No one can forecast where markets are going in a consistent fashion. The key for investors is to understand how to diversify your portfolio and take advantage of asset prices when they are showing good relative value, while avoiding or reducing those that are overvalued.
I call this style of investing "smart tactical rebalancing." It starts with a goals-based low-cost efficient global portfolio of ETFs where the correlation between your holdings are reduced. Goals-based means that the portfolio is constructed with a return and risk target that is based not on any market benchmark, but on your personal income needs relative to the risk you are able to take to get it.
To illustrate how this can be done, let's look at so-called smart beta ETFs.
Beta can be thought of as the market risk. A beta of 1 means that if the global stock market goes up 20 per cent, your portfolio would be up 20 per cent and if it went down 20 per cent, your portfolio would fall the same.
Take the S&P TSX index. A beta strategy like XIC (iShares S&P TSX Composite Index) or ZCN (BMO S&P TSX Composite Index) would simply replicate the return of the market for a very low 5 basis points.
First Asset has two smart beta ETFs that represent what's known as "factor" investing. There are many others; I've pick these because they have been around for several years. One is a momentum ETF, WXM (First Asset Morningstar Canada Momentum Index). Momentum stocks are those that show the strongest outperformance relative to other stocks as measured over the previous 12 months. The other ETF is FXM (First Asset Morningstar Canada Value Index). Value investing looks for characteristics that Warren Buffet would look at, like the price-to-book or the price-to-earnings of a company, to measure how cheap a stock is relative to others. It has been found that on average, over time, cheaper stocks tend to outperform other stocks.
The MERs for these ETFs are 0.67 per cent and 0.68 per cent, respectively, according to Bloomberg data.
You can judge how good a strategy is by its returns adjusted for risk. The accompanying chart shows that both ETFs handily beat the market on a returns basis, but the risk - or volatility - on the value strategy was considerably higher. We can compare risk and return by looking at the sharpe ratio. A measure for calculating risk-adjusted return, it looks at the average return earned in excess of total risk. It's helpful in making apples to apples comparisons with different styles of investment.
Since these ETFs were issued Feb 15, 2012, the simply index-tracking XIC had an annualized return of 6.68 per cent with a standard deviation - a measurement of the volatility of returns - of 11.94 per cent. The sharp ratio therefore is 56 per cent. The higher the percentage, the better the risk-adjusted returns are.
XIC costs you 5 basis points to own annually. So it's very low cost. The bigger cost, however, may very well be its drawdowns - how much the value of an ETF fell from its high point of the past year. I always say, the biggest cost to investing is your ability to stick with it. Drawdowns were 8 per cent in 2012, 7 per cent in 2013, 12 per cent in 2014, 21 per cent in 2015, and 9 per cent in 2016. The drawdown in 2008 was over 50 per cent. The biggest challenge of getting that average return was your ability to sit through the difficult periods and not sell at the worst times.
Now, let's look at the smart beta strategies. They cost more in MER terms, but typically look for the best company attributes to hold in an index rather than just replicating the market index.
The WXM momentum strategy had an average return of 10.55 per cent with a standard deviation of 12.04 per cent for a sharp ratio of 88 percent. That typically means a higher-than-average return and with a similar or lower risk. The FXM value strategy had an 8.28 per cent average return with about 14 per cent standard deviation. So when it fell, it fell more on average. If you are risk adverse, you were likely more inclined to sell at the worst times.
But watch what happens when the three ETFs are equally weighted. There's a good overall return of 8.28 per cent and more importantly, risk has significantly been cut. The standard deviation is only 10.76 per cent, less than each individual holding. The sharpe ratio is a whopping 77 per cent, handily improving on the XIC and FXM alone. We also cut the average MER to 45 basis points for those who are fee sensitive.
This strategy gets better yet when expanding to a global focus and bringing in additional asset classes and smart factor ETFs that have lower correlation to the markets.
Larry Berman is co-founder of ETF Capital Management. He is a Chartered Market Technician, a Chartered Financial Analyst charterholder, and is a U.S.-registered Commodity Trading Advisor. You can catch one of my upcoming talks at a city near you.