Tracking My Journey: Portfolio Management and Asset Allocation

This post will be devoted to creating a base case for tracking my investment journey. Note that I said investment and not trading.

Over the years, I've come to believe that for the average retail investor with no edge (or special powers), trading is just one aspect of creating an investment plan, and lets leave at that. To me, trading is the mechanical act of purchasing or selling an asset consistent with the overall objectives and constraints of my own personal asset allocation model (more on this shortly).

And I will say this loud and clear, I give TONS of credit to professional traders who are able to consistently generate alpha negotiating an ever changing market landscape. One of the topics taught in finance is that financial time series have a non constant variance (financial markets are non-stationary). To me, this means that modelling, or extrapolating the future based on the past as seems to often be the case in trading (i.e., expecting patterns to resolve a certain way in the future simply because the same patterns have resolved in the past), is a mugs (or "muppets") game, and those who can successfully negotiate their way around an ever evolving real time experiment and make money consistently without losing their minds, well, kudos to them.

I will hazard a guess that the greatest of the great, playing this zero sum game daily, are far and few between. And I am not one of them.

So knowing my own strengths and limitations, and given the above, here's what I believe I'm very good at doing:

• I'm very good at creating cash flows in excel. I do a bi-weekly excel budget cash flow and I've been doing this for as long as I can remember, and this document becomes the basis for managing my entire family's finances.
• I'm very good at adhering to my bi-weekly excel cash flow budget. I'm usually spot on in terms of allocating cash within my budget. I never carry a credit card balance as a result, and I never have any debt used for personal expenditures as result of being short cash flow. Every penny is accounted for within the context of my budget. 
• Knowing the above, why not use this skill to develop a multi-faceted portfolio management / asset allocation budget in excel? So, this is exactly what I've done (more on this shortly)
• I believe I've become very good at developing my "sniffer" in the context of distinguishing financial bunk from non-bunk. For the most part, the average retail asset allocation plan should be pretty simple: develop a plan based on objectives and constraints, and from that plan, choose the lowest cost vehicles to achieve objectives subject to constraints. The financial universe now offers tons of low cost vehicles available to choose from, so for the simple couch potato plan, an investor could simply choose low cost Vanguard balanced ETF's for anywhere between a 60/40 equity/FI target allocation (using VBAL), to a 40/60 equity/FI target allocation (using VCNS). If the target here is an average pretax return of between 3% and 5%, my guess is that a disciplined plan using either or both of these ETF's with regular contributions and annual rebalancing, will get an investor where they need to go at a .22% MER. Contrast this with traditional A series balanced mutual funds (have a look at the RBC Balanced Fund, Series A, with an MER of 2.15%), and tell me why in hell an investor would want to pay 193 bps to RBC for the privilege of earning 3-5% when they can achieve the same or better return using Vanguard for an equivalent product, with arguably, same or similar risk? In RBC's defense, the Series D fund has an MER of 1.33%, which is still ridiculous compared to .22%. So, this is what I mean by distinguishing bunk from non-bunk.
• I believe I've become better at understanding portfolio management and asset allocation. This is mostly due to my recent studies. Knowing what I have learned, I feel the urge to put theory into practice using a multi-faceted portfolio management / asset allocation budget in excel. 

The real time portfolio experiment:

I've embedded a real time link to my asset allocation cash flow budget in google sheets to my blog on the home page. I've been working on this budget with a view to tracking my asset allocation budget on a quarterly basis between now and June 2022. The amounts are stated at book value, but I think I should also add a fair value allocation budget at the end of each quarter to (in a separate tab) in order to compare return expectations with actual returns over time in order to a) see if my return objectives are being met, and b) determine if I need to rebalance.

Starting as at December 31, 2018, I figure I have around $290K in retirement savings spread across different accounts (not including RESP's).

I have outsourced approximately $183,000 of retirement savings to a third party asset manager. The asset management mix there is approximately 65% equity and 35% fixed income. I'm comfortable with this allocation, but obviously, any allocation has to be done in the context of objectives and constraints, and with a view to where we are in the business cycle.

