The stated asset allocation model is based on a single assumption.

As will be expected from historical data and the causations behind, trends favouring either small or large caps will continue for at least a few years most of the time.

As a consequence of the above, there is only one simple rule to follow when doing asset allocation between small and large caps, which is to cash out from current holdings in small or large caps and invest in either one that returned more in the preceding year. The challenge now lies in choosing suitable benchmarks and ETFs that tracked them for use in this simple asset allocation exercise between small and large caps. The first step in implementing this asset allocation model is to choose a suitable benchmark to represent both the small and large caps respectively. There are two factors to consider for choosing the best benchmark for doing this asset allocation exercise. The first is that it is best or even essential that the indexes contain almost all the listed small and large caps stocks listed on the various stock exchanges as the fundamental reasons for the large differences in return between small and large caps is due to four reasons affecting their earnings in various economic climates. Indexes like the Dow Jones Industrial Average and S&P500 are definitely not a good representative of the whole large caps stocks due to their relatively small numbers of large caps include compared to how much large caps there are in the whole country. After which is choosing the index that has the longest history. Finally, still needs to choose a suitable ETF that track the index chosen from among many others.

When the above mentioned steps have been done, the next is to analyze historical results and see whether historical data conforms to this theory for the case of your country. For the sake of illustrations, we will choose the Russell 1000 for large caps and Russell 2000 for small caps. With these two indexes or benchmarks in mind, then take the following steps to decide which market caps stocks to invest in.

1. For simplicity, we will use the last day of the calendar year, as in last trading day of the calendar year to ascertain the total returns.

2. There are only two possibilities, either the small or large caps returned more, which to invest in for the coming year will depends on which one return more for the preceding year. For instance, if small caps returned more at the end of the year, then continue staying invested in small caps or switched to small caps for the coming next year if hold large caps currently.

We can analyze the results from past returns data, compare and contrast two investing strategies, having a fixed asset allocation and holds small and large caps all the way, that is buy and hold for a really very long term versus a slightly more active method but still not active to the extent of spending your life watching stock tickers of basing investment decisions on which market caps returned more during the year at the end of the year. That is if you observe, will give significantly higher returns than just simply buy and hold.

Translating into physical actions by implementing the above asset allocation plan with ETFs,

There are some slight differences between the returns of indexes and the ETFs that tracked them, returns from market indexes do not consider tax effects and distributions from capital gains when the ETF involved needs to sell a stock when the company is removed from its index, though it does includes dividends and that capital gains distributions are relatively minor. In addition, see that ETFs historical and current price information can be easily obtained from Yahoo Finance or other similar websites. Do take note that ETFs returns will match pretty close to but still less than their underlying indexes since there is this expense ratio, though still much smaller than actively managed mutual funds.

In conclusion, the reason behind this asset allocation is to increase returns significantly relative to just buy and hold a fixed percentage of asset allocation between small and large caps for decades, without corresponding increase in risk. Another crucial point to take note is that in any statistical game of chance, one still needs to stay in the game long enough to reap its rewards, even if the odds is in your flavor. In this case, as you can find out for yourself, by following the above two steps or strategy, you will be correct around 70% of the time, from historical data, a pretty high success rate. But to be correct 70% of the time, one needs to follow the strategy consistently through the decades. But since past performance is not guarantee of future results and if you are a high net worth individual, there is no need to do this asset allocation using 100% of funds intended to invest in equities. Like if worth more than $10 million and got $5 million invested in stocks, can use $1 million or less for this particular asset allocation model.

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2. Exchange Traded Funds 101 – a simple introduction
3. Concepts in managing portfolio and asset allocation

Why it is that market capitalization of companies affects their performance in various economic climates?

While it is a fact that both small and large caps represent a wide range of industries, with so called different performances in different economic and financial conditions. The following four factors do affect the relative performance of both small and large caps stocks, as can be seen historically. As a result, it follows that the same effect by the same causation will persist in future.

1. Rate of growth in corporate profits

Small caps have a much greater sensitivity to changes in main factors affecting profitability, one of which is labour costs, a slower rate of growth in labour cost translates into much greater profitability of small and medium sized businesses than is for the large ones.

2. Broad economic conditions and growth

During times of strong economic growth, small caps and their stocks are benefiting more than large caps. In other words, they are able to expand more rapidly than large companies. In the reverse sense, during recession, small businesses faced a higher chance of failure and/or their earnings shrink faster.

