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How do foundation portfolios work?
Investors generally agree that one has to incur risk if one hopes to generate a return. If there was only one formal investment vehicle in the world (for example, the S&P 500 Index), then the decision would be simple: how much of my savings do I put into the S&P 500, and how much do I keep under my mattress? Those would be the only two options, making the choice binary. The more you put into the S&P 500, the higher your expected return and expected risk, since there is a great deal of variability to the return.
In the real world, this dearth of investment options is far from the case. Instead, there exists a world of investments that offer a positive long-term expected return. There are also myriad ways to mix assets with the aim of generating a greater expected return with a lower expected risk.
Nobel-Prize winning economics Harry Markowitz developed the concept of the “Efficient Frontier” back in 1952. In short, a variety of investment offerings have a certain expected return, and some degree of correlation (positive or negative) with each other. You can combine these investments to target a certain level of overall portfolio risk, as measured by the portfolio’s expected standard deviation. Expected return and expected risk can never be known precisely before the fact, but they can be estimated based on past history, trends, and logic.
In the graph below, the line represents the best (or most “efficient”) mix of assets (or “portfolio”) for a given level of risk. If your portfolio is not on the line, there is a mix of assets that can move you straight up to a higher expected return, with no increase in risk.
Therefore, the objective is to find the right mix of assets at a risk level you are comfortable with, which maximizes expected return and puts you on the efficient frontier (again, subject to given estimates of return, risk and correlation).
The Efficient Frontier
It must be said that this idea of investing on the efficient frontier is suitable with respect to a passive investing approach, whereby an investor is not seeking to find a stock, fund or manager that can “beat” or “outperform” its asset class, but is simply looking to keep the bulk of his or her assets safely in a global portfolio. With this approach, an investor is aiming to avoid a portfolio that falls under the efficient frontier (as that would mean it is a sub-optimal portfolio because it does not provide enough return for the level of risk).
The asset mix
The proper mix of assets balances simplicity with precision. Each asset class responds differently to market movement, therefore making their relationships important. Holding investments from each asset class reduces your overall risk through increased diversification, meaning that your portfolio is designed to weather market volatility as the positive performance of some investments will offset the negative performance of others. The mix of assets is primarily determined by your investment profile - your investment objectives, time horizon, and risk profile. These three factors influence the allocation of funds across the broader asset classes and directly impact the expected return of the portfolio.
Diversified portfolio returns
Considering the above goals, simplicity, and value-add diversification, the recommended Compound public investment asset allocation universe consists of 10 Asset Classes:
- US bonds
- International bonds
- Developed market stocks
- Emerging market stocks
- US small-cap stocks
- US large-cap stocks
- Real estate funds
- Cash
- Treasury inflation-protected securities
- Commodites
When designing our Foundation Portfolios, Compound starts by taking a global approach. This approach ensures that our clients have exposure to companies in both foreign developed markets (e.g. Europe, Australia, and Canada) and emerging markets (e.g. Brazil, India, and China). While the US economy has historically provided attractive investment returns, it makes up less than half of the world’s market cap, making it imperative to have non-US exposure to ensure proper diversification, especially when US markets are down. Maintaining a global focus also helps offset the potential overweight to US companies that many tech employees experience through their public investments and company equity. Additionally, we include exposure to real estate and commodities due to their low correlation with different asset classes and ability to hedge against inflation.
After ensuring the stock side of our Foundation Portfolio allocation is appropriately diversified across asset classes, we introduce resiliency into the portfolio by adding both US and Non-US bonds. Bonds serve as a mechanism to diversify, lower portfolio volatility, and provide access to relatively stable funds in need of liquidity, allowing stocks to continue working for you.
Why use ETFs?
After developing a mix of assets suitable for various levels of risk, the question then arises as to what specific investment vehicles will obtain that desired exposure. These building blocks should each individually contribute to the overall investment strategy and collectively achieve the desired diversification. This requirement leads us to structure Foundation Portfolios as a mix that tracks the broader market, maximizing the portfolio’s diversification.
Since a large number of financial instruments provide passive exposure to the market, investors must choose based on a few traits:
- How closely will my instrument track to the asset class (known as “tracking error”)
- How much is the financial instrument going to cost me (in management fees)
- How costly is the instrument to implement, trade, and rebalance (in effort, taxes, and bid-ask spreads to buy/sell)
Historically, retail and institutional investors used mutual funds to help design portfolios that achieved a risk-aligned level of diversification. Mutual funds can hold hundreds or thousands of assets in a single fund, making them inherently less risky than holding individual companies, which is what investors were relegated to before their creation.
In the 1990s, the advancement of technology helped create a more efficient and lower-cost option than mutual funds, called exchange-traded funds (ETFs). ETFs were designed to achieve the same level of diversification as mutual funds, with the added benefit of enabling investors to trade positions intra-day (while mutual funds were only priced at the end of each day). ETFs also provide more access for the retail investor due to their significantly lower investment minimums and lower management costs. Lastly, compared to Mutual Funds, ETFs are a more tax-efficient way to achieve broad exposure (since ETFs buy and sell securities less often and investors do not incur capital gains taxes from holding ETFs).
At Compound, we have chosen low-cost, highly liquid, passive ETFs that best represent the asset classes for which we desire exposure. Below is a sample of the core ETFs Compound’s Foundation Portfolio utilizes to achieve a tailored allocation that ensures our client portfolios are at the risk-desired point along their efficient frontier.
SPDR S&P500
US Large Cap Stocks
SPY
Vanguard FTSE
Developed Markets
VEA
Schwab 1-5 Year Corporate Bond ETF
US Bonds
SCHJ
Invesco Commodity Strategy
Commodities
PDBC
iShares Core S&P 500 Small Cap
US Small Cap Stocks
IJR
Vanguard Emerging Markets
Emerging Market Stocks
VWO
Vanguard Real Estate
Real Estate
VNQ