In past articles, we have favored the use of the Powershares QQQ Trust ETF (QQQ) over small cap value weighted methodology http://seekingalpha.com/article/1915041-market-map-model-2-using-small-cap-value-weighted-portfolio for use with the Market Map model because of QQQ’s ultra low expense ratios, tax ratios, and accompanying comparable performance. The model and QQQ has also held a performance advantage, historically, over the SPDR Trust ETF (SPY), and Vanguard Total market ETF (VTI).
In this article, we explore portfolio “diversification” using: 1) a portfolio of popular dividend growth stocks 2) the “growth” universe (the QQQ etf) and 3) a “small cap value” universe (the Vanguard Small Cap value ETF (VBR)). As many investors find psychological comfort and safety by the “mere exposure effect” of owning a portfolio of “great” U.S. company names with growing dividend streams, they tend to shy away from exposure to the growth stock and small cap value universes because of perceived risk. Yet, for the population of middle and upper aged investors that have gotten a late start in their retirement asset accumulation phase http://www.fool.com/investing/general/2013/05/02/the-biggest-retirement-myth-ever-told.aspx, a compound “total return” from a strict dividend growth portfolio or the buy and hold of low cost total market fund(s) or S&P500 index fund(s) may be too little, too late in helping them meet their goals. Portfolios consisting of growth and small cap value etfs combined with the Market Map asset allocation models diversified with a buy & hold/annually rebalanced portfolio of quality dividend growth stocks (with the possible eventual goal of, as preferred by many, a total dividend paying/income producing portfolio), is a reasonable approach in alleviating the reluctance of investing in the growth and small cap equity universes while exposure to those universes can serve as the “faster turtles” in the “long term” accumulation phase of the assets.
In order to build a resolute belief in the “long term” view, we rely on data driven methods as defense against the “noise” of the financial markets and the anecdotal information presented by the media. Chart 1, prepared by Robert Shiller, reveals total market return statistics for varying time frames. We can see that, over the last 140 years, 20 year investment periods have had 100% probability of success, 15 year have had 95%, and then lower probabilities of success as the data moves left. Since the Market Map model was designed towards the long term investing time frame, we have used the 20 year time frame in our diversification study.
Additionally as described in the beginning of the article, with the increasing longevity of the population http://www.fool.com/investing/general/2013/11/29/everything-is-great-and-nobody-is-happy.aspx , investors who are “slow starters” on their retirement asset accumulation plan and have missed the conventional 30 to 40 year asset accumulation “glide path” window (with a retirement age commencing at 65 ) typical of a more stable work, salary, and 401K contribution history, may still be afforded a chance in accumulating sufficient assets for a financially satisfying “late” retirement in a 15 plus year accumulation phase window.
The Quality Dividend Growth portfolio
The Dividend Growth portfolio applied to the diversification study* comprised of MMM, XOM, MRK, JNJ, MCD, PG, ED, GE, MO, KO (with a switch of GE for WMT on 01/02/08 for performance optimisation). The stocks are useful because they possess 40 plus year price history and have been stalwarts of consistent dividend payment increases.
Additionally, an analysis was conducted on the effect of different rebalancing frequencies on this portfolio over two different 20 year time frames and we found that, as Chart 2 and Chart 3 reflect, an annual rebalancing frequency was sufficient, did add value to the returns, and was implemented into the management of the 2 and 3 style allocation blends represented below.
Portfolio Diversification Using 3 Style Universes
Charts 4, 5, 6, and7 illustrate the types of returns achieved over the past 20 year period in terms of $ accrual using different percentage “blends” of asset allocations of the 3 style universes.
Chart 4 represents the first example of diversification “blend”. The Quality Dividend Growth portfolio was assigned a 60% allocation and the Growth** and Small Cap Value portions were each assigned a 20% allocation. The total portfolio was rebalanced every 5 years:
Chart 5 $ growth of each separate portfolio allocation and the combined total return of the 20-20-60% blend since 1994:
Chart 6 represents the second example of diversification “blend” using a 20-20-60% configuration.
Quality Dividend Growth was again (initially) assigned a 60% allocation and the Growth and Small Cap Value portions were assigned each 20%. However, after a 5 year period, the allocation percentages were switched so that the Quality Dividend portion received 40% allocation and the Growth and Small Cap portions each increased to 30% allocation, or at total of 60% for both. Also, during this switch, the total portfolio was rebalanced.
3 Portfolios and Volatility
Diversification Using 2 style Universes
In the previous charts 8, 9, and 10, we can see that the volatility, as measured by peak to trough drawdowns, was highest with the Small Cap value universe. In consideration of those investors who may have concern about having portfolio exposure to the greater volatility as represented by the small cap universe, we can utilize a 2 portfolio blend of the lesser 2 volatility universes by excluding the Small Cap Value style from the allocation mix (and consequently forgoing style diversification). These results are seen in charts 11, 12, 13, and 14 below:
Chart 12 $ growth of each separate portfolio allocation and the combined total return of the 40-60% blend since 1994:
Chart 13 represents the second example of diversification “blend” using just the QDG and Growth portfolios.
Similar to the 3 style diversification blend, Quality Dividend Growth was again assigned a 60% allocation and the Growth portion was assigned 40%. After each 5 year period, the allocation percentages were switched so that the Quality Dividend portion received 40% allocation and the Growth portion increased to 60% allocation (and vice versa), accompanied with a rebalance:
As with the value that the annual rebalancing provided the 10 stock Quality Dividend Growth portfolio over the non rebalanced version in charts 2 and 3, so did the 5 year 60% allocation “switch” between Quality DG and Growth/Small Cap value styles provide value versus the non “switched” versions.