3. General credit conditions

Businesses seldom don’t need credit from banks and financial institutions to operate. Even large, cash rich companies like Microsoft still got make a bank loan, for reasons of leverage while small and medium businesses are no choices have to borrow money. When times are good, banks are more likely to lend to small companies without too high an interest rate or premium, relative to a large and well known company with strong balance sheet. This can be seem before the subprime mortgage crisis, whereby any Tom, Dick and Harry can loan 100% to finance the purchase of a house, which ultimately causes the subprime mortgage crisis. During periods of financial crisis, prolonged recession and great depression, banks and financial institutions are very reluctant to make loans to small companies, especially just after getting burned, like after the economic crisis during the year 2008. Large companies during hard times are relatively easier to get loans as they are generally perceived to be more stable.

4. Local, regional and international political stability

Theoretically speaking, at least according to this feller, Pradhuman, in his book called Small Caps Dynamics, large caps are good defensive stocks during periods of local, regional and international instability. Common sense will tell you that when the Earth is stable, the general public will feel safe investing in riskier assets such as small caps as they are also potentially able to generate higher returns. However, what is supposed to be true theoretically may not be true sometimes, due to unknown reasons. For instance, after the 911 incident, small caps unexpectedly perform better than large caps until end of the year 2006.

The four conditions result in differences in performances of small and large caps such that periods of time that flavours either of them can last a few years so that you can recognise the trend and profit from it. As you shall see from historical data, there is really a large disparity between returns from large and small caps for any given year. Fortunately, there is a simple asset allocation model that any person of average intelligence can used to increase overall returns from wise and timely shift between large and small caps stocks, no need to have first class honours.

Related posts:

1. A simple asset allocation model for deciding between small and large caps
2. A more comprehensive analytical framework for analysing asset classes
3. Three different and essential ways to measure an asset rate of return

When considering investing in any of the major asset classes, it will be wise to see through the above mentioned perspectives so as to identify major trends, length of these trends and how these trends affect asset prices in terms of extend and magnitude. Savvy investors should consider all the following modes of analysis for better investment performance.

1. Social conditions analysis

There are many aspects of a country that affects the prices of assets in that country in both the long and short run, not only commonly used factors like interest rates, price-earnings ratios or present value of future cash flows of an asset. The overall economic health of a nation consists of political, social, financial and economic spaces that are not mutually exclusive to one another.

For the case of political space, conditions favorable to rising asset prices are including but not limited to credible legal and regulatory frameworks, privatizations of assets, checks and balances, and of course respect of human rights of the general populace. In contrast, nationalizing of assets and unstable political environments leads to declining asset prices. In the economic domain, more integration into the world’s and regional markets, with increases in living standards over time and rising GDP points to favorable asset prices. In reverse, reducing domestic consumption, savings and investment in businesses as a whole leads to drop in value of assets.

In addition, economic policy of trade barriers and declining standards of living for residents will be destructive to assets generating income from the place. For financial realm, efficient financial markets would promote the formation of capital for investment, coupled with free markets.

2. Market cycle analysis

Be it stocks or any other asset classes, you seldom see their prices remain stable throughout the time. Not only equities, but other assets like bonds, gold, silver and commodities go through market cycle characterized by five distinct phases. In general, at each stage of the market cycle, people valued assets differently. People don’t always value a piece if financial asset by their discounted cash flows or fundamentals like supply and demand of the products and services that the businesses are procuring. There are times when other factors like liquidity and psychological play a part.

There are three major factors that determine asset prices. They are psychological, fundamentals, technical and valuations. Psychological simply means investors’ emotions from greed, fear, panic to euphoria while valuations means things like present value of future cash flows and riskiness of future cash flows. Technical factor refers to the attractiveness of an asset comparing with other assets.

i) Bear market

At this stage, investors are more affected by psychological factors. That is why one can find various blue chips sell below their intrinsic values when there is a bear market.

ii) Bottoming

This basically means bottom of the market cycle. Note that there is no way for a normal person to determine when bottoming occurs exactly and accurately every time.

iii) Early stage recovery

At this point, the bottoming prices lead investors to buy at a bargain, hence lead to a small rally.

iv) Middle stage bull market

During this stage, fundamentals and valuation of intrinsic value of assets will be reflected in the prices. In other words, reversion to the mean will occur much more frequently during this stage of the market cycle.

v) Peak bull market

This is similar to the bear market in the sense that rational valuations are thrown out of the window and people’s greed elevates prices to high levels. Formation of asset bubbles and high price-earnings ratios are the norm.

