Investment Outperformance (Part One & Two)

Part 1: What You Invest In

This article assumes that you're already familiar with the basics of investing: how to use your risk tolerance and risk capacity to determine an optimized asset allocation that fits them. That's going to determine the lion's share of your volatility and returns, but what if you're looking for even more efficiency? What if you've got your asset allocation set up and want to turn the dial to 11? The magic of compound interest means that small improvements compounded over time add up to huge gains, so let's take a look at some of the options for optimization.

First, a Ground Rule

I'm not talking here about speculation. If you have a crystal ball that tells you that TSLA is going to turn into TSLAQ, or that Apple stock is going to split yet again, well then by all means: put your life savings into the appropriate purchase, or short sell, or option strategy of choice, and prepare to get rich. I just hope your crystal ball isn't fueled by Internet comments or a paid investment newsletter subscription...

But no, we're not talking about that, so I'm not going to talk about limit orders or calls or puts or iron condors or golden pterodactyls or whatever. We're the casino, remember? Not a player in it.

So What's left?

But if we rule out speculation, how do we outperform? If markets price efficiently, what more is there for us to do? As it turns out, there are several ways to add "alpha": increased returns that aren't just a result of the added reward you get from taking on more risk. Some of them have to do with what you invest in -- "tilts" to your asset allocation -- and some of them have to do with how you invest. This article is going to talk about the "what", and next week, we'll talk about the "how".

"Tilts": Factor-based Investing

Regardless of the efficiency of the market, it's clear that some investments that have statistically higher expected returns than others. The easiest example to think of is stocks: because of their higher volatility, they offer a "premium" over bonds. You accept more risk, you get more returns. ("But I thought we were looking for increasing returns without taking on more risk?" Good point, and we'll get there in a few paragraphs!) There are other factors out there, as well, though some of them are more proven than others. 

But first, let's lay out what constitutes a "factor of increased returns". This can't be some "here today, gone tomorrow" anomaly that some smart analyst discovered but will vanish once everyone else knows it's there. No, this needs to be something that's "persistent, pervasive, robust, investable, and explainable", to use investment researcher Larry Swedroe's terms. There are five such factors on the stock side, and two on the bond side. To go over them briefly:

Beta: Beta, simply put, is how much the stock moves with the market. High beta = high volatility, high returns. Low beta, low volatility (relatively speaking), lower returns. 

Size: Smaller stocks tend to outperform larger stocks. Why? Because it's easier for them to go bankrupt!

Value: Stocks that are underpriced relative to the net value of their assets tend to outperform stocks that are overpriced ("growth" stocks). Again, there's a higher risk here, with a corresponding reward.

Profitability: Stocks that are underpriced relative to their profitability tend to outperform as well, for nearly identical reasons as value stocks.

Momentum: Finally, stocks that outperform tend to keep outperforming, at least over a few months. There are two popular arguments for why this is the case, one based on behavior (investors tend to underreact and/or have delayed overreaction), and one based on risk (momentum investing increases exposure to "crash risk", the risk that a given investment will be particularly bad during a market crash, above and beyond their "beta" in normal times). Whichever one is true, both indicate that the momentum premium will almost certainly persist as it has in the past.

Term: On the bond side, bonds that have longer terms tend to have higher returns than ones that have shorter terms. Longer terms means more susceptibility to interest rate changes, which means more risk, which means a premium. 

Carry: Higher-yielding assets -- ones with higher interest rates relative to their price -- tend to outperform lower-yielding assets. The risk here is similar to value and profitability, and is best illustrated when looking at junk bonds: the yields are higher because the company is more at risk of default. ("Wait -- shouldn't this apply to dividend stocks, as well? Maybe even commodities?" you say. "Good catch," I say. "Gold star for you. While most people talk about the carry premium in the context of bonds, it works everywhere.")

But I Don't Want More Risk!

You spent all this time figuring out your risk tolerance and capacity, and carefully designed an asset allocation that fits them -- the last thing you want to do is take on more risk, right? Why, then, would I even bother talking about factors of increased return that give you more risk?

Well, as it turns out, you can combine them in ways that don't. Remember Dimensional Fund Advisors, that mutual fund company I like to talk about? Well, check out the 20-year analysis that Mr. Swedroe did on DFA and Vanguard. In it, he notes that not only does DFA outperform Vanguard just about everywhere, but he also notes that the Sharpe ratios (risk-adjusted returns) are higher, as well!

