Beating the market to maximize retirement income – part II

A while back I wrote about some historical analysis I had done that showed several ways that an investor could achieve market beating returns and thus maximize retirement income. It has been known for a long time that several ‘factors’ or characteristics of stocks generate market beating returns. The two classic factors are value and size. Value stocks outperform the market over long periods of time. Small cap stocks outperform as well. The third and newest factor, at least relative to value and size, is momentum. I also showed that contrary to efficient market theory these extra returns do not come with extra risk, or that the extra risk, is more than compensated by extra return. Below I reproduce the key table from that post.

FF Market Small Large Value Returns Jan 2013

Now, the question that I left open at the time is how does an investor best gain exposure to these market beating factors? That’s what I’d like to talk about briefly in this post. Briefly because its pretty simple. The best way to gain exposure to the value and size factors is through ETFs. I’ll come back to momentum in a bit. Today there are a ton of ETF offerings in the value and small cap styles for an investor to choose from. And ETFs that combine small cap and value. For, example, here is a list from ETFdb of all the value ETFs they keep track of. There are 100 ETFs on the list. The small cap list has 107 ETFs. By the way, for dividends fans like myself out there, dividend ETFs for the most part are considered as value investments. As far as selecting ETFs, I always start with Vanguard first (because fees matter a lot and they have the lowest overall fees) and then go from there, unless I’m looking for something very specific. I would then look for the ETF on my broker’s commission-free ETF list to further reduce my cost (here is the list for my broker TD Ameritrade). Below are the Vanguard choices for value and small cap stocks.

Vanguard Value ETF offering

Vanguard Small Cap Offering

That’s the easy part, finding value and small cap ETFs. The harder part is constructing portfolios around them. But its not all the difficult either. You start with the concept of holding a broadly diversified portfolio and then add value and small cap exposures to it. Lets look at an example using the IVY portfolio as a model to start from. In the table below I picked out a few value and small cap offerings and inserted them into the overall IVY allocation. The concept is the same whatever your starting portfolio, 60/40, Permanent Portfolio, etc… Notice that there are even value ETFs for the real estate sector. There are tons of ETFs out there and these are by no means meant to be the ‘best’ ETFs for value and small size.

IVY with basic and small value ETF exposures may 2013

I chose allocation percentages that I see recommended often. Basically, they have the majority of the allocation to the broad index in a given asset class and then gain exposure to factors like value and size through small allocations to them (e.g the 5% allocation to VBR). Now, if value and size give an investor such outperformance over the long run why not have all of the asset allocation geared towards these factors? Like any strategy there will be periods of time when it will outperform and periods of time it will underperform. Anyone remember for how long value stocks underperformed in the late 90s tech bubble? I think it was 6-7 years. Most investors don’t have the emotional tolerance to underperform the market for extended periods of time and often end up abandoning strategies like value investing during those times, even though over the long run they would be better off. But you have to respect investor psychology and adjust portfolios accordingly. If you are a tried and true value or small cap investor maybe you could have equal allocations among a broad index and the factors like value and size.

What about the last factor, momentum? This one is a bit harder because only recently have ETFs been announced to gain exposure to momentum. The ETFdb list only shows 3 momentum ETFs so far. Probably a bit early to include one of these in a portfolio allocation. I’d like to see then grow in size and see how well they do. So, lets leave it at that for now. But this does bring up another way that many professional investors and funds gain exposures to the factors I’ve discussed here (value, size, and momentum) and many others. It’s called Quantitative Investing. In the simplest sense quantitative investing is basically mechanical investing, the use of a computer to choose a portfolio of stocks based on any factor an investor chooses. Usually quant strategies are associated with very complex models that are used by large hedge funds (see here) but that doesn’t have to be the case. They can also be quite simple. I’ll be introducing the concept more in subsequent posts and how it can be simple and applied by individual investors.

In summary, an investor can increase portfolio returns over the long term by tilting their portfolios to factors that have been proven to outperform the market over time. Size, value, and momentum have been proved to increase investor risk adjusted returns and also increase withdrawal rates in retirement. Investors should consider allocation and least some of their assets to these factors.

Full Disclaimer - Nothing on this site should ever be considered advice, research or the invitation to buy or sell securities. These are my personal opinions only.

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About paul.novell@gmail.com

4 thoughts on “Beating the market to maximize retirement income – part II

  1. Paul:
    Thanks to you, I’ve been invested in the IVY Portfolio for almost a year. Your blog introduced me to the Mebane Faber and his book, The Ivy Portfolio. I’m impressed with the results. Most of all I’m impressed with the methodology. If memory serves me correctly, it was a Mr. Johnson who after graduating from UofW with a degree in Economics and who did his graduate studies at Yale before heading to Wall Street that we have to thank for this. I wish I’d discovered this when I was a Financial Advisor with AG Edwards, back in the day. It would have saved me a lot of “nail biting”, to be sure.

    Having said all that, let me get to the heart of my question. I’ve been thinking for some time of trying to use the methodology of the Ivy Portfolio (SMA) to become a little more aggressive in my strategy. After reading your post today confirms for me the direction I want to go in.

    Using Dshort and/or Stock Tracks do you think the hold/buy above the SMA and the sell when below would provide enough protection during draw downs to employ the same strategy, ala The Ivy Portfolio??

    As always, I’d be interested in your thoughts on the idea


    1. Kevin,

      I meant to say that in my post but yes the moving average strategy could be applied, and I would recommend it, to the expanded portfolio I presented in the post. The more un-correlated the asset classes, the better.


      1. Paul:
        Thanks for the clarification. I’m going to set the charts up soon. Also apologize for a mistake I made. The “godfather” of the Ivy Portfolio was Dennis Swenson from U of W.


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