I don't have much in the way of constraints at the moment, so I believe I can assume risk. I'm in my mid 40's, my kids are still in grade school, and I'm employed in a very steady position as a partner at an accounting firm. My cash flow constraints are mortgage, tax instalments, and various cost of living expenses (insurance/s, groceries, heat/hydro/utilities, car, entertainment, etc.). We live pretty well, but nothing extravagant in terms of lifestyle. My biggest bi-weekly cash flow decisions are how to split excess cash flows between RRSP contributions and tax instalments after automatic mortgage repayments. The mortgage is currently $300K and should be done within 12 years.

This leaves $84,000 in assets to self-manage as another $23,000 of retirement assets have been funded to an Interactive Brokers account with a view to outsourcing these assets to another third party investment manager once the assets at IB get to $50K (sometime between Q1 and Q2 2019). The IB assets are currently invested in a mix of short term bond ETFs and investment savings vehicles with a view to topping up another $27,000 before Q2 2019 to get to $50K. Once I get to $50K, I am happy to let the third party manager manage the account.

My return objectives are 10% equity, 3.5% fixed income, and 1.5% cash, and with an overall weighting of between 65/35 - 70/30 equity/FI, I expect to achieve a weighted average return of between 7.7% and 8.05%. The question then becomes as follows: how do I achieve a return between 7.7% and 8.05% investing in a low return environment, without taking excessive risk?

The answer is not straight forward.

First, is an expected weighted average return of between 7.7% and 8.05% reasonable? It depends on a lot of factors, most important being time horizon. I'm 46 and shouldn't need to start drawing on funded savings for another 25 years. This gives me time to wait. And time is an asset. Over 25 years, I believe the return expectations are reasonable, but it won't be a smooth ride getting there.

I also can't think about return expectations without thinking about risk. Arguably, we are currently in the longest economic expansion in US history. Whether we are at the tail end of the expansion is another question, but let's pay lip service to this possibility. What should expected risk and return expectations be if we are close to the peak or end of the cycle?

Being an avid reader of Dave Rosenberg, I'd like to point out that Dave has published extensive research on expansion peak start through recession trough and recession start through recession trough historical declines in the S&P 500 a lot this year. The average recession start through trough drawdown is around -21%, and the average expansion peak through recession trough drawdown is around -29%, with average durations of  between 6.5 months through 13.6 months respectively (using the last 10 recessions commencing in 1949), with the nastiest recessions occurring in 1970 through 1973, 2000-2002, and most recently, 2007 through 2008.

Given the above, what is acceptable in terms of risk today? Risk being the flipside of the return coin, an argument could be made that 65/35 equity/FI is too high across the entire portfolio. If I experience a -29% (peak to trough) decline on the book value of the equity component, my portfolio could theoretically fall from $290K currently to (1-.29) x .65 x $290K + 1.035 x .35 x $290K = $240K, a peak to trough drawdown of around $50K.

Now, this drawdown estimation doesn't take into account the regular contributions per quarter being redeployed 70/30 in accordance with my cash flow budget, and arguably, as the fair value of equities fall, as long as I adhere to the quarterly contribution and allocation budget, I should end up buying a cheaper equity allocation over time, which should lead to higher future returns.

Notwithstanding the above, if my equity allocation falls $50K with zero contributions between now and end of 2019, I would end up with an overweight fixed income allocation and an underweight equities allocation at the end of the period.

$290K x .65 x (1-.29) + $290K x .35 x 1.035 = $134K + $105K = $239K

Equities: $134K / $239K = 56%
Fixed income $105K / $239K = 44%

And if this was the case, I would need to rebalance at the end of 2019 and sell $33K of fixed income, and buy $33K of equities to get back to a 70/30 target allocation.

I could also theoretically revise my allocation budget to 50/50 starting January 1, 2019, but this would mean selling off current equity holdings in anticipation of being able to buy equities cheaper at some point over the next two years. No easy feat, although in hindsight, should 2019/2020 turn out to be really dismal, I (and lots of other folks) will probably wish they had lower exposure.

And this takes me back to my point above about time. I believe that time will end up being the best argument towards staying the course in terms of target allocation, and using pronounced weakness to rebalance.

Which brings me to my next point:

What do I mean here by equities in the context of my own holdings?

In the past, I have held the view that individual equities are the key to my own investment success. I no longer believe this to be the case, with a caveat.

I still believe that as an asset class, equities are a useful component of an overall plan. But when it comes to my own stock picking prowess, I've come to realize that buying and holding individual names is extremely difficult for me. Why is this? Lots of reasons, not limited to: self-doubt, emotions, bias, information disadvantage, incorrect position sizing, and overall lack of understanding the linkage between choosing to invest in an individual company and that individual company's contribution to the overall return objective.

