How to Fix the Flawed Tilt with the PP's Equity Component

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How to Fix the Flawed Tilt with the PP's Equity Component

Post by MachineGhost » Tue Mar 24, 2015 11:25 am

Marketcap weighted funds suck for a variety of reasons that I'm not going to expound upon here.  The bottom line in keeping with the core PP philosophy is you want to have agnostic exposure to all nooks and crannies of the public equity marketplace and not favor one segment at the expense of others -- just as you do with the macro assets themselves.  Unfortunately, there are zero funds that provide this common sense, equalized exposure.  So, I have crunched the numbers to come up with the fix.  Abracadabra!  To wit:

Market Capitalization
Size    % of Portfolio
Mega    21.46%
Large    18.54%
Mid    20.00%
Small    20.00%
Micro    20.00%

It's difficult to equalize mega and large because all the large funds have more mega than large; no concentrated large only.  The portfolio weights to accomplish the above equalization is:

Fund    Weight
Vanguard MegaCap (MGC)    36.3%
Schwab SmallCap (SCHA)  35.10%
Wilshire Micro-Cap (WMCR)  14.39%
Russell Mid-Cap (IWR)    14.2%

These are the strategic weights, i.e. what you would rebalance back to whenever you hit a rebalancing band.  The total expense ratio is a modest .18%, or $1.50 per month per $10K.

In contrast, the Wilshire 5000 Total Return Equal Weight (which never debutted as an ETF, despite filing for it) would have had a market capitalization something like this:

Market Capitalization
Size    % of Portfolio
Large    21.21%
Mid    14.14%
Small    49.49%
Micro    29.27%

Needless to say, such a portfolio trounces any broad marketcap weighted fund due to the overexposure to small and micro.  But it is clearly a flawed tilt just as marketcap weighting is a flawed tilt.

I couldn't backtest the above weights exactly; had to do 20% into each except 27.73% mega, 12.93% small and 19.33% micro due to data limitations.  It's still good enough to see if there would have been any edge:

PP with Market Cap Weight:
    Total    CAGR    Std.Dev    Sharpe Ratio    Sortino Ratio
Portfolio Growth - Nominal    $389,369    8.89    7.77    0.53 1.54
Portfolio Growth - Real    $68,125    4.56    6.87    0.57    0.90

PP with Equal Cap Weight:
    Total    CAGR    Std.Dev    Sharpe Ratio    Sortino Ratio
Portfolio Growth - Nominal    $425,183    9.11    7.83    0.55 1.69
Portfolio Growth - Real    $74,391    4.78    6.83    0.61    1.00

Higher numbers all around!  Here are the actual equity returns:

Market Cap Weight:
    Total    CAGR    Std.Dev    Sharpe Ratio    Sortino Ratio
Portfolio Growth - Nominal    $702,854    10.40    18.05    0.39 0.65
Portfolio Growth - Real    $122,973    6.01    17.85    0.38    0.51

Equal Cap Weight:
    Total    CAGR    Std.Dev    Sharpe Ratio    Sortino Ratio
Portfolio Growth - Nominal    $942,948    11.15    19.02    0.41 0.74
Portfolio Growth - Real    $164,980    6.74    18.61    0.41    0.58

The actual weights should do even better.  Case closed!
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by sophie » Wed Mar 25, 2015 11:03 am

Thanks MG!!!  This is great.

Would it be possible to simplify this down to two funds by using, say, VTSMX combined with a small cap fund?

Also what would you do with international stocks?  Some of us keep a small slice of the stock allocation in international, although perhaps it could be argued that this isn't necessary or helpful.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by MachineGhost » Wed Mar 25, 2015 12:32 pm

Here are equalized portfolios with more severe tracking error that are also commission-free at their respective issuers if you don't want to use Motif:

VANGUARD
Market Capitalization
Size    % of Portfolio
Mega    28.07%
Large    21.50%
Mid      20.00%
Small    20.00%
Micro    10.43%

Fund    Weight
Vanguard S&P 500 (VOO)  53.78%
Vanguard Russell 2000 (VTWO)  33.44%
Vanguard MidCap (VO)  12.78%

Total management fees: 0.13%.

