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An Evidence-based Approach to Investing with Asset Allocation ETFs

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Getty Images, courtesy BMO ETFs

By Erin Allen, CIM®, BMO ETFs

(Sponsor Blog)

Introduction

The importance of asset allocation in investment management cannot be understated. Pioneering research by Brinson, Hood, and Beebower attributed over 90% of a portfolio’s performance variability to asset allocation decisions, making it the most important determinant in long-term investment outcomes1.

ETFs are remarkably effective market access tools, offering investors precision, liquidity, and cost efficiency to enhance portfolio construction.

This article explores asset allocation in depth, focusing on how Asset Allocation ETFs can serve as evidence-based approach for building resilient and diversified portfolios.

Theoretical Foundations of Asset Allocation: Modern Portfolio Theory (MPT)

Harry Markowitz’s (1952) Modern Portfolio Theory (MPT) laid the groundwork for efficient portfolio construction2, pointing out the benefits of diversification to manage risk levels. According to MPT, an optimal portfolio balances risk and return by combining assets with low or negative correlations, thereby reducing overall portfolio volatility2. This is the idea of diversification with which we are likely more than familiar, not putting all your eggs in one basket.  While some investments go up, others will go down, thereby mitigating losses.

MPT allows investors to find an optimal asset mix that reflects both their return aspirations and their risk tolerance, minimizing the prospect of unexpected outcomes.

BMO’s suite of Asset Allocation ETFs, such as the BMO All Equity ETF (ZEQT), enables investors to achieve broad global diversification — a key principle of MPT — by providing exposure to multiple geographies and sectors within a single vehicle.  Regular rebalancing helps to align your portfolio with your personal risk tolerance and types of assets needed to meet your financial goals.

Asset allocation decisions must align with an investor’s risk tolerance and time horizon. Younger investors with longer time horizons may favor equity-heavy allocations, while retirees may prioritize income and capital preservation through fixed-income or conservative balanced strategies.

The key here is that individual investor needs are unique, and ETFs provide the tools for investors to create the optimal portfolio for their needs or, in the case of asset allocation ETFs, to choose from a pre-set mix ranging from conservative all the way to 100% equity.

 A Note on Diversification

Diversification determines the level of volatility in your portfolio. A paper by S&P Dow Jones Indices research team titled Fooled by Conviction, showed that Between 1991 and May 2016, the average volatility of returns for the S&P 500 was 15%, while the average volatility of the index’s components was 28%.3 Looking at the variability between one stock and 500 is an extreme example, but it  illustrates the important point that if the typical active manager owns 100 stocks now and alters to holding only 20, the volatility of his portfolio will likely increase.

Behavioral Finance and Asset Allocation

Behavioral biases, such as loss aversion, confirmation bias or overconfidence, often lead investors to deviate from their optimal asset allocation strategy.4 Common mistakes include choosing portfolios that may be too conservative to meet their financial needs, panic selling, following the latest meme trend, or failing to strategically rebalance their portfolio over time.

It’s not about timing the market; it’s about time in the market that pays off in the long run.

Rebalancing a portfolio is another potentially daunting task for investors.  You have to remember to do it on a monthly or quarterly basis, but there’s also the emotional/psychological aspect which can often get in the way.  Rebalancing is essentially selling your winners and adding to your loser. Not an easy thing to do, though we all know to buy low and sell high, as the old adage goes.

Allen Roth did a study around the benefit of rebalancing over time5. In a moderate or balanced portfolio, you can see that it added close to 20% to returns over a year period of almost 20 years.  Although there is no guarantee rebalancing will add to your returns going forward, history has shown that it is effective, and it is an important risk control measure.

Investment Performance 12/31/99 – 12/31/17
Total Returns with/without Rebalance

Boosting Returns with Rebalancing, Allan Roth and etf.com, 2018 – For illustrative purposes only

An automated rebalancing facility, such as the one embedded in BMO’s Asset Allocation ETFs, can help mitigate the risks of a portfolio that becomes concentrated due to a failure to rebalance,  ensuring portfolios remain aligned to their predetermined asset mix and risk levels.

