The Fundamentals
of Asset Class
Investing
Solving the Investment Problem
The first goal of your financial plan should be to
avoid outliving your money.
Investing Is About You
We Are Living Longer
No matter what your age, you can expect to live much longer than the generations before you. For example, the typical 65-year-old couple today has a 30-year joint life expectancy, meaning there is a high probability that at least one of them will live to age 95. Moreover, there are more people living to the age of 100 than ever before.
This Increased Longevity Has Important Financial Implications
Obviously, if you’re living longer, your money needs to last as long as you do! Therefore, the first goal of any financial plan should be to avoid outliving your money.
People aren’t just living longer, they are healthier and more active than previous generations. Many retirees participate in recreational activities, get involved in volunteering, or even enjoy a second or third career. All of this should be taken into account within your plan.
How you choose to invest your money for the long term could have major implications for your overall success. We believe there are two important decisions that can help you lay a strong foundation for your future.
Two Fundamental Ways to Invest: Active and Passive
Active Management
Active managers try to beat the market by buying what they believe to be the “right” investments, avoiding the “wrong” ones, and by market timing (getting in and out of the market at the “right” time).
Passive Management
Passive managers don’t try to beat the market, but aim to capture the market’s returns. They seek to maximize diversification and focus on keeping costs low in order to achieve greater potential returns.
Active vs. Passive Investing
Active Managers Have Had a Difficult
Time Beating Their Benchmarks
This study by Standard & Poor’s looked at the performance of active mutual fund managers over the last 10 years (through 2018) versus Standard & Poor’s Indices. As you can see, over the 10-year cycle the percentage of active managers who beat their respective benchmarks was very low.
This does not mean active investing cannot beat the market — it can. In the last 10 years, 16% of U.S. stock managers who tried to predict the market beat the index, while 84% did not. The challenge is, active investing beats the market a minority of the time, which makes it hard to deliver the market returns that are the foundation of your plan.
If your plan is built using historical market return assumptions, and this is the outcome for active managers, would you implement your plan with these odds?
Investors Have Increasingly Embraced the Passive Approach
While active management has been the historical standard on Wall Street, investors are beginning to realize the opportunities and possible advantages of passive investing. Starting from 0% of total assets under management in 1970, passive funds have become more popular in recent years, rising from just 3% of the market in 1993, to nearly 37% in 2018.
The total amount invested passively today tops $6 trillion. With strongly positive asset flows into passive investing, and actively managed funds seeing net outflows from 2016 to 2018, it’s clear investors have begun to realize the differences between the two.
The Differences Between Asset Class Investing and Indexing
Once you have decided on a passive approach to investing, you still have to make one more decision.
Index investing and asset class investing are two ways to implement a passive investing approach. While they have similarities — like diversification and tax efficiency — there are important differences.
Asset class investing is based on asset classes — groups of securities with similar risk characteristics, like small company stocks, large company stocks, and international bonds. Asset class investing attempts to capture the performance of a specific market segment, while index investing attempts to replicate the performance of an index. Depending on how asset classes are determined, they may have returns that underperform index benchmarks at times.
Key Similarities and Differences Between Index and Asset Class Investing
The Asset Class Difference
Precision
Asset class investing seeks to maintain a consistent risk exposure to a given market segment. The companies included in that market segment change over time, and an asset class is updated to reflect that in real time. Some companies may appear to be a part of a market segment, but they may not have the same risk characteristics, so they may be excluded from an asset class.
Index funds, on the other hand, are only intended to replicate a market segment, and as such they don’t exclude companies based on risk. Additionally, most index funds update their portfolios as infrequently as once a year, so they aren’t as “real time” in updating the companies that make up the market segment.
Examples of the types of securities asset classes may exclude are:
- Highly regulated utilities
- Investment funds
- REITs
- Recent IPOs
- Share classes with foreign restrictions
- Extreme financial distress or bankruptcy
- Merger or target of acquisition
- Insufficient liquidity
S&P 500 data source: Anthony Lynch and Richard Mendenhall, “New Evidence on Stock Price Effects Associated with Changes in the S&P 500 Index,” Journal of Business 70, no. 3 (July 1997): 351-83. MSCI EAFE Index data source: Rajesh Chakrabarti, Wei Huang, Narayanan Jayaraman, and Jinsoo Lee, “Price and Volume Effects of Changes in MSCI Indices: Nature and Causes,” Journal of Banking and Finance 29, no. 5 (May 2005): 1237-64. For illustrative purposes only. Past performance is not a guarantee of future results. Indexes are unmanaged baskets of securities in which investors cannot directly invest; they do not reflect the payment of advisory fees or other expenses associated with specific investments or the management of an actual portfolio.
Flexibility
Have you ever needed to take a flight at the last minute? Not only do you experience the frustration of limited flight options, but then there is the added expense. The same may be true of investing. Asset class funds have the kind of flexibility you wish you had when booking a last-minute flight. Asset class fund managers can trade when they can get the best price, both when they are buying and selling; index fund managers must buy a stock or bond only on the day it’s added to the published index.
In fact, all index managers must do all trades on the same day, which may result in paying a higher price due to the short-term demand for the security. (See the chart for how changes to the index can affect pricing.)
Factors of Return
Drawing on years of investing research, including the work of 11 Nobel laureates, asset class investing pursues the known factors of return when constructing funds. These factors include size, value, and profitability. Investors — with the help of their financial advisors — need to decide how much exposure