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Investment returns: Don’t thank me, thank the ratio

In this article, I’m going to put forward the argument that investment firms, wealth managers and fund houses are actually not doing anything particularly special. That returns are generated by a simple formula and that is the relationship between two broad assets, equities and bonds.

An investment in this context is a portfolio of assets. How well an investment does is determined by the underlying assets held by the investor. No big shock there. What may come as a surprise, though, is that returns are largely dependent on the mix and type of assets held by the investor and not by the firm, wealth manager or fund house that selects them. Anything outside of this is either too small to be significant, timing or luck. And yet, it is often the perception that the wealth manager has generated the returns, whereas it is the assets held and each wealth manager generates similar returns, if they hold the same asset mix. And when they do hold a similar asset mix, the returns ‘cluster’ in a predictable manner.

The allocation of the assets, that is, the percentage split between stocks and bonds, determines the return received. Can it really be that simple? The answer is yes, I believe. And certainly, once an investor understands that principle, it lifts the lid on where investment returns arise from and should mean the investor is able to determine what is market return and what is wealth manager.

To illustrate my point, I downloaded the factsheets from five of the top wealth managers using a simple Google search, a composite index of advisory firms (and their combined portfolio performance) and the pure market index of 60% stocks and 40% bonds. This would equate to about 40 different portfolios, illustrated across seven data points. Not the biggest sample you may say but big enough to hopefully convince you I am right.

The returns you receive are determined by the proportion of stocks and bonds held in your portfolio. And, if your portfolio holds other assets, such as commodities or property, they have little impact for two reasons. Firstly, all the portfolios are highly diversified, so a small percentage in, for example, 5% in direct commodities, has little meaningful impact on performance. And secondly, the stock market is a wonderful metric and fully reflects the price of many sub-assets such as oil, or commercial property and any other such asset you can think of. For example, BP is one of the largest stocks in the FTSE 100 and its share price is determined, to a large degree, by the prevailing global oil price. My point is, in a diversified global stock portfolio, ‘diversifying’ into commodities, for example, is not quite the diversification it appears to be. If you wish to run this test on several portfolios yourself but there is a mix of assets, follow this rule – if it’s not stocks, class it as bonds and compare it to the fixed equity/bond allocation.

Each of the equity/bond allocations of the portfolios analysed had a split of 60% stocks and 40% bonds, with some variation permitted by the parameter ascribed to “balanced managed” portfolios. These portfolios are all managed by humans. One of the portfolios was created by an algorithm and held a fixed  60% stock and 40% bond allocation. This means the portfolio is constructed on market-capitalised weighting, with no strategic or tactical allocation. All of the portfolios labelled themselves as “balanced” (or similar).

To save their blushes and my legal fees, I have labelled them alphanumerically and listed the returns achieved over three years.

A – 34.3%

B – 28.9%

C – 33.4%

D – 30.9%

E – 22.7%

F – 33.0%

G – 27.6%

Apart from portfolio E, you will observe that the portfolios all cluster around the average return, across this sample, of 30.11%. The fixed index of 60% equities and 40% bonds algorithm portfolio (F) returned 33.0%, which was 2.89% higher than the mean figure. This means that 5 of the 7 portfolios underperformed the market. That, in itself, is a whole other article and will follow this. This article simply serves to illustrate that it is the equity/bond split that is dictating returns and not the wealth manager per se. However, one final point on the returns recorded is that portfolio G was the broad advisory index of firms, which returned 27.6%. Many wealth managers benchmark themselves against this portfolio and probably beat it. Note again that the pure market return was 33.0%.

If I were to repeat the same test at any equity/bond ratio, you would see the same cluster of returns around the mean. This concept is known as the Efficient Frontier (EF) and was first formulated by the brilliant Harry Markowitz in 1952. Moreover, the clustering of the 7  portfolios around a similar level of return, and even the poor performance of Portfolio E, can be explained by the definition of the Efficient Frontier.

“It is the set of portfolios which satisfy the condition that no other portfolio exists with a higher expected return but with the same standard deviation of return.” In other words, the theory predicts that the portfolios will cluster if they all have a similar mix of assets and be no higher than the cluster, with the possibility that a few outliers will produce lower returns (as was the case with portfolio E). If the theory holds, the one portfolio that did beat the market must have taken more risk. And when I analysed it further, the winning portfolio, held 68% stocks and 32% bonds, which in a three year bull market was the reason for the higher returns, over the fixed 60%/40% fixed algorithm, if the theory is correct.

The dominant force, in any diversified portfolio, is its relationship with equities and bonds. The point of this article is not to comment on the optimum equities to bonds ratio, simply that it is the only meaningful thing that can be known and selected at outset, and that it dominates returns.

There are some rules to the application of this theory. The clustering of the portfolios, depending on their relationship with equities and bonds, stops if you no longer diversify and cease to invest in broad terms.

For example, two portfolios which invest 60% stocks and 40% bonds but one in Indian and the other in UK stocks, solely, would not be expected to cluster around the same level of returns. They would diverge and under or outperform the diversified portfolios. But, because you never see wealth managers investing solely in a particular region and, instead, hedge their bets by diversifying across a broad spectrum of global equities and bonds, the “cluster around the equity/bond ratio” holds true. Nor is there any desire from investors to see big swings from the average return. With conviction comes winners and losers.

If the risk/return or stock/bond relationship holds true, the only way to break this and offer returns above the average is to move up or down the stock/bond allocation before or after market rises or falls. Timing the market, as many investors already know, is near impossible to do. Secondly, compliance departments insist investors remain within their risk tracks. So, if the intuition of the wealth manager is that the market is going to rise or fall, they are only permitted to remain close to the pre-agreed stock/bond allocation for the original risk mandate. To move from 60% stocks to 80% stocks will, usually, require the investor to sign a new risk agreement. The modern way of managing money, certainly from a legal or compliance perspective is that – if the investors view of risk hasn’t changed, why would their allocation to risk alter? And hence, another reason why wealth managers cluster around the returns of their asset allocation.  

The counter-argument could be that this is a bull market, which means share prices have risen on a continual basis over the timeframe considered, which may benefit fixed allocation. But next time the stock market falls, looks closely at your stock/bond allocation and you may find your losses are tempered by bonds and again, your portfolio clusters around the same mean return as either the fixed allocation and all other portfolios in that risk category.

Therefore I conclude that wealth managers and any firm that is building a diversified portfolio are not really doing anything special and certainly not anything over and above that which can be bought and traded by the investor. Risk too is a commodity. And your investment decision should be less influenced by the “top down, macro collegiate, thematic approach”, or any other spurious way the wealth manager attempts to articulate the relationship we are discussing and instead by the primary driver of performance, which is determined by how much you have invested in stocks and how much is invested in bonds. Anything else is just marketing.

Unless your manager is showing you real conviction and moving your up and down that equity/bond allocation, as the market rises and falls and ahead of this, or unless they are investing in a weighting such that is very different from the natural market allocation, ie. they hold all their stocks in India, for example, then you can expect your portfolio to cluster around a similar set of returns as everyone else.

To simplify this argument even further, the only meaningful aspect of return characteristics that can be known at the outset is asset allocation of stocks and bonds, less cost.

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