3. Financial analysis

Financial analysis simply means to determine the value of a financial asset, be it exotic investments like art and wine, stocks, bonds or real estate. Be it investment research or ordinary investors, all have to answer one particular question at the end of the day.

Is the value of an asset < , > , or = to its given market price?

The inequality signs refers to greater than, less than or equal to.

There are many quantitative and qualitative concepts and tools to find out the answer to this question. But many people uses the following two, hence by using these two concepts to determine value of an asset relative to its market price, one can reasonably certain that the estimation is correct to a great extent, though no guarantee since what people will pay for in future for the same asset is based on what ideas they used to value the same asset in future. One other asset valuation is simply by comparing the market prices of similar assets and another is by using the many different discounted cash flows models available.

4. Financial market analysis

The climate for financial markets can decide to a great extent how major asset classes will perform for long holding periods of five years or more. As a result, when doing asset allocations, that are allocating investment capital among different asset classes, there is a need to analyze the financial market climate also since it will result in either positive or negative returns from asset classes with their respective distinct characteristics.

Prevailing signs in certain financial market conditions point to a reduced holding in equities and assets that behave like equities. These are when there is dramatically expanded use of financial leverage, increase in magnitude and complexity of derivatives and you started seeing highly leveraged institutions surfacing here, there and everywhere, like Lehman Brothers and Bear Sterns. In addition, traditional equity valuation measures like price-earnings ratio and price-to-book value show unrealistically high values and coupled with low dividend yields.

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We all know that mutual funds are in general are diversified, how diversified it is for active managed funds will depends on each specific fund and for the case of passively managed index funds, will have to depend on the specific index tracked, like both the United States Dow Jones Industrial Average and Singapore Strait Times Index only got 30 companies each. For current purpose, we assumed that mutual funds and ETFs in general are well diversified such that the probability of losing every capital is next to zero.

However, you can still lose everything if the company that issue that mutual funds and/or ETFs or brokerage house that stores your mutual funds and/or ETFs, went bankrupt due to the greed of the CEOs. There was a time when Bear Sterns and Lehman Brothers operated America’s most prestigious brokerage houses, now their names have become history.

Most of us know that our savings and fixed deposits will be safe if the banks are FDIC insured. The insurance by government on savings and fixed deposit is necessary so as to prevent banking panic in times of financial crisis. But given that the citizens and residents of the nation and most other developed countries also got billions in various countless mutual funds and exchange-traded funds, is there similar protection for it?

Similar to Federal Deposit Insurance Corporation to insure liquid cash and savings in banks, there is this Securities Investor Protection Corporation, short form SIPC, which insures your funds up to US$500 000. In other words, if the brokerage houses went bankrupt like Bear Sterns and Lehman Brothers, the mutual funds still remain yours for transfer to other financial institutions. But just like the FDIC for liquid assets, there is a limit, but in this case, higher at US$500 000 which will be more than enough for most people.

For cash and savings, if what you have exceeds the limits, simply place in different banks, for mutual funds, you can also simply do so should you exceed the US$500 000 limit by utilizing the services of different brokerage houses. Alternately, you can check whether the brokerage houses involved got carry supplemental insurance to protect portfolio beyond half a million. For example TD Ameritrade and Zecco got offer protection for up to US$150 million and US$35 million respectively.

More information on this risk that has got nothing to do with the stocks and bonds that the funds contain is available at official website of Securities Investor Protection Corporation, http://www.sipc.org/.

For other countries, you will need to check with relevant authorities whether your government got provides this protection for the average investor who can only well afford to participate in returns from equities through mutual funds, be it actively managed or index funds, in mutual fund form or exchange-traded funds.

After your portfolio exceeds or going to exceeds US$500 000, or have initial capital near to or more than US$500 000, it is wise to ask current or prospective brokerage houses about whether they got contain supplemental insurance to cover amounts more than half a million as it is simply stupid to lose whole or some capital due to no faults of the stocks and bonds that you invest in.

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This blog post will touch on this type of product from several different aspects, including costs, size of markets that ETFs tracked, trading details, and tax considerations.

Exchange traded funds is without doubt, a very cost effective tool for constructing a well diversified portfolio of stocks. ETFs is very similar to its older relative – the index fund in the sense that both are low cost and both only seeks to duplicate the performance of an index. The more new versions of ETFs got hold a basket of stocks that contain certain attributes like dividend yields above a certain percentage but they are nevertheless, still passively managed with much lower costs than active managed funds by first class honour fund managers.