SCHWAB
Market Capitalization
Size    % of Portfolio
Mega    20.00%
Large    15.95%
Mid    20.00%
Small    20.00%
Micro    20.00%

Fund    Weight
Schwab U.S. Broad (SCHB)    46.29%
Schwab SmallCap (SCHA)  31.44%
Wilshire Micro-Cap (WMCR)  13.86%
S&P 500 Equal Weight (RSP)  4.36%

Total management fees: 0.14%.
Last edited by MachineGhost on Wed Mar 25, 2015 2:24 pm, edited 1 time in total.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by MachineGhost » Wed Mar 25, 2015 12:34 pm

sophie wrote: Would it be possible to simplify this down to two funds by using, say, VTSMX combined with a small cap fund?
That's not possible as I included all domestic Vanguard mutual funds as consideration for the backtest.  If you want to keep VTSMX, then you can substitute it for SCHB above and buy the rest.  The new weights would be: 46.33%, 31.52%, 13.51%, 4.58% respectively.
Also what would you do with international stocks?  Some of us keep a small slice of the stock allocation in international, although perhaps it could be argued that this isn't necessary or helpful.
I would just carve it out of domestic and dedicate it to foreign.  I don't think there's enough funds available to equalize foreign, but I'll look into it.
Last edited by MachineGhost on Wed Mar 25, 2015 12:40 pm, edited 1 time in total.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by MachineGhost » Wed Mar 25, 2015 2:14 pm

Here are equalized portfolios with more severe tracking error that are also commission-free at their respective issuers if you don't want to use Motif:

FIDELITY
Market Capitalization
Size    % of Portfolio
Mega    23.61%
Large    16.28%
Mid      20.11%
Small    20.00%
Micro    20.00%

Fund    Weight
iShares Core S&P 500 (IVV)  45.54%
iShares Core S&P MidCap (IJH)    20.51%
iShares Core S&P SmallCap (IJR)  18.92%
iShares MicroCap (IWC)  15.03%

Total management fees: 0.17%.

TD AMERITRADE
Market Capitalization
Size    % of Portfolio
Mega    30.00%
Large    20.00%
Mid      20.00%
Small    20.00%
Micro    10.00%

Fund    Weight
iShares Core S&P 500 (IVV)    42.65%
iShares Core S&P SmallCap (IJR)  30.14%
Vanguard Mid-Cap (VO)  17.87%
iShares S&P 100 (OEF)  9.34%

Total management fees: 0.10%.
"All generous minds have a horror of what are commonly called 'Facts'. They are the brute beasts of the intellectual domain." -- Thomas Hobbes

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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by Pointedstick » Wed Mar 25, 2015 2:34 pm

What am I missing here? This sliced-and-diced stock allotment looks to me like it replicates a broad stock index ETF (e.g. VTI) almost perfectly if you buy-and-hold, but it has higher complexity and cost. Is there any actual advantage that's observed, not theoretical?

[img width=700]https://i.imgur.com/6y2Ohbh.png[/img]
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by MachineGhost » Wed Mar 25, 2015 2:51 pm

The point is not to be biased to one market cap or another so you don't underperform when the market cap that you're underexposed to decides to outperform or the marketcap your overexposed to decides to underperform.

Just as with the PP, you must rebalance to correct the inevitable overweighting because all of these -- with the exception of RSP -- are market cap weighted funds to keep transanction/tax costs low.  If you don't rebalance then it will wind up being just another generic market cap fund.

If that's not clear, then you guys don't quite understand the "piling on" that market cap weighting involves.  Market cap overweights overvalued securities and when rebalancing you are buying even more overvalued securities as opposed to undervalued securities -- the diametrical opposite of how the PP itself works.  Even if only relative value, it still makes a difference.  Also, the mega caps are a consistent negative drag on index returns due to how overvalued they are by the nature of market cap weighting.  Eliminating exposure to those would actually be preferable, but that is tilting.
Last edited by MachineGhost on Wed Mar 25, 2015 3:03 pm, edited 1 time in total.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by Pointedstick » Wed Mar 25, 2015 3:32 pm

Using https://www.portfoliovisualizer.com/backtest-portfolio to show an annually-rebalanced version of the ETFs I backtested in my previous graphic, I still don't see any meaninfgul difference between the proposed allocation (portfolio 1) and 100% VTI (portfolio 2):

[img width=700]https://i.imgur.com/M1WUq58.png[/img]

I appreciate your work on this, but is the risk you point to an actual risk? Or just a theoretical one? Has it ever happened? If it does, is its magnitude large enough that we need to care?

Simplicity that is "good enough" has a lot going for it IMHO.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by dragoncar » Wed Mar 25, 2015 5:10 pm

Pointedstick wrote: Using https://www.portfoliovisualizer.com/backtest-portfolio to show an annually-rebalanced version of the ETFs I backtested in my previous graphic, I still don't see any meaninfgul difference between the proposed allocation (portfolio 1) and 100% VTI (portfolio 2):

[img width=700]https://i.imgur.com/M1WUq58.png[/img]

I appreciate your work on this, but is the risk you point to an actual risk? Or just a theoretical one? Has it ever happened? If it does, is its magnitude large enough that we need to care?

