This month the Fed signaled its confidence in the U.S. economy, as the FOMC continued with its plan for unwinding its bond purchase program, known as quantitative easing. The decision to raise key interest rate by 0.25% in June, signaled a strengthening economy, prompting investors towards global diversification in search of yield. This month’s issue of The Samra Report will focus on the dangers of over-diversifying, the need for global diversification, and how investors should allocate their portfolio’s 8 years into a bull market.
Financial advisors have for years, educated their clients on the benefits of diversification, as part of a sales process. However, many financial advisors lack a fundamental understanding of Modern Portfolio Theory, resulting in over-diversification: “Over-diversification occurs when the number of investments in a portfolio exceeds the point where the marginal loss of expected return is greater than the marginal benefit of reduced risk.” When adding individual investments to a portfolio, each additional investment lowers risk but also lowers the expected return,” essentially watering down returns. Modern Portfolio Theory (and the Markowitz Efficient Frontier) suggests an investor can only lower their investment risk to a certain point, beyond which there is no further benefit from diversification. As a matter of fact, an investment of one share in each of the top 5 mutual funds by asset size, would create an investment portfolio worth approximately $355.00, and would invest in over 26,000 investments, providing a lower return than the comparable benchmark. This widely unknown case of over-diversification plagues client portfolios, as financial advisors typically do not build or manage client investment portfolios, however, they assess the clients risk profile and select pre-constructed investment allocations. Essentially, off the shelf investments, deemed suitable for all clients within a specific risk profile sleeve. At Samra Wealth Management, no two clients have identical portfolios. The rationale behind individualized portfolio construction and management comes down to market timing. Although it is possible for two clients to have similar needs, expectations, and appetite for risk. It is improbable these clients would enter the market during the same market cycle. This flaw is prevalent amongst passive investment themes, as client funds are invested into a mutual fund, regardless of the price of the underlying securities within the mutual fund. This investment strategy, or lack of strategy, can cause an investors to purchase assets at inflated prices. At Samra Wealth Management, our portfolios are researched based, and aim to capitalize on factors effecting the macroeconomic landscape.
As the S&P 500, NASDAQ and the Dow hover around all-time highs, at Samra Wealth Management, we emphasize the need for global diversification in select markets. In recent weeks we have seen Moody’s downgrade Australian and New Zealand banks on increased housing risk, downgrade China on mounting debt, and a weakening Yen. These unfavorable conditions are not only concentrated to Asia, however, spill over into Europe and Latin America: A weakening Swiss Franc, lower U.K. earnings expectations as the likely outcome of Brexit discussions will be unfavorable to Britain. Although political uncertainty has calmed in recent months throughout the EU, Latin America continues to be plagued with corruptions and uncertainty. It is important to remember that volatility and uncertainty are not necessarily always negative, as they can create opportunity. For instance: with the Nikkei rising, investors in Japanese equities would expect to see their gains cannibalized as the Yen weakens against the greenback. However, investors placing these trades on a currency hedged basis would see a rise in the Nikkei magnified through the currency hedge. We expect to see above average growth in India and China, as a growing middle-class with increasing incomes contributes to a greater degree towards GDP. With growth in entrepreneurship and workforce mobility, technology utilization creates greater opportunity in the small and micro-cap space. Furthermore, with India on track to implement GST July 1st, this single tax on the supply of goods and services looks to provide stability, structure, and increased tax revenue. China, meanwhile has proven to be a global customer, as it is not only the largest consumer of coal, iron ore, and aluminum, however, their growing middle-class may be able to save Hollywood as American consumers migrate towards online streaming platforms. China now accounts for 48.6% of the worldwide revenue for the top 7 films released in the first 9 weeks of 2017, adding up to $983 million or a total $1.69 Billion. What is more astonishing, is U.S. Box Office only accounted for $216 million, or 22% of China’s $983 million. As the U.S. economy starts to lose steam, American’s will see more companies catering towards a global consumer, specifically those of India, China and Spanish speaking countries.
With U.S. equity volatility at all time lows, financial advisors and investors should rethink their investment philosophies. For the most part, the largest wire houses use a cookie-cutter approach. Placing their clients into risk profile sleeves, from conservative to aggressive. However, this passive investment strategy comes with a caveat: as investors lose out to opportunity cost. There are more variables effecting the financial markets then most investors are aware, and although there is no crystal ball for predicting financial risk and returns, using a research based investment philosophy can highlight areas of opportunity. For example, bad weather from Southern California to Texas, causes wind turbines to create more electricity from wind, scaling back the demand for natural gas, pushing down prices. Longer winters create increased demand for winter clothing, increasing earnings of retailers, however, have an adverse effect on local travel, decreasing the demand for oil, pushing down prices of WTI, correlating to a decrease in the value of oil producers. In using this research, we aim to invest more aggressively when we believe equities are trading below fair valuations, and decrease portfolio equity weighting when we believe valuations may have little upside. Investors should expect more from their financial advisors, as the opportunity cost of investing in a conservative 10-year treasury note would yield an investor a negative 2.39% over the last year, whereas a portfolio equally weighted over the 30 largest U.S. corporations would have returned 23.43%. The table below quantifies this difference in returns, along with returns from the other major benchmarks:
It is important for investors to remember, a conservative allocation does not mean investor will not sustain loses, however, correlates to the amount of volatility a single holding, or portfolio experiences. For example looking at the table above, one of the most conservative investments: the 10-Year Treasury Note returned a negative 2.39%, with minimal fluctuations. An investment in the Dow Jones Industrial Average Moderate Index, would have returned 10.90% over the last year, by taking only 58% of the risk of the S&P 500. In comparison, and theoretically speaking, an investor would double their investment with the moderate portfolio 10-years sooner.
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All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. All economic and performance data is historical and not indicative of future results. All views/opinions expressed herein are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. The information and material contained herein is of a general nature and is intended for educational purposes only. This does not constitute a recommendation or a solicitation or offer of the purchase or sale of securities. Before investing or using any strategy, individuals should consult with their tax, legal, or financial advisor
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