The ETF achieve the effect of matching the performance of an index by holding financial assets like stocks or bonds in the same percentage as the underlying index itself. For instance, if the index contains 5% of General Electric, that the ETF attempting to track that index will also have 5% of its assets in General Electric stocks.

ETFs differ from traditional mutual funds in at least 4 ways,

1. Degree of transparency

While an index fund also have total transparency, the same cannot be said of actively managed mutual funds. This is simply to prevent rival mutual fund companies from mindlessly copying the investment strategies of truly top performing fund managers. This is like Warren Buffett only announces to public after his acquisitions of stocks in a particular company is complete as people will simply jack up the prices if he tell the whole world before starting to acquire substantial stakes as almost everyone knows his track record in picking stocks. But traditional mutual funds do reveal fund holdings at regular time intervals to comply with some regulations.

2. Ways of trading

ETFs are like stocks, and traded like stocks, their prices change throughout the whole trading day while index and mutual funds prices are only based on the net asset value of that fund at the end of that trading day. To further elaborate, it does not matter when you placed an order for a mutual fund during the day, the price you paid when buying and you get when selling is that day closing price. This is in sharp contrast to ETFs where you can get different prices depending on when you placed the order during the day. However, this should not be an issue for long term investors as opposed to short term traders.

3. ETFs can use leverage to invest while traditional mutual funds cannot

ETFs are listed on the stock exchanges like stocks, hence they can be traded freely like stocks and all the things that can be done with stocks can also be done with ETFs. As a result, one can short or engage in contra trading on ETFs. However, this is not recommended for the great majority of people as other than losing money in the long run, you also have to spend your life doing meaningless things like watching the changes in stock tickers values on a computer screen. Other than leverage, one can also employ different types of orders like market or limit.

4. No sales and load charges on ETFs but got brokerage commissions and vice versa for traditional mutual funds

As ETFs are traded like stocks, there is no sales charge to speak of but of course there are brokerage commissions to be paid when you buy and sell. As a result, whether it is more cost effective to invest in an index through index fund or a corresponding ETF depends on the size of capital for your case.

Related posts:

1. How to choose from among so many Index funds and exchanged traded funds?
2. Neglected risk when invest in stocks and bonds through mutual funds and ETFs
3. Danger of leveraged and inverse index funds and ETFs

As of now, there are more than 1000 index funds and exchanged traded funds available in the United States, without including other countries. Out of these 1000 passively managed funds, around 300 consisted of index mutual funds and more than 700 exchange-traded funds. The number of such funds will continue to increase as a result increasing popularity of average investors in them. With so many funds available, it will be hard to choose from without some reasonable guidelines, just like housewives choose apples and oranges in the supermarket with some “quality control” criteria also.

1. Begin with the end in mind – begin with the type of needs required for your investment dollars

Steven Convey seven habits of the highly effective people apply to almost everyone and everywhere. In the investment universe for paper assets, not considering real estate and real estate related intangible assets like real estate investment trusts (REITs) and exotic investments like wine or fine arts and commodities, there are basically only two choices to grow your wealth – stocks and bonds.

The deciding factor between these two major categories is simply whether the investor involved wants more growth over the long run or stability in returns. It is a well known fact that stocks achieved much higher total returns when measured over a long investment horizon of more than 10 years. The higher returns of stocks come from both capital appreciation and dividends receive along the way. As for bonds, the income from coupons payments is rather consistent and there is clearly a limit to the value of bonds as they ultimately can only be redeemed at face value when the bonds reached maturity date.

Everyone has different needs for each percentage of their investment dollars, especially if already got a portfolio of stocks, by right, theoretically speaking, one should invest in others like bonds, to balance the portfolio. As a result, even when it comes to index funds/exchanged-traded funds, the first issue to consider is basically what you needs.

Even within these two broad categories of paper assets, there can be even greater diversification, like in terms of market capitalization, for example, like allocating between blue chips and small caps, other than diversified using different geographic regions.

As you can see, even for passively managed funds, it begins with your needs.

2. Index mutual funds or exchanged-traded funds?

The difference between index mutual funds and exchange-traded funds (ETFs) lies in the former is not listed on stock exchange while the latter is. For the case of index mutual funds, its value is determined using net asset value while the price of one share of exchanged-traded funds changes throughout the day depending on market sentiments.

In general, ETFs have lower operating expenses than index funds but cost some dollars to buy and sell. Hence, they are better options for dollar cost averaging during bear market, after purchasing, buy and hold for the next 10 years or more until retirement. When it comes to dollar cost averaging all the time from regular contributions from paychecks and IRAs accounts, even when stock market is clearly overheated, then index mutual funds may be better.

