Index Funds: an introduction to
Asset Class Investing

Welcome to Asset Class Investing, a method of using a broad mix of passively managed funds (for example index funds) to construct a portfolio that meets your specific needs and maximizes your return for the volatility you allow in your portfolio.

In other words, owning index funds or any other good investment alone is not enough. You must own the right mix of investments for your specific circumstances.

The issue can be put simply. Not all asset classes have the same risk-reward characteristics; some are high risk, some are low risk. Some zig while others zag. Investing in a broad range of asset classes in appropriate amounts yields greater benefits than owning just a few.

So Asset Class Investing allows you to turn tools (such specific index funds or passively managed funds) into an appropriate, well-rounded portfolio of investments specific to your circumstances.

This is merely an introduction. We hope it provides you enough detail to be interesting but leaves you asking more specific questions which we’d be happy to answer.

How does asset class investing work?

There are three distinct decision layers, with the first layer having the most impact on your ultimate risk and return:

• Debt/Equity Decision: How much debt (for example bonds and fixed interest) vs. how much equity (for example shares and property) should you own? This has the largest impact on your ultimate risk and return.
• The Market Decision: Which markets (domestic, international and emerging) will you invest your money in?
• The Risk Factor Decision: Within a specific equity market what is your exposure to small cap shares (small), large cap shares (large) and inexpensive share (value), and what is your exposure to loan length (term) and to credit worthy borrowers (quality) on the debt side?

We summarize this in the figure below.

The Debt/Equity Decision

Over time, many factors will influence the performance of your portfolio. The single most important factor, however, is the debt to equity decision i.e. how much you invest in shares relative to fixed interest.

We summarise the key differences between debt (loaning assets) and equity (owning assets) in the table below.

The ultimate goal of the debt to equity decision is to influence volatility. Equity (shares also known as stocks) is far more volatile than debt (bonds and cash) as illustrated below.

It’s common for shares to lose value in 1 out of 3 years. However, by investing in 50% shares (equity) and 50% fixed interest (debt) you lower the odds to 1 out of 7 years.

If you hold on the investment for periods longer than a year the chance of losing money falls considerably. The table below highlights the risk mitigating effects of holding a mix of shares (equity) and fixed interest (debt).

The Market Decision

So why have sub-asset classes? Why not stop simply with debt and equity? Amongst equity markets, some do well one year while others do well the next. In other words, equity markets themselves are not perfectly correlated.

For example, see the equity returns below in charts provided by US based Index Funds Advisors (in terms of US dollars) for 10 different developed countries. When looking at markets this way it can almost appear obvious which markets to invest in and which to avoid.

However, when we rank the returns each year from best to worst we find no pattern. Thus by holding the shares of all the markets below rather than just one market an investor can reduce volatility and in some cases increase return.

Some New Zealanders can have trouble grasping the concept of diversification. Diversification means more than simply owning a few different shares listed on the New Zealand Stock Exchange.

Bradley Nuttall holds about 8,000 securities in our portfolios spread across 40 plus countries.

On a humorous note, let’s say that your portfolio was made up of beer rather than shares and bonds. If that were the case, many New Zealand investors’ portfolio looks similar to the picture below:

This is not a diversified beer portfolio.

A diversified beer portfolio would look similar to the map below.

It’s important to recognize that New Zealand is only a small portion of the world global economy. Since most of our jobs depend on our local economy, it makes sense that the majority of our portfolio should be spread overseas.

To illustrate this point, imagine that the size of every country represented their proportion of the world’s share market. If that were the case, New Zealand would be the dot to the left of the green arrow.

The Risk Factor Decision

Financial Economists noticed something interesting when looking at the long term histories of various types of shares and bonds.

They noticed that shares of small companies have higher returns than large company shares. They call these companies “small”.

Likewise, they noticed that companies with low share prices relative to the company’s assets (also called its “book”) had higher subsequent returns than companies with high share prices relative to the company’s assets.

The evidence of these return differences is very robust.

Below we show the historical returns of four different groups of shares:

• Value Index: Returns of companies with low share prices relative to their assets
• Small Index: Returns of small companies
• Total Market Index: Returns of all companies listed on the exchange
• Growth Index: The opposite of value, these are firms with high prices relative to their assets (on the assumption that they’ll grow assets in the future)

We look below at three markets. In the United States we have data from 1927 – 2010. For international developed markets we have data from 1975 – 2010. And in emerging markets we have data from 1989 – 2010.

In all three cases small companies and value companies have had higher annual returns than the returns for the total market.

Whilst small and value companies do have higher expected returns, it doesn’t happen every year.

In fact, trying to predict next year’s winning asset class is about as futile as trying to pick next year’s winning international market. Below we show the returns of several asset classes (in NZ dollars) and you’ll see that there is virtually no pattern:

However over 5 year periods, small companies have higher returns than large companies about 78% of the time in international markets, and value companies have higher returns than growth companies about 98% of the time. Thus a strategy using these risk factors must be committed to over the long-term even if in a single year it hasn’t appeared to work.

What about debt or fixed income?

It is easier to understand risk factors in fixed income because many investors have had the experience borrowing money in the form of mortgages or credit cards.

Borrowers who want to pay back their loan over a long time period must pay investors higher interest rates. Why? There’s a lot more that can go wrong in a 10-year time horizon than in a 2-year time horizon. To compensate investors for that risk, the borrower pays the investor higher interest.

Likewise, an investor that loans money to struggling company will require higher interest payments than if loaning to a superbly managed and very profitable company. In other words, non-creditworthy borrowers pay higher interest payments.

So those two risk factors of term (loan length) and quality (credit worthiness) describe nearly all the returns of fixed interest (debt or bonds).

The catch with fixed interest is this, while you earn higher interest loaning for longer terms and to less quality borrowers, you also take on much increased odds of the borrower defaulting.

The chart below is based on fixed interest in the United States and provided by Index Funds Advisers. It shows return on the vertical axis and volatility on the horizontal axis. As the term of the loans (bonds) increase, the return does as well but not nearly as much as the volatility or risk increases.

For example, extending the loan term of US Treasury bills from 1 month to 6 months increases interest payments by over 0.50% and also increases risk as well. Note however that extending the loan term much beyond 5 years doesn’t increase the return very much but it does add a lot of risk. It’s for this reason that Bradley Nuttall doesn’t recommend long-term bonds.

It often makes sense for the debt part of your portfolio to have very low volatility so that you know it will always be there for you, especially during the bad times. This means investing with borrowers that are high quality and loaning over relatively short time horizons. Doing this allows investors to take more risk with equities in order to provide growth and outpace with inflation.

The Results

Below you see our allocation for a 50% Equity and 50% Debt portfolio (known as 50/50). This portfolio is made up almost entirely of passively managed funds like index funds, but which employ the risk factor modifications outlined above. (This is just one example from our range of portfolio weightings designed to suit different risk profiles).

By intelligently diversifying into foreign markets, using the small and value risk factors and (perhaps most importantly) staying disciplined, Bradley Nuttall investors enjoy higher returns for less risk than the New Zealand stock Exchange 50 Index Fund.

The important thing to note is that the returns were not earned via speculating on shares or putting our hope in a fund manager, but via asset class investing.

So in summary, asset class investing is a methodology to use tools such as Index Funds or passively managed funds in specific combinations using the debt equity decision, the market decision, and the risk factor decision, to tailor an investment portfolio for our clients that improves their return and customizes the overall volatility to an amount acceptable and appropriate for them.