Many portfolios are encumbered with dead weight that could be easily and profitably tweaked for higher long-term performance, finds advisor and investment blogger Eric Nelson.
The principal of Servo Wealth Management, in his most recent post, offers three simple ways to do so, each in turn bringing higher returns.
The first way involves what is typically a core item in an investor portfolio: total stock indexes. Nelson points out that “they are anything but ‘total,’” given that they are typically skewed 90% in large- and mid-cap stocks and just 10% in small-cap stocks.
This despite the fact that small stocks have higher expected long-term returns and offer greater diversification from the larger stocks that move with the market return.
“From 1975-2013, splitting the U.S.-stock allocation of a diversified portfolio 60% into large-cap stocks and 40% into small-cap stocks and rebalancing annually has resulted in over 1% per year higher returns when compared to a traditional index fund, with only a slight increase in volatility.” This is accomplished with only minimal tracking error, he adds.
But an advisor could do still better than this with client portfolios by following Nelson’s second tweak, which involves further splitting that 60-40 portfolio into equal halves value and growth indexes and rebalancing annually.
Because total stock indexes are typically cap-weighted, and thus overweight companies with high recent returns (and lower future expected returns), the lowest-priced value stocks and most profitable growth stocks are underrepresented.
What’s more, value and growth stocks tend to move countercyclically, such that increasing their representation would lower the portfolio’s volatility.
Over the same time period going back to 1975, Nelson finds that the two separate value and growth portolios increase historical returns by almost 4% per year — again with minimal market tracking error.
Nelson’s third tweak is only for the daring, as this approach raises portfolio volatility by almost 3%.