A Passive Approach to Investing

Asset allocation ETFs take a strategic approach to portfolio construction, using passive index-based investing tools to build the underlying portfolio.  Passive investing brings the benefits of being lower cost, efficient, diversified, and transparency to a portfolio. Here is a common misconception that is easily negated with SPIVA (Standard and Poors Index versus Active) research (SPIVA | S&P Dow Jones Indices).  The evidence shows that active managers are highly cyclical but can add alpha or outperformance. In the majority of cases, however passive out-performs because it does not make predictions or assumptions.  As is often said, the market, or its index, is a giant weighing machine that tracks capital movements over an economic cycle.

Continue Reading…

What the Carbon Tax teaches us about investing

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Image courtesy John De Goey

By John De Goey, CFP, CIM

Special to Financial Independence Hub

The very first thing Prime Minister Mark Carney did upon taking office was to scrap the consumer carbon tax. Depending on your degree of cynicism, the move was either desperate or brilliant. There is not much middle ground. He did so while noting that the tax had become divisive.

Few would disagree. The very large majority of economists who study the subject argue that putting a price on carbon is the most efficient and effective way of curbing CO2 emissions. Nobel laureate William Nordhaus has shown this convincingly.  Despite the evidence, retail investors simply hated the scheme.

Sometimes there’s a major disconnect between public policy and retail politics. Sensible policies can be rejected because a large percentage of the populace is determined to make decisions based on emotion rather than rationality. People will do what feels good you respective of what the evidence says.

It has been proven many times over that four out of five Canadians were better off paying the tax while cashing the rebate cheques, yet a large percentage of those same Canadians rejected putting a price on carbon at the consumer level. Since about 89% of all emissions come from industrial outputs, the political capital gained by Carney in dropping the consumer portion of the tax far exceeded the opportunity cost of a marginal emissions reduction. Why do so many people viscerally hate policies that conspicuously work against their own self-interest?

Confirmation Bias and Cognitive Dissonance

I believe the answer lies in both confirmation bias and cognitive dissonance. Simply put, people believe what they want to believe:

  1. a) because it makes them feel good; and
  2. b) because they engage in herding behaviour and conform to groupthink

It seems a substantial percentage of the human population actively resists evidence. Sometimes, that resistance appears in the form of political populism where ‘elites’, ‘globalists’ and ‘intelligentsia’ are rejected in favour of whatever populist leaders pass off as ‘common sense’. Confirmation bias is essentially pretending to look for evidence dispassionately, well actually looking for evidence that merely ‘confirms your priors.’ Stated differently, if you were predisposed to disliking a tax on carbon, no evidence to the contrary would have likely changed your opinion.

Similarly, in investing, there are several long-held beliefs that many people harbour that often go unchecked. Some are factually false, while others are merely dubious and open to interpretation and debate. In all cases, however, there is at least some suspension of disbelief to protect a pre-existing viewpoint that simply feels better than the evidence-based alternative. Continue Reading…

Coping with Market Smackdowns

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By Mark Seed, myownadvisor

Special to Financial Independence Hub

Hey Everyone,

Welcome to some new Weekend Reading, the market smackdown edition.

In case you missed any recent posts, here they are!

Before I started semi-retirement/part-time work this month, I shared some big retirement mistakes I hope to avoid in the coming years.

After reading about a 23-year-old athlete earning $2 million, I wondered if he was “set for life”?

And finally, I shared our latest dividend income update below – despite the stock market going down our income stream went up! Continue Reading…

Extremes breed Opposites

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Darling, I don’t know
Why I go to extremes
Too high or too low
There ain’t no in-betweens
And if I stand or I fall
It’s all or nothing at all
Darling, I don’t know
Why I go to extremes

 

  • I Go to Extremes, by Billy Joel
Image Shutterstock, courtesy of Outcome

By Noah Solomon

Special to Financial Independence Hub

The stock market crash of 1929, which was followed by the Great Depression, was arguably the best thing to happen to investors in the history of modern markets.

I am in no way suggesting that investors took pleasure in having their life savings largely obliterated, nor am I implying that bear markets are enjoyable. However, the tremendous pain that people experienced left them with a deep distrust of stocks that lasted for decades. It was this wariness that kept valuations in check, thereby paving the way for strong returns.

Both the passage of time and rising markets eventually led investors to relinquish their pessimism. Eventually, acceptance morphed into adulation, the widespread view that stocks harbored no risk, and an “it can only go up” mindset that culminated in the late 1990s tech bubble. This excessive optimism caused valuations to become untethered from reality, with the S&P 500 Index reaching its highest valuation in history and huge market capitalizations being awarded to companies with little or no earnings.

