My 1st Million At 33 – yes, you can do it too

This is the next install ment in my series on asset allocation. The first draft of this article was written in March 2006.

Now that the asset mix has been determined, the logical next step is to choose the best available securities that represent each asset class. These securities are likely to be mutual funds or exchange traded funds since individual stocks do not offer the kind of diversification necessary. Moreover, most proponents of the asset allocation approach are also proponents of the passive style of investing and shun away from picking individual stocks. It’s been shown that many mutual fund managers have a hard time consistently beating their indices, especially among domestic, large cap funds.

However, it bears reiterating that index investing under the paradigm of asset allocation aims to obtain above-market returns. A common perception of index investing equates it with buying a fund of the S&P 500 or the Wilshire total market index. While an S&P index fund is as good a way as any to fulfill the US large cap segment, it should constitute only a small portion of the asset allocation plan. The following diagram from Money Chimp illustrates various indices and their relation to the entire stock market.

Someone buying the Wilshire 5000 is devoting only about 5% to the small cap space. Now recall the asset allocation for domestic equities that called for an equal weight in large blend, large value, small blend and small value segments. In effect, the small and value components are accentuated relative to the overall market. This approach is rooted in the seminal work by Fama and French that quantified the extra return potential by value and small cap stocks.

To appreciate the extra return provided by small(er) cap and value stocks, let’s look at the comparison between SPY, the popular ETF that tracks the S&P 500 index, and RSP, the Rydex S&P equal weight index ETF. RSP has the exact same stocks as those in the S&P500 index, but assigns the same dollar amount to each; in other words, the stocks with smaller market caps that also tend to be value stocks are overweighed in RSP vs. SPY. The expense ratio of SPY is 0.11%, lower than RSP’s 0.4% (A moment’s reflection should convince you this should be the case even if the two funds are of the same size. Annual turn over is 55% for RSP and only 2.23% for SPY.) In spite of this handicap, RSP handily outperforms SPY as shown in the chart below. The equal weight index actually has a longer track record than the ETF and has made all-time highs while the S&P is still below its 2000 peak. Frequent rebalancing (quarterly, I believe) as stock values change incurs higher expenses, but apparently not enough to deter RSP from out performing SPY in the past three years, and by 15.28% to 9.81% in the past year. (All figures from Yahoo Finance dated Mar 3, 2006.)

So again the point is that by properly allocating the index funds, one can achieve above-market returns. We should always keep in mind that the goal of diversification is not to replicate the stock market, which will naturally give market returns. The goal of diversification is to reduce correlation of portfolio components such as with large and small caps, or on a greater scale, domestic and foreign funds, to achieve above-market returns. That’s why I don’t have mid caps in my allocation plan even though they are perfectly fine investments by themselves. They also happen to behave like a mixture of the large and small caps, thus add to expenses without providing extra returns.

There is also something to be said about the precision of various indices, e.g., the kind of value metric, P/E, P/S or whatever, to differentiate value and growth stocks. I’ll discuss that in a future post.

Update November 2006
Since May, large caps have outperformed small caps; consequently, SPY has outperformed RSP. Rather than an argument against diversification into various asset classes, it should be taken as an argument for portfolio rebalancing, i.e., never let one part of your portfolio getting too heavy no matter how good the recent performances were.