Eric Nelson's third tip is only for the daring.

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.

Writes Nelson:

“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%.

The approach is easy to grasp, if hard to tolerate in terms of market volatility. Since small stocks outperform large over the long term, he suggests flipping the large-small split to 40-60; and since value outperforms growth over the long term, Nelson suggests using only value stocks for both large and small segments.

Doing so would increase returns another 2%, for a total improvement over a U.S. total stock index of 5.5% annually. Over the same time period of 1975 to the present, that would result in annual average returns of 18% versus 12.5% for a total stock index.

Return-hungry investors should note Nelson’s warning that there’s more than just volatility to endure in this approach:

“Despite considerable long-term historical outperformance, during the short-term periods from 1984-1990, 1995-1999, and 2007-2008, the all-value mix underperformed the market by -3.1%, -7.3% and -8% per year!  Of course, the diversified asset class mix also trailed the market, but by a much more palatable -1.8%, -4% and -2.6% per year.”

The Oklahoma City-based advisor also cautions that such an aggressive approach is not suitable for every investor based on their unique needs and risk tolerance, and thus portfolio decisions can only be made after extensive conversations and pointed questions.

As Nelson put it to ThinkAdvisor, “at least when it comes to conversations I have with clients, in many cases a lower-expected return portfolio (from less extreme small/value tilts) is often a better one for you if: a) it still is expected to achieve the returns you need, and b) it’s easier for you to stick with when our way is ‘out of favor.’”

Asked if the past 5 to 10 years underperformance in value stocks strengthens the case for a more aggressive value tilt, Nelson quipped: “I’d certainly say value has some catching up to do,” but he discouraged what he calls a “short-term investing” approach that looks for good times to get in and get out of the market.

“Over an investor’s lifetime, or at least two decades or so, it will all come out in the wash,” he said, adding:

“But more important than what returns will be, or the small spreads between portfolios with different small/value tilts, is finding one you’re most likely to stick with.” 

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