What can I do instead of buying individual equities? I can a) look to invest directly in index funds or ETF's, and b) use what I've studied to find good active managers with a view to capturing excess return over time.

On a) I've come to realize that having an allocation to indexes makes sense in trying to achieve long term return objectives. Why? Because indexes are the benchmarks against which active managers are evaluated, and because of this, indexes aren't going to disappear. Individual stocks on the other hand, can and do disappear. History is littered with individual fallen angels. A related point: why take the risk of owning an individual company (unsystematic risk) when I can achieve stated return objectives by owning the index? The counter-argument to this point is that I will not make outsized (or excess) returns by just owning the index. Duly noted. This problem gets addressed in b) below.

This doesn't mean that indexes cannot draw down, and draw down materially. On the contrary, between 2000 & 2002 the Nasdaq composite drew down close to 80%, and the S&P 500 drew down close to 50%.

Therefore, I would rather use indexes as a base towards building an equity allocation, with a view towards understanding that equities as an asset class are a building block towards achieving long term portfolio return objectives, supplemented by strategic allocations to a handful of proven active fund managers who can help me in achieving excess return over and above index returns, and further supplemented by allocations to individual equities if and only if, they make sense in the context of the entire portfolio and sized appropriately so as not to add unnecessary risk.

On b) it's a straight-forward exercise to evaluate active fund managers using traditional risk and return attribution metrics like sharpe and information ratios, so this will now become my homework: find active managers who have managed to generate high relative sharpe and information ratios (over time), and who charge reasonable MER's, with a view to supplementing index allocations as noted above. I will probably do a separate post on the results of my findings at some point in the future. Suffice to say, there are a ton of active managers out there, and the trick is narrowing the search down from many to few. Thankfully, high MER's a great tool for screening out the nonsense and narrowing down the search.

Going into 2019, and looking at the composition of my entire portfolio currently, I have the following observations:

• Of the $183K allocated to an active third party manager, there is nothing I need to do here except continue to make regular contributions. The active manager will allocate those contributions according to the firm wide mandate in the context of my objectives and constraints and will rebalance accordingly.
• Of the $23K allocated to IB, my goal is to top up the contributions to $50K and outsource this component to another third party active manager. The manager uses a value approach, and I believe that the manager has a good long runway ahead. 
• Of the remaining $84K, approximately 66% is currently allocated to equities, and 34% is allocated to GIC ladders and a mix of short term laddered bond ETF's and actively managed bond funds. Of the 66% equities, 20% is allocated to individual equities (via Shareowner),  80% is allocated to actively managed funds, and nothing to indexes. Thinking about this, I may have gone about things backwards, but that's not a bad thing. Therefore, the quarterly allocation decision becomes how much of available excess contributions to allocate to base case indexes (and which indexes) in order to get to a target 70/30 allocation.
• On the subject of which indexes to use, this is tricky. Certainly, I want to start adding exposure to the S&P 500 at some point as it's the widest used benchmark. The question is, how much to the S&P 500 vs. anything else. This also becomes a question of where the portfolio assets are located. For example, 40% of the $84K of portfolio assets are located at TD Direct, and 35% are located at Scotia Itrade . At TD, I can choose from TD e series funds, while at Scotia, I can choose from commission free Index ETF's. I'll need to research if there are any alternative solutions to adding index exposure at lower cost. If I buy the Vanguard S&P500 hedged Index ETF over 4 quarters in size of $2,000 per quarter, my commissions through TD will be $40 + $8,000 x .08% = $46.40 vs. $8,000 x .33%  = $26.67 buying just the e series fund. Suffice to say, it probably makes sense to split the allocations equally between S&P 500, MCSI EAFE, and TSX, although an argument could be made to tilt the allocations (at least initially) to the worst performing indexes first with the remainder to the S&P 500. 

Whatever the case ends up being, I have lots of time to think about the above as the majority of the allocations in Q1 and Q2 2019 are already benchmarked for IB, so this takes some pressure off of having to initiate equity allocations until sometime in after Q1 2019.

I realize that this has been an extremely long post, and I've done this purposely to document my thoughts at a point in time.

It will be interesting and insightful to start updating my progress quarterly using actual return figures, so I can monitor progress in real time.