Simplicity that is "good enough" has a lot going for it IMHO.
I'd guess it's more important over very long time frames.  There may be a decade here where small cap outperforms, a decade there where large cap does.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by Kbg » Wed Mar 25, 2015 5:48 pm

So everyone is correct here...MG for focusing on cap size and others for cost. I think Marjory asked the best question which was also the answer...get a large cap and a small cap and get the really cheap cost ones. If you do a simple 50/50 split between the two you are going to get high 90% of the benefit. Let the two ride until you have to do an overall portfolio rebalance.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by MachineGhost » Wed Mar 25, 2015 7:49 pm

Pointedstick wrote: I appreciate your work on this, but is the risk you point to an actual risk? Or just a theoretical one? Has it ever happened? If it does, is its magnitude large enough that we need to care?

Simplicity that is "good enough" has a lot going for it IMHO.
It's not theoretical.  You're not using a long enough time period to do the backtest.  Consider the small cap outperformance of the 70's or the mega cap outperformance of the 90's.  Look at the Wilshire 5000 Total Return Equal Weight (W5K EW) below for 1972 to 2014 and consider why it has such a huge outperformance vs marketcap weighting:

[align=center][img width=800]http://i62.tinypic.com/23jlvt0.png[/img][/align]

Keep in mind that this backtest is not even remotely close to 20% cap equalized due to data limitations.  The unfortunate underweighting to small caps will hurt performance a lot.  But even with that, you can see there is a clear edge so long as you keep your fees and taxes low.

Also, I wonder if the Morningstar distinction between Mega and Large is artificial and still overtilts the portfolio.  Wilshire doesn't even break it down like that.
Last edited by MachineGhost on Wed Mar 25, 2015 7:58 pm, edited 1 time in total.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by MachineGhost » Wed Mar 25, 2015 7:56 pm

Kbg wrote: So everyone is correct here...MG for focusing on cap size and others for cost. I think Marjory asked the best question which was also the answer...get a large cap and a small cap and get the really cheap cost ones. If you do a simple 50/50 split between the two you are going to get high 90% of the benefit. Let the two ride until you have to do an overall portfolio rebalance.
I used the lowest cost funds available.

This is what a 50/50 VTI/VTWO looks like:

Mega    20.95%
Large    15.01%
Mid    14.21%
Small    32.95%
Micro    16.90%

Too tilted.

Or a 50/50 VTI/VIOO:

Mega    20.95%
Large    15.01%
Mid    10.22%
Small    36.17%
Micro    17.67%

Still too tilted.

Caps go in and out of favor, so being tilted is unwise.
Last edited by MachineGhost on Wed Mar 25, 2015 8:00 pm, edited 1 time in total.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by Kbg » Thu Mar 26, 2015 10:02 pm

I must not be understanding your first post as it sure seems to me a 50/50 split is good enough for government work
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by MachineGhost » Fri Mar 27, 2015 9:31 am

Kbg wrote: I must not be understanding your first post as it sure seems to me a 50/50 split is good enough for government work
"Government work"???
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by sixdollars » Fri Mar 27, 2015 3:41 pm

MG,

Great work, the only qualm I have with implementing something like this is that adding 2 to 3 more funds feels like a big hit to re-balancing simplicity.  If you find any way to implement this with less (i.e. two funds), please let me know :)

I'm mostly invested in VTSAX for my stock portion of the portfolio at the current time.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by Kbg » Fri Mar 27, 2015 5:49 pm

MachineGhost wrote:
Kbg wrote: I must not be understanding your first post as it sure seems to me a 50/50 split is good enough for government work
"Government work"???
Close enough.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by MachineGhost » Fri Mar 27, 2015 5:53 pm

That's why Motif is ideally suited.  You can rebalance up to 30 stocks/ETF's for $9.95 and do it by setting exact weight percentages.  And since you would need to rebalance annually to match a marketcap weighted fund's rebalancing frequency, that is really nothing.  However, Schwab does look superior at this point in terms of overall fees.  I'm not too familiar with their order management system -- anyone know if they have a portfolio rebalancing by weight feature?
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by MachineGhost » Fri Mar 27, 2015 5:56 pm

