You Can Get Higher Expected Returns with Lower Risk, but There's a Catch

Yesterday, we looked at how global diversification across asset classes improved the efficiency of a portfolio. Today, we'll look at another way to accomplish that objective, one that should be particularly attractive to risk-averse (probably you) investors.

The following is the table from yesterday's post that demonstrated how investors could use modern portfolio theory to develop more efficient portfolios.*

Now, we'll consider one more portfolio, which will let us see how the risk and return of our diversified portfolio would have been impacted if we concentrated our exposure to the higher expected returning asset classes of small-cap and value stocks, while lowering our exposure to equities.

(Of course, keep in mind that you can't directly invest in indexes, they don't show how your returns would be reduced by advisor fees, taxes and the like, and past performance is no guarantee of future results.)

The previous portfolios had a 60 percent equity/40 percent fixed income split, with the equity portion diversified among many asset classes. For this one, we'll limit our equity holdings to just the Fama/French US Small Value Index (ex-utilities) and the MSCI EAFE Value Index. (To keep the time periods consistent, I couldn't use the MSCI EAFE Small Cap Value Index.) We'll also lower our equity allocation from 60 percent to just 50 percent (split equally between the two indexes) and increase our bond allocation from 40 percent to 50 percent.

As you can see, portfolio 7's annualized return was 0.9 percent higher than portfolio 6 and a full 2 percent higher than portfolio 1. In addition, its volatility was lower as well. In relative terms, portfolio 7's annualized return was 8 percent higher, while volatility was 2 percent lower than portfolio 6, and its return was 19 percent higher than portfolio 1, while volatility was 2 percent lower.

There's another consideration especially important to risk-averse investors (which most are). Since high-quality bonds are safer investments than stocks, we might see fewer years with negative returns and lower maximum losses with a 50 percent equity allocation than with a 60 percent one. We can see that effect in the following table:

In addition, during the three years of losses for portfolio 7, there was only one (1990, with a loss of 7.3 percent) when produced lower returns than did portfolio 1.

It's important to note that if we had been able to use the MSCI Small Cap Value Index, the data almost certainly would have looked even better.

Before you rush to convert your portfolio to have such a high tilt to small-cap and value stocks, it's important to note that the more you diversify your equity holdings beyond that of the S&P 500 Index, the more you create the potential for becoming subject to tracking error regret. Tracking error is the amount by which the performance of a portfolio varies from that of the total market or other broad market benchmark, such as the S&P 500. By diversifying across asset classes, investors take on increased tracking error risk. While very few investors are upset when tracking error is positive (meaning their portfolio beats the benchmark), many care when it's negative.

To have a chance for positive tracking error, investors must accept the likelihood negative tracking error will appear from time to time, or there would be no risk. Emotions associated with negative tracking error can lead many investors to abandon carefully developed investment plans. Only those investors willing and able to accept tracking error risk should consider diversifying across the other risk factors.

Eugene Fama and Ken French identified two additional risk factors you should consider when constructing portfolios. You can either use those risk factors to try to increase the expected return (and risk) of a portfolio, or maintain the expected return of the portfolio by diversifying across them while lowering the equity allocation. For many investors, we believe diversifying across these independent risk factors is a more effective way to diversify portfolio risk.

If you consider this strategy, remember that just as the equity premium is compensation for taking risk, so are the size and value premiums. Thus, we add the usual "disclaimer:" The future may look different from the past.

*Portfolio Compositions:
Portfolio 1

• S&P 500 Index -- 60%
• Barclays Capital Intermediate Government/Credit Bond Index -- 40%

• S&P 500 Index -- 30%
• MSCI EAFE Index -- 30%
• Barclays Capital Intermediate Government/Credit Bond Index -- 40%

• S&P 500 Index -- 15%
• Fama/French US Small Cap Index -- 15%
• MSCI EAFE Index -- 30%
• Barclays Capital Intermediate Government/Credit Bond Index -- 40%

• S&P 500 Index -- 7.5%
• Fama/French US Large Value Index (ex utilities) -- 7.5%
• Fama/French US Small Cap Index -- 7.5%
• Fama/French US Small Value Index (ex utilities) -- 7.5%
• MSCI EAFE Index -- 30%
• Barclays Capital Intermediate Government/Credit Bond Index -- 40%

• S&P 500 Index -- 7.5%
• Fama/French US Large Value Index (ex utilities) -- 7.5%
• Fama/French US Small Cap Index -- 7.5%
• Fama/French US Small Value Index (ex utilities) -- 7.5%
• MSCI EAFE Index -- 15%
• MSCI EAFE Value Index -- 15%
• Barclays Capital Intermediate Government/Credit Bond Index -- 40%

• S&P 500 Index -- 7%
• Fama/French US Large Value Index (ex utilities) -- 7%
• Fama/French US Small Cap Index -- 7%
• Fama/French US Small Value Index (ex utilities) -- 7%
• MSCI EAFE Index -- 14%
• MSCI EAFE Value Index -- 14%
• Goldman Sachs Commodity Index -- 4%
• Barclays Capital Intermediate Government/Credit Bond Index -- 40%

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