The irrational enthusiasm which created and propelled one of the greatest bubbles in modern history also set the stage for its ultimate demise in the form of a painfully long and deep bear market. Over shorter periods, fear can result in missed opportunities and regret while greed may get rewarded. However, over the long term, starting points of excessive pessimism set the stage for healthy markets while starting points of excessive optimism pave the way for disappointment. This observation is captured in the following graph, which clearly demonstrates that higher starting valuations lead to lower returns, and vice versa.

S&P 500 Index: PE Ratio vs. 10-Year Annualized Returns

 

 

 

This relationship brings to mind the following guiding principles of legendary investor Howard Marks:

  • It’s not what you buy, it’s what you pay that counts.  
  • Good investing doesn’t come from buying good things, but from buying things well.  
  • There’s no asset so good that it can’t become overpriced and thus dangerous, and there are few assets that are so bad that they can’t get cheap enough to be a bargain.  
  • The riskiest thing in the world is the belief that there’s no risk.

Forget Forecasting: Context is Everything

I know that booms, recessions, bull markets, and bear markets have happened and that they will happen. Where I run into trouble is knowing when they will happen. I am in good company when it comes to this deficiency, as economic forecasting has by and large proven to be an exercise in futility. As famed economist John Kenneth Galbraith stated, “The only function of economic forecasting is to make astrology look respectable”.

Given that predicting when changes in economic conditions will occur is a fool’s errand, investors should instead concern themselves with how markets will react if they occur. Importantly the same change can have a vastly different effect on markets depending on where valuations stand. Specifically, stock market multiples can be a gauge of the extent to which prices will decline in reaction to an adverse shift in the economic backdrop. Continue Reading…

New to a RRIF? Make sure you have enough cash and consider dialing down risk

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My latest MoneySense Retired Money column has just been published and covers something that was a new experience for me: starting and managing a RRIF or Registered Retirement Income Fund.

You can find the full column by clicking on the highlighted headline: How to make sure you have enough money to fund your RRIF withdrawals. 

At the end of the year you turn 71, those with RRSPs are required either to cash them out  (not recommended from the standpoint of taxes), to to annuitize orto convert it into a RRIF, or Registered Retirement Income Fund. The latter is the most popular action and recommended by experts like The Successful Investor’s Patrick McKeough.

            However,  as I’ve discovered since my own RRIF started up this past January, the sweetness of the RRSP tax deduction over the decades is offset by the sourness of having to pay taxable withdrawals on your new RRIF.

            In my case, I am a DIY investor who uses one of the big-bank discount brokers to self-manage the taxable distributions and to manage the remaining investments, most of them carryovers from the RRSP.  While accumulating funds in an RRSP is a matter of making annual contributions and reinvesting dividends and interest, a RRIF represents a departure from the psychology needed to build an RRSP for the future. Suddenly, regular selling is necessary. The RRIF rules mean that in the first year you’ll have to withdraw something like 5.28% of what your balance was at the start of the year (rising to 5.4% at age 72 and every upwards each passing year).

Payments can quarterly, monthly or any frequency you choose

          If you choose monthly payments, as I did, that means every month you have to have 1/12th of the required annual distribution in the form of ready cash to be whooshed out monthly on whatever date you specify. As most retirees will be getting other pensions near the end of the month, I chose mid-month for the RRIF distribution. You also need to choose the percentage of tax you wish to pay to Canada Revenue Agency: I picked 30%, which automatically leaves your account each month. The remaining 70% transfers out into your main chequing account, ideally at the same financial institution where the RRIF is held: It’s easier that way.

Setting regular tax payments

          You also need to choose the percentage of tax you wish to pay to Canada Revenue Agency: I picked 30%, which automatically leaves your account each month. The remaining 70% transfers out into your main chequing account, ideally at the same financial institution where the RRIF is held: It’s easier that way. Sure, you could set the tax at 10% or 20% but if you have other sources of taxable income, like taxable dividends and other pensions, I’d rather not have the unpleasant surprise of a larger-than-expected tax bill a year from April. Once you have a year of RRIFing under your belt, you may see fit to adjust the 30% upwards or downwards. Continue Reading…