Kbg wrote:
MachineGhost wrote:
Kbg wrote: I must not be understanding your first post as it sure seems to me a 50/50 split is good enough for government work
"Government work"???
Close enough.
Explain what the hell you mean?
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by Dieter » Fri Mar 27, 2015 9:56 pm

sixdollars wrote: MG,

Great work, the only qualm I have with implementing something like this is that adding 2 to 3 more funds feels like a big hit to re-balancing simplicity.  If you find any way to implement this with less (i.e. two funds), please let me know :)

I'm mostly invested in VTSAX for my stock portion of the portfolio at the current time.
I don't have the fancy tools, but per free MorningStar Portfolio X-Ray:

VTSAX: 40% (VG Total Stock Market)
VEXAX: 60% (VG Extended Market)

Gives:
Large: 33%
Mid:    36%
Small: 31%

Or:
38/34/27 if replace Total Stock with VLCAX (VG Large Cap Index)
34/32/34 with 40% VLCAX Large Cap Index; 60% VSMAX Small Cap Index

Far from exact, but closer in two funds and more balanced cap-wise than total by itself... (73/18/9 per MorningStar)
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by MachineGhost » Sat Mar 28, 2015 5:49 pm

I thought that was interesting.  I've taken out Mega/Large in a backtest from 1972 to 2014 to see their contributions towards returns:

[align=center][img width=800]http://i.imgur.com/qmPoTXz.png[/img][/align]

The EW PP weights were:

Mega    0%
Large    0.29%
Mid    17.20%
Small    20.00%
Micro    20.00%

Difference from 100% in T-Bills.  So basically all market caps other than Mega/Large contribute 94% vs long-term market cap weighted returns.  Mega/Large contributes only 6%.  Too bad I can't eliminate Mega only.  That might have been a bigger eye opener.
Last edited by MachineGhost on Sat Mar 28, 2015 5:57 pm, edited 1 time in total.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by Greg » Wed Apr 08, 2015 11:59 am

MachineGhost wrote:
Kbg wrote:
MachineGhost wrote: "Government work"???
Close enough.
Explain what the hell you mean?
Good enough for government work definition:

sufficiently close; done just well enough. (Alludes to the notion that work for the government is not done with care or pride.)
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by Kbg » Sun Apr 12, 2015 3:28 pm

1NV35T0R (Greg) wrote:
MachineGhost wrote:
Kbg wrote: Let's go with sufficiently close...vice the rest.

Close enough.
Explain what the hell you mean?
Good enough for government work definition:

sufficiently close; done just well enough. (Alludes to the notion that work for the government is not done with care or pride.)
"I didn't do the best job of mending your shirt, but it's close enough for government work."
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by fi50@fi2023 » Sun Apr 12, 2015 3:41 pm

I use the Paul Merriman "Ultimate Buy and Hold Portfolio" for my equity component.  It is equal weighted between US/International and diversified between, large, large value, small, and small value.  I use the "aggressive" split, which does not include any bond/cash allocation, since I address those needs elsewhere.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by ochotona » Sun Apr 12, 2015 4:15 pm

At Schwab, no portfolio rebalancing by weight feature. But if you write a paragraph or two describing the features you'd like to see, I will forward it to their customer service for consideration. I think it would be a great thing. I have found bugs in their software, and they are quite godd at fixing them quickly based on user feedback,so I know they listen.
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Re: How to Fix the Flawed Tilt with the PP's Equity Component

Post by ochotona » Mon Apr 13, 2015 6:54 am

I was on Schwab today, and submitted this email to their team for MachineGhost and the rest of us:

Product suggestion, intelligent.schwab.com

Product concept: Schwab intelligent no-cost robot-advised portfolio rebalancing and tax-loss harvesting for the self-directed investor"

An interesting way make a new service offering by "dumbing down" intelligent.schwab.com would be to allow the customer to design his or her own portfolios with fixed percentages of their own selected ETFs... then, if the portfolio drifts off the allocation, it would adjust in as tax-efficient a manner as possible.

The rebalancing should be able to be specified as follows:

- at customer supplied fixed time intervals (specified in months)
- when any rebalancing bands are crossed, also customer sepcified; for example, if the initial allocation for SCHZ is 25%, the customer could order the entire portfolio to rebalance is SCHZ drops above or below some percentage, like plus-minus 2, 5, 10, 15 %. The initial allocations and rebalance bandwidths would be custom for each ETF, of course

Thanks for you responsive service on Schwab software bugs in the past. I have report a big one in the past, and you fixed it quickly. I hope you will take a look at this suggestion.
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