Performance Comparisons and Vanguard Target Retirement
The charts shown below present an overview of the $ returns and compound growth rates of select items that have been covered in the article. We can see that the rate of growth for Quality Dividend portfolio slowed dramatically from 1994 – 2013 vesus the 1970-1989 period and that the performance of the combined diversified blends took the lead in the latter. As the data used for the Growth portfolio calculation in the 1970 – 1989 period was taken from the Nasdaq OTC composite and that the Nasdaq 100 outperformed the Nasdaq Composite from 1985 – 1989 (and beyond), we can assume that the performance for the blends would have been improved if the Nasdaq 100 was a viable option for use in a portfolio in that period.
An additional item included for comparison in charts 16, 17, and 18 is a mix of Vanguard funds that is part of their “Target Retirement” series (as with many other investment companies’ “Target date” offerings) and is a popular choice with the disciples of the John Bogle investment approach ***. The portfolio shown was constructed using a diversified equal weighted mix of three Vanguard funds: 1) Total Stock Market 2) Total International and 3) Total Bond Market. In the calculation, the mix was rebalanced every 5 years in order to maintain consistency with the calculation of the other portfolios in this article.
As we can see in chart 16, the compound returns and $ accrual of the Quality Dividend Growth and the Vanguard Target portfolios were admirable. The returns for most retirement plans constructed using Exchange Traded Funds **** seem to fall somewhere in between that of the Quality Dividend Growth and Vanguard “Target retirement” trajectories shown. Of course, there are many disparate factors that could affect contribution regularity applied towards a plan in “later” years and terminal asset accrual could vary from a strict extrapolated target.
Surprisingly, focusing on volatility concerns, the largest peak/trough drawdown for the Vanguard portfolio fared slightly better than the buy & hold of the Small Cap value (VBR) etf. Granted, the sample size used in the volatility calculation for the Vanguard portfolio is smaller than the other universes’ volatility charts in the study, yet the results still seem to run counter to the premise that holding a broadly diversified portfolio of funds (including the incorporation of a Total bond fund) provides “less risk”.
A Long Term Look at Compound Growth
A look at chart 19 shows 20 year compounded growth rates for various combined portfolio blends and universes over a 25 year span. Some observations include:1) The Quality Dividend Growth portfolio (yellow line) appeared to have a 6 year, 20 year Compound Growth Rate performance run of 3000% – 5000% from 1996 to 2002 and has since slowed to a sub 1000% 20 year CGR performance 2) the Small Cap Value universe (blue line) stayed in the 1000% CGR range until around 2004 and has since trended upward 3) the Growth universe CGR (green line) has consistently trended upward and 4) the combined 20-20-60% diversification blend (black line) tracked the performance run of the Quality DG portfolio until 2003 and appears to have stabilized between the 2000% – 3000% range, reflecting the strength of the Small Cap Value and Growth universes.
The reason to review this visual information, along with chart 1 and 16, is that it can further help solidify our conviction in “staying the course” for 20 year period(s). Knowing, for example, that the 20-20-60% blend is the product of the calculation of the 3 diversified universes with varying cyclical natures (at this moment, upward trending Growth universe, lower trending Quality DG, and awakening ? Small Cap Value) gives us an idea, along with historical volatility information, of the 20 year potential performance percentage and behavior of this blend. Obviously, an investor can invest in just the QQQ or the SPY with the Market Map model exclusively if they so choose, but this study provides some food for thought towards a diversified retirement asset accumulation plan.
In the broad world of retirement plan investment choices, there are many different schools of thought and somewhat confusing misconceptions. As shown in this study with additional input from the previous articles:
a) tactical asset allocation models that have produced repeatable and consistent outcomes when applied to a Small Cap value and Growth stock universe, and combined with a buy & hold of a Dividend growth stock portfolio, have produced steeper asset accumulation trajectories over a 20 year investment period versus an exclusive buy & hold portfolio of Dividend growth, further providing style diversification albeit with more volatility.
b) tactical asset allocation models ( in “a)” ) when applied to a Growth stock universe and combined with a buy & hold of a Dividend growth stock portfolio, have produced steeper asset accumulation trajectories over a 20 year investment period versus an exclusive buy & hold portfolio of Dividend growth, providing less style diversification albeit with only slightly more volatility.
c) the use of the term “less risk” in literature regarding a broadly diversified portfolio of Vanguard funds targeted towards retirement is a misconception see here https://investor.vanguard.com/mutual-funds/target-retirement/#/mini/holdings/0304
Last but not least are the questions asked such as:
40 years ago, the dividend “stalwarts” were younger, mid to large cap size companies and have since turned into “mega” cap companies … If the slowing of the 20 year CGR shown in chart 19 has been a a reflection of a cap size growth effect and in order to achieve the types of returns produced from 1970 – 2002, which mid to large cap companies would represent the “new” era of dividend growers as replacements for the mature companies?
Or … will the expansion of the sales of products and services into developing markets give the mega cap dividend payers a cyclical move up in the portfolio’s 20 year CGR moving forward ?
To alleviate the management of annual rebalancing of a 10 stock dividend growth portfolio, would a dividend ETF used in it’s place be a reasonable option?
Unfortunately, the above questions are the very ones that turn us into stock selection portfolio managers (with all of the latent obsessional behavioral tendencies and performance drift accompanied therein) and pull us slightly away from the non-subjective rule based simplicity of using a data driven tactical model. Yet for the comfort that “brand” stocks provide an investor, it is an uncomfortable reality in this particular form of style diversification.
** Growth as represented by Nasdaq 100 index/QQQ using the Market Map model. Small Cap value as represented by the French small cap value weighted 2 factor model/Vanguard Small Cap Value ETF using the Market Map model.
instead of settling for the conventional, we frequently remind ourselves that “there’s gotta be a better way” and “we can take it to the next level“.