Wait, so I'm taking on more risk, but it's increasing returns without increasing volatility? What sorcery is this? 

(If that phrase sounds familiar, it's because I've used it before -- and if you remember where it came from, you've already figured out what's going on. Another gold star for you!)

As it turns out, the various factor premiums are pretty uncorrelated. And what happens when you effectively combine uncorrelated factors? Sorcery, in the form of a more efficient portfolio!

Implementing "Factor Tilts"

How does one go about wielding this black magic? There are two routes one can take, which you can mix and match as you see fit.

Modify your asset allocation. In addition to allocations to broad asset classes (e.g. US stocks), you can "tilt" your portfolio towards factors of increased returns by adding allocations to factor-based classes (e.g. US value stocks). Just make sure you rebalance systematically! And while you can effectively, easily, and cheaply get exposure to the small and value premiums* this way, the profitability and momentum premiums aren't as readily available. The momentum premium in particular is tricky -- because it is by nature ephemeral, any fund that tries to track it is going to be doing a lot of trading, which will bury your premium in costs! 

Invest in (low-cost) multifactor funds. DFA's "US Core Equity Portfolio" fund invests in US stocks, with a tilt towards the factors I mentioned above -- and it does the rebalancing for you. DFA even works to capture the momentum premium, not by using it to dictate its trades, but to guide the timing -- if a stock is due to be sold but is exhibiting momentum, they might delay selling it in order to capture that premium. Of course, the premium needs to outweigh the expense ratio, so these funds need to be low-cost! (For comparison, as of 2018, the fund mentioned above (DFEOX) is 0.19%, within striking distance of Vanguard's Large Cap Index fund (VLACX), at 0.17%.) 

A note of caution. I'm not recommending you try and combine the above factors willy-nilly. Every factor has the potential to introduce so much volatility as to not increase your risk-adjusted returns, some (e.g. term and carry) more so than others. This is another reason to invest in multifactor funds -- they've run the numbers to figure out which factors to use in which proportions!

Part 2: How You Invest

 You've determined your risk tolerance and risk capacity, and you've used them to create an efficient asset allocation of uncorrelated asset classes that balances risk and reward. You've taken factors of increased returns into account, adjusting your allocation and/or mutual fund choice accordingly. So far, so good. What next?

Everything we've talked about so far has been somewhat abstract, portfolios drifting in the ideal theoretical space inhabited by physics homework involving frictionless surfaces and spherical cows. The real world, though, has friction and cows that are less than geometrically perfect; it has markets that go up and down, taxes, and 401(k)'s with funds that don't quite match what you were hoping to invest in. And therein lie several more opportunities to optimize your investments.

Opportunistic Rebalancing

If you set up a portfolio that's 60% stocks and 40% bonds and then just let it run, chances are pretty high that after a few decades it won't be 60/40 anymore. Odds are it'll be tilted towards stocks, given their penchant for outperforming bonds -- more risk will have snuck into your portfolio, like a thief in the middle of the bull market. Hence the need for rebalancing: a periodic "reset" of your portfolio to bring it back in line with your chosen asset allocation.

You could rebalance your portfolio once a year, and that would be fine -- but is it optimal? In 2008, researcher Gobind Daryani proposed that "opportunistic rebalancing" could produce higher returns, in addition to controlling risk, and this method is now widely accepted as optimal in the investing research community. So: what does opportunistic rebalancing look like?

• • For each asset class, set a target error percentage. Daryani's research indicates 20% as optimal. 
  • Check your asset allocation frequently. According to the paper, biweekly works well, and weekly or daily seem to be even better.
  • When an asset class exceeds the error threshold, rebalance. For example, if your large-cap asset allocation target is set at 20% of your portfolio and your error threshold is 20%, rebalance if it exceeds 24% or goes lower than 16%.

But don't take my word for it -- read the paper! 

Tax-loss Harvesting

If all of your assets are in 401(k)'s, 403(b)'s, or IRA's, you can skip this section, as it only applies to taxable investments. Otherwise, read on!

The idea behind tax-loss harvesting is relatively simple, though it has a few wrinkles that you need to be aware of. The theory is this: if a taxable investment dips below the price you bought it for, you can sell it at a loss for a deduction on this year's taxes. By "harvesting" these taxable losses, you're able to increase your gains by lowering your overall tax bill. There are some caveats, though!

