US.
I was intrigued to read in an updated post by blogger Lyn Alden that a seemingly simple strategy by Max Faber, which compares the CAPE ratio of different countries and invests in the 25% which are the cheapest. Although it was not expanded upon, I am assuming here that this strategy is rebalanced annually. The result is an investment which trounces the S&P 500 since 1993.
Source: Max Faber
He calls this strategy the global CAPE value strategy. He notes that the Sharpe ratio is higher for this strategy than just investing in the US market and although volatility is higher, it is mostly to the upside.
I was curious to see what markets would fall in this 25% range and came across a list published by Star Capital, which updates the CAPE for 40 different investable markets every quarter.
Source: Star Capital
Interesting enough, this strategy currently would include some developed markets like Austria and Spain in addition to some smaller emerging market names.
Be Mindful of the Index
There is some further rationale for a strategy which departs from the traditional emerging markets cap weighted fund. The MSCI Emerging Market Index, which is what most emerging market ETF’s track is heavily weighted towards China which makes up 40% of the index. If we lump Taiwan in with mainland China as the party would like, China represents over half of the entire index. If you are looking for high growth outside of China, it may pay to take a look at implementing a CAPE value strategy utilizing the many country specific ETF’s offered by iShares, a subsidiary of global find provider BlackRock.
Source: Morgan Stanley