This is Part 4 of our series on Telarray investment portfolios, where we’ll discuss the kinds of funds we use to create portfolios for our clients. We talked in Part 2 about active vs. index vs. factor-based funds, and identified that we primarily use factor-based funds. What does it mean to say a fund is factor-based?
Stock or equity exposure gives actual ownership of companies to our clients, and that is the primary driver of Telarray investment performance. There are somewhere between 10,000 and 100,000 public companies in the world, depending on which estimate you use and whether you count over-the-counter securities. How exactly do our fund providers start with the entire universe of public global companies and decide how to pare that list down? Even once the target companies are selected, how do our funds decide what relative weights to apply to each holding?
To answer that question, we have to look back in time. Portfolio theory didn’t really get going until around the 1950s. Before that, investing meant having a stockbroker that would buy (and sell and buy, over and over) stocks for you on a commission basis.
In 1952, Nobel Prize winner Harry Markowitz wrote a seminal paper documenting the beginnings of modern theory on diversification and portfolio risk. It may seem pretty obvious now, but this paper shows (among other things) that a rational investor should not put everything into the single stock that seems likely to do the best, but rather into a collection of stocks optimized for the best expected returns while minimizing variance (risk). The paper noted that diversification was important, but also the “right kind” of diversification matters, meaning not just a large number of stocks but different types of stocks from different sectors and industries were critical to minimize correlations and risk without unduly hurting returns. This work implies the concept of investing in the entire market itself rather than a handful of different companies.
Had research stopped there, we’d probably invest Telarray portfolios exclusively in broad market-weighted index funds. Many people do invest that way, but by doing so, they’re (in our opinion) leaving potential excess returns on the table by ignoring some compelling follow-up research from the 1950s all the way into the 2000s.
In addition to exposure to the market itself, a number of other factors have been identified that have led to outperformance in the past, and many believe will continue to lead to outperformance in the future. Here are a few prominent factors used in our funds:
- Value. The term value means different things to different people. For this discussion, value refers to companies that are cheap rather than expensive. This doesn’t mean a low price per share, it means that according to calculations like price-to-book ratio, the total price to buy the company is relatively low compared to its book value, or assets minus liabilities. This is one of the earliest factors identified and still one of the best-known.
- Size. Research indicates that in the long run, smaller companies tend to outperform larger companies. Smaller companies can grow very quickly percentage-wise, while large companies need massive wins to move the needle in the positive direction. One of our fund providers has a fascinating chart that shows the top 10 largest companies in the world for each decade (1990, 2000, 2010, etc.). Almost none of the largest companies in one decade continue to be the largest companies ten years later.
- Profitability. Again, this may seem obvious, but more profitable companies have tended to outperform historically. This is a relatively newly identified factor in the grand scheme of things, but the data are compelling and we are glad to see this factor expressed in our funds.
These factors are well-documented in academic literature and used by our fund providers today. If you start searching on the internet, you can see dozens or even hundreds of different factors that have been identified over the years, with varying levels of rigor and support from practitioners. Some factors that might seem useful, such as favoring dividend payers, are not supported by the research our fund providers follow.
The term “tilt” is important, because it’s not an all or nothing approach. Growth does beat value sometimes, large caps outperform small caps, and unprofitable companies do very well in certain market environments. Our fund providers overweight and underweight based on this research, but it’s important to know that our funds do provide exposure to many different parts of the market.
These are examples of the ways our fund managers overweight and underweight the positions in the funds. Like everything in investing and life, there’s no completely free lunch. These approaches to weightings have outperformed over long periods in the past. We expect them to outperform in the long term, but they don’t work all the time. There can be months or even years where this factor-based approach underperforms the broader market. We may seem stubborn about this at times, but we believe our long-term commitment to this type of investing is one of the most attractive things about our firm and we believe it will lead to long-term success for our clients.
Next time, we plan to discuss the role of international diversification in more detail as an important element of our Telarray portfolios.
Interested in learning more about Telarray portfolios? Join us on Thursday September 23rd at 6PM central for an encore presentation of Telarray Investment Process Review, our online seminar exploring our approach to investments in Telarray portfolios.