Expert knowledge combining financial science with real world applications.

Wealth, Factors and the Strategic Core Portfolio

November 1, 2015

At VCM we view the investor’s broad portfolio as consisting of three buckets – floor, core, and explore. Your provision for wealth in the unlikely case of a global financial meltdown, the floor bucket, should consist of investments in real assets—your house, real estate, etc.—that are likely to retain some value even under the most stressful conditions. How these investments interact with the other two buckets is something we can counsel you on, but presumably these are assets you already have in place.

For most, the majority of your remaining accumulated wealth will take the form of investments in financial instruments such as stocks and bonds. Smart investors should lock in the majority of their wealth in a well-diversified portfolio that will protect their core assets, while exploring potentially more concentrated investments in hopes of achieving rewards beyond a simple index strategy. Our Alpha products are designed to fill the latter role, while our Strategic Core Global is designed to create an optimally diversified core portfolio that is advantaged.

In this discussion we will focus on the product we recommend as the anchor for your investment portfolio, our Strategic Core Global strategy.

The foundation of every investor’s financial portfolio should be grounded in the accumulated wisdom of financial economics:

  • Diversification1 works. Although we can argue about many concepts in finance, this one is well established in both theory and practice. However, diversification is much more than an S&P500 index fund. It involves carefully spreading exposures across many asset classes and many geo-political regions. Our Strategic Core Global portfolio is based on a strategically selected matrix of Exchange Traded Funds (ETFs) that provide intelligent diversification across a variety of asset classes and countries.
  • Risk and return. On average, over the long run, the market should reward you for taking on certain types of risks. This is the essence of investing. All investors must choose how much uncertainty they can tolerate as they reach for more substantive returns. For a core portfolio these risks should not be idiosyncratic risks associated with concentrated positions. However, even a well-diversified portfolio must strike a balance between preservation and accumulation of capital.

While we are continually examining a broad mix of ETF’s to assure we have the best ingredients for our core product, the latter point of balancing risk and return is where we can advantage your portfolio. Essentially the market will provide returns for the level of risk you choose, but identifying and measuring risk is something that both academics and practitioners find most challenging. In our white paper on “Factors” we provide an overview of the strategies we use to provide you an advantage beyond an indexed portfolio.

Although predicting future returns is challenging, the nature of and measurement of returns is relatively straightforward. The counterpart to the return yin of finance is the yang of risk, which is far more elusive. While risk, in general, is seen as the volatility of your return, as an investor you want to focus on that part of volatility for which you expect to be rewarded. The essential conclusion of modern finance, and the basis for many Nobel prizes, is that diversifiable risk will, on average, not be rewarded—for the obvious reason that it simply can be avoided through intelligent diversification.

In a risk/return world that makes sense, investors should be rewarded for taking those systematic risks that cannot be diversified away. In the first generation of modern finance this risk was viewed—via the Capital Asset Pricing Model—as how a security moved with the market (beta). That is, does a security’s pattern of returns magnify or dampen the risks common across all investments? A second generation of finance, parented by Ross (1976) and launched into practice by Fama and French (1992), shows that a simple one dimensional view of systematic risk is most likely not the answer. The multiple sources of common risks are generally referred to as factors.

Finance now views risk through a factor lens. Although there is much debate and fluidity in the academic discussion of what these factors are, we focus on a combination of factors that have stood the test of time: Size, Value, and Low Volatility, with the latter being measured by both systematic risk (beta) and unsystematic risk (standard deviation).

relative weath factor performance fig1

Figure 1 displays the impact of factor focused portfolios relative to a broad measure of the US Equity market.2 Notice that both “Small Caps” (Size) and “Hi BE-ME” (Value) are more volatile, but clearly outperform the broad equity market index over the long term. Although the graph is a comparison of US Equities, these factor effects have been shown to impact returns across asset classes and internationally. The “Low-Vol” (Low Volatility) portfolio in Figure 1 shows a return level very similar to the aggregate market, but the anomaly here is that the return is generated with much less volatility. Clearly these factors have appeal beyond a traditional indexed portfolio.

Let’s now consider each factor in more detail.

The Size factor was first identified by two PhD students at the University of Chicago, Rolf Banz and Marc Reinganum, in papers published in 1981. Size is typically measured by market capitalization, i.e., the product of company’s outstanding shares times their share price. The basic empirical finding is that small cap firms appear to outperform the general market on a risk-adjusted basis. Size was anchored in modern risk measures as one of the factors popularized by the three factor model of Fama and French (1992), with the three factors representing Size, Value, and the traditional market factor.3 There is some debate about whether the Size factor persists, which we believe is an issue confounded by the interaction between Size and the other factors. Thus while we strategically manage size exposure relative to the individual’s risk tolerance, it is most important to balance exposure simultaneously with the other factors. For example, a portfolio singularly focused on size will also tend to be much more volatile.

Value could also be labeled the Buffet factor. Historical data shows that high book-to-market stocks—traditionally labeled as value stocks—also tend to outperform the aggregate market on a risk-adjusted basis. Arguably this factor could be traced back to Graham and Dodd in their well-known text entitled Security Analysis. Unlike the Size factor, the Value factor has been far more robust over time, but if not carefully managed, is subject to significant slippage during unusual periods in the market.

Low Volatility also has a long history and to some extent represents the failure of the simple one-factor Beta model (CAPM) to hold true. The essential result for this factor is that, relative to the expectation that higher volatility stocks should generate higher returns, the reward for risk is not as robust as expected. Whether this volatility should be measured by total risk (standard deviation) or just systematic risk (beta) is a matter of debate, but we balance the Strategic Global Core portfolio in both dimensions.

In sum, the Strategic Global Core portfolio provides a strategy that should underlie the foundation of every investor’s financial portfolio, broad and strategic diversification along with a careful identification and management of risk exposure optimized in a way to enhance returns. Through our proprietary mix of ETFs, optimization across multiple factors, and personal customization to fit your tolerance for risk, we provide an intelligent core for your broader investment goals.


1 Diversification does not guarantee a profit nor protect against a loss in a declining market. It is a method used to manage investment risk.

2 We use time series data provided by Ken French.

3 More recently Fama and French have proposed a five factor model. Because these new factors have not yet been widely tested and because one of the new factors essentially substitutes for one of the originals we choose not to expand the factors we consider.

Investment Advisory services are offered through Versatile Capital Management, LLC, a Registered Investment Advisor.
This newsletter contains general information that may not be suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security.

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