1. Substitute O’Shaughnessy Capital Management’s All-Cap Core fund for DFA’s US Large and Marketwide Value funds, making it roughly equal to 25% of the US stock allocation for most clients.
One major change will be the greater use of O’Shaughnessey Asset Management (“OSAM”) strategies across more of our client portfolios. You may wonder how this fits with the mutual funds from Dimensional Fund Advisers (“DFA”), which we have used for many years.
DFA funds provide very broad diversification, at very low cost (i.e. low expense ratios), and are managed in a very tax-efficient way. We love the fact that DFA funds enable us to invest in the very smallest stocks, and in “deep value” stocks (which trade at the largest discount to book value). The higher returns of these stocks are two of the long-term trends that we intentionally wish to capture for our clients.
For clients with larger dollar amounts to invest, we have also sometimes also engaged the services of OSAM. While the current version of OSAM was only formed in 2007, the principals of the firm have been managing money using largely the same strategies since 1987 and have managed money for Abacus clients since 1998, originally in mutual fund form, then through separate accounts. Over the last ten years, OSAM purchased individual stocks for our clients, using several criteria to select a small group of the very deepest value stocks in the US. Like DFA, OSAM gives us access to “deep value” stocks. But unlike DFA, a current OSAM client account might hold fewer than 60 stocks. The long-term average results have been great, but this hasn’t been available to most of our clients. And different clients have had different results, because each client has different holdings, based on when they first engaged OSAM.
OSAM recently changed a couple of key factors in how they manage the portfolios, and also launched mutual funds to remove these obstacles, and after a great deal of due diligence, we intend to incorporate one of the OSAM funds into our US stock allocation for all applicable clients. It is the O’Shaughnessy All Cap Core, ticker symbol OFAIX. (There may be dollar limits, tax issues, or other reasons you may not see this appear promptly in your portfolio.) In contrast to DFA, which uses only book-to-market as its measure of a value stock, OSAM considers book-to-market along with other metrics of value. Since they might hold only about 200 stocks in their mutual fund, OSAM wants to be certain they’re truly buying the deepest value stocks, viewed from several perspectives.
We also reviewed several other potential investment vehicles in this asset class, and rejected them. For example, a former DFA employee has started a mutual fund seeking to concentrate with even greater focus on the smallest and deepest value US firms. But because it is a new firm with an untested strategy, we have shelved this idea for now, to see whether they can truly deliver on their plans.
FACTORING IN MOMENTUM
The small size of a firm’s stock market value, and its discount to book value, are called “factors”, which affect long-term returns in predictable ways. In recent years, considerable attention has been given to whether momentum is another reliable factor one should seek to exploit in investing.
Momentum is simply the tendency of a stock, which is moving rapidly up or down in value, to continue moving in that direction for some time. This “directionality” is pronounced enough that some managers devote their entire approach to capturing it. While it’s easy to dismiss this as “chasing hot stocks”, academics do acknowledge that this effect exists in a non-random way. However, to capture it requires a constant buying and selling of stocks (as they begin to move rapidly, then slow down). The transaction costs and taxes typically offset the entire advantage gained by all the trading. However, this is not always the case.
AQR for example has published data indicating good returns for its strategies going back many years. So our Investment Committee dug deeper. First, we noted that this is a “back test”. This means they weren’t actually managing money during those years, so there is some danger that they have designed particular rules about when to buy or sell that fit the historical data very well. Wouldn’t anyone pick the strategy that did the best in the past? Second, we looked at particular time periods. When you think about how clearly the major trend in the market was visible for years at a time (with dramatic declines from 2000 to 2003, increases from 2003 to 2007, declines from 2007 to 2009, and increases in 2010), it shouldn’t be surprising that individual stocks might move in a specific direction for months at a time. Third, are their trading rules sensitive enough to capture real opportunities? Since AQR doesn’t short stocks, they couldn’t capitalize on the plummeting financial stocks in 2008. And financial stocks recovered so quickly in 2009 that huge gains occurred before AQR’s trading rules could recognize the momentum and instigate a purchase. Fourth, we asked what will happen in a choppy, sideways market, such as we were having in 2011. Two months later, results confirmed our intuition. Their Momentum Fund had lost 2.68% in 2011, while the S&P 500 was up 2.2%. Perhaps AQR was “whipsawed” by the year’s reversals in market direction, or perhaps markets didn’t move enough to offset AQR’s trading costs and taxes. A fund that uses momentum as its major decision driver may be subject to significant periods of poor performance.
Instead, we prefer to use managers who integrate momentum into their larger perspective. DFA, for example, considers momentum when it has decided (based on other factors) to buy or sell a stock. If a stock begins to trade at a deep discount, for example, perhaps because its price is falling, DFA may want to buy it. But if the price is falling too rapidly, DFA will delay the purchase until negative momentum subsides. They use the colorful analogy of not wanting to “catch a falling knife”, which blindly algorithmic trading might otherwise do. If they decide to sell a stock because it’s no longer a value stock, perhaps because of a rising price, they’ll nonetheless hold it a bit longer so long as it is rising rapidly, but they will ultimately sell (since growth stocks provide less return over time, tempting as they may sound). O’Shaughnessey Asset Management also uses momentum in determining which stocks to buy or sell, as one of several factors, never as the sole determinant.
2. Changing Domestic Real Estate Fund
The Abacus Investment Committee has decided to substitute Vanguard REIT Index ETF (ticker symbol VNQ) for DFA’s Domestic Real Estate Securities Portfolio (ticker symbol DFREX) as part of our client portfolios, making it approximately 38% of the alternative security allocation for most clients (this security may not immediately appear in your portfolio as a result of tax issues or other reasons). The Vanguard REIT Index ETF provides exposure to a broadly diversified range of domestic property types at a considerably low cost with a net expense ratio of .12%, which contrasts the DFA Real Estate Fund with a net expense ratio of .32%. Given the interest rate environment, the Vanguard REIT Index ETF offers a generous dividend. We believe that is a great fit to the Abacus model and will play a role in providing additional diversification and mitigating exposure to risk.
3. Trigger a rebalance whenever fixed income (bonds) varies from its target by 10% or more. This limit used to be 20%. Here’s an example. If your target for stocks is 60%, and for bonds it is 40%, and then bonds increase to 44% of the portfolio (because bonds went up in value, or stocks declined), we would sell some of your bonds and buy more stocks. Previously, bonds would have had to increase to 48% of the portfolio to trigger such a move.
The primary reason for this change is that we believe that markets may be more volatile for at least a few years. We had set a fairly broad “band” within which values could fluctuate before we would rebalance, because we like to minimize taxes and transaction costs, and most of these fluctuations even out over time. Rebalancing more frequently increase trading costs, and may cost more taxes (outside of retirement accounts).
However, rebalancing is a wonderful tool to reduce overall portfolio volatility. If stocks were to grow from 60% to say 70% of the portfolio, under our old rule, we wouldn’t have trimmed them. Now we’ll trim them back towards 60%, harvesting some of the gains. This means you have less exposure to stocks if they should then decline in value. Given the “directionless”, up-down-and-sideways behavior of markets during times of economic uncertainty, we think this rebalancing is more valuable than ever, and that it outweighs the costs.
There is some academic literature about rebalancing, but it’s hard to draw general conclusions, since each study tends to test a different set of rebalancing rules across different asset classes and different time periods. Our review of the literature suggests that the primary benefit is in creating a smoother ride, and not necessarily increasing overall returns.
We think that lower volatility is definitely worth pursuing these days.