You can't just turn around and buy back the same investment (which would be ideal). If you sell an investment at a loss and then buy it back within 31 days, that's called a "wash sale", and the tax loss is ignored by the IRS. You have to either hold the proceeds of the sale in cash for 31 days (not ideal!), or buy an investment that isn't "substantially identical". What exactly is a "substantially identical" investment? Well, the IRS hasn't come out with recent guidance to make it crystal clear, but one thing most experts agree on is that different ETF's that track the same index are, in fact, substantially identical. Beyond that, you'll have to work with your CPA to figure out something they could defend to an auditor.

You can only deduct a certain amount from this year's taxes. While investment losses can be used to offset an unlimited amount of taxes on investment gains, they can only give you up to a $3,000 deduction from taxes on other income (e.g. your paycheck). That doesn't mean the excess is lost, though! It's just carried forward to next year, and the one after that, etc., offsetting investment and other gains until it's used up.

It's a tax deferral, not a tax avoidance. When you sell that investment at a loss and buy a nonidentical one, you're effectively lowering your cost basis (the price you bought the investment for). That means that when you sell the investment down the road, you'll be taxed on an additional gain equal to the loss you harvested. For example: let's say you buy an investment at $20. If you sell it in 20 years at $40, you're taxed on $20 of gain. But if it dipped down to $10 in the meantime and you harvested those losses, the price you bought that investment at would go down from $20 to $10, which means selling at $40 would get you taxed on $30 of gain.

So with all those caveats, is it still worthwhile? Yes! The $3,000 limit only applies to non-investment income, and the old accountant saying of "a tax deferred is a tax avoided" holds up to empirical research in this case. 

Efficient Asset Location

No, that wasn't a typo: I'm speaking here not of asset allocation, but asset location. You've chosen which asset classes you want to hold and in which amounts, but which accounts do they go in? For example, let's say you've decided on a 75/25 stock/bond allocation. Do you mirror that allocation across all accounts, holding 75% stocks in your 401(k), and 75% in your IRA, and 75% in your brokerage, and so on? That's certainly fine, but again, it's not optimal. There are two items to look at when it comes to optimization here: available implementations and tax efficiency.

With regards to available implementations, sometimes an account just doesn't have a good implementation of what you're looking for. Maybe your 401(k) doesn't have access to real estate investment trusts (not uncommon), or maybe its implementation is super expensive (extremely not-uncommon, though getting better). In this example, you could allocate what would otherwise go into real estate into something similar -- for example, mid-cap stocks -- or you could cut that allocation out of the 401(k) entirely and overweight it in another account that does have access to REIT's.

Tax efficiency can be even more beneficial to take into account. The aforementioned REIT's are an excellent way to invest in real estate...but they're very tax-inefficient, as they must receive 75% or more of their income from rent and pass 90% of their taxable income onto shareholders, which means a big chunk of their returns are taxed as ordinary income. Contrast this with domestic US stocks, whose returns are often primarily in the form of capital gains, and whose dividends are often "qualified", and thus are taxed at the capital gains rate as well. Therefore, to optimize on this front means to put the tax-inefficient classes in your tax-advantaged accounts, and to leave the tax-efficient ones in your taxable accounts.

Before you go off to optimize for tax efficiency, there's another issue to take into account: tax efficiency matters in direct proportion to the expected returns. In other words: sure, short-term bond dividends are taxed at ordinary income, but the expected long-term growth is tiny compared to, say, that of emerging markets stocks! When determining what goes where, make sure you take this into account as well.

Do or Delegate?

If all this sounds like a fair amount of work: it is, especially if you don't have the tools to automate it all. The good news is that any investment manager worth their salt will do this for you (but many aren't, so you should definitely ask). Of course, they're going to charge you for it, so the question then becomes: is it worth it? Some things to take into consideration. (Full disclosure: Seaborn does investment management.)

I'm not interested in doing this myself. If the idea of implementing daily opportunistic rebalancing, tax-loss harvesting, and efficient asset location is so mind-numbing it makes your teeth hurt, then it's a no-brainer: find a good financial advisor who will! Otherwise, you're just lighting money on fire -- money that could be compounding over time.

I'm interested in doing this myself, but I can't find the time. See above. Like I just said, this is money that could be compounding over time -- don't put it off until some later date, when you magically find more free time!

I'm interested in doing this myself, and I've got nothing better to do. Go at it! While good investment managers are worth much more than their fees, they're not free -- if you're looking for a way to make money long term, there are worse things than being your own investment manager. Just make sure to do your research; a few tenths of a percent in optimization can easily be worth tens of thousands of dollars over the long run!