This will depends on each individual investing strategies based on the fundamental differences between these two types of passively managed funds.

3. Owning businesses or investing, bottom line is always crucial.

After deciding on the index and whether index funds or ETFs, there will most probably be many funds offered by many companies in this wealth management industry that tracked the same index. By right, from the definition of index funds and ETFs, all the index funds/ETFs should be almost the same. If they are the same, why on Earth should you choose one that charges high upfront load and higher annual operating expenses than the others?

This is like buying apples and oranges higher in this supermarket when the supermarket next door sells the same apples and oranges that come from the same farms for significantly lesser.

4. Closely examine the index that the index fund/ETF tracks

At the end of the day, an index fund/ETF can only do as well as the index that it represents, minus the operating expenses of course. There are many well known and lesser known indexes after Dow Jones Industrial Average and S&P 500.

Take a look at the top five factors in choosing an index to invest in, though they may not be comprehensive.

5. Estimating returns of the index fund/ETF

As I mentioned above, the returns of index fund/ETF cannot exceed the returns of the index that it represents. How well the index fund/ETF do depends on the index and most important, timing of entry and exit, while most, if not all, cannot accurately predict the exact top and bottom. It is definitely possible to as least know where the top and bottom areas lie. Timing of purchases should be done near the bottom. Do your market timing in years, not seconds, minutes, hours, days and even months. Spend your life starting and engaging in part time businesses or professions that generate the cash, not watching stock tickers. You incur less transactions costs also.

In addition, by looking at the historical returns and trends from the indexes that the index fund and ETFs tracks assist a lot in gauging the risk and return since most ETFs are less than 10 years in existence.

In general, stocks are expected to perform better than bonds when measured over long periods of time but the downside is greater volatility. Then under stocks, small caps are also expected to return more than large caps in the same long periods, but with greater volatility also.

Then how long is long?

Long in this context should be at least 5 years or more.

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3. What is a good index for index investing?

The drawdown of an investment is simply defined as the largest loss that occurs in the past. That is the difference between the highest and lowest price in all the historical price movements of the asset. Measurement of drawdown needs to consider the time period. In other words, the percentage lost from the highest point to the lowest point within a period.

In equation form,

Drawdown = highest price – lowest price X 100%
lowest price

Further extending the concept of a drawdown, another parameter can be used to assist in deciding on what stocks, bonds and other financial assets to buy and when to buy.

The length of a drawdown is the time taken for the price of an investment to equal or exceed its previous peak price. Again, the time period in measuring the length of drawdown also needs to consider.

What is the significance of using drawdown and length of drawdown as opposed to standard deviation?

The answer is very important and very significant. Standard deviation does not tell you certain elements that are crucial for you as an ordinary investor. Unlike Warren Buffett and Bill Gates, most of us may not have substantial capital in the first place and income along the way to invest until we can simply live on from dividends from stocks, coupon payments from bonds and rental income from properties. That is mean to say we need to cash out the capital from those financial assets.

Secondly, asset allocations accounts for more of the results than selecting individual stocks and bonds. For example, selecting individual stocks does not determine investment performance more than selecting based on value/growth, cap size and industries. One perfect example is in two different and yet related industries in view of changes in oil price. During periods of rising oil prices, a great number of energy stocks rises while that of automobile companies fared badly. In other words, developments that occur across industries had a greater impact on its stocks than company-specific events.

As a result, drawdown and length of drawdown came in handy when invest based on some categories rather than individual stocks as behaviors of these two measures of risk are much more predicable than single stocks.

Subjecting to differences in each person’s profile and his expected holding period, there are three simple steps to compare the risks of distinct investments using drawdown.

1. Determine the “bear market”, i.e. worst period for each investment that you are considering and hence comparing.

This is making a conservative estimate using the historical worst case scenarios.

2. Calculate the historical value of the drawdown and length of drawdown for each investment during the period that it fared the worst which most probably not be the same for each class of asset.

Although past performance does not equal future results, it is still wise to know how badly the investment does in the past.

3. For each worst “bear market” period, a higher risk investment is defined by a larger historical drawdown and/or larger length of drawdown.

A high drawdown, together with high corresponding length of drawdown means that the investment is more risky and allocation of capital in the particular class of asset needs to plan and adjust accordingly. In addition, it’s annualized returns during the calculation of the drawdown period needs to be higher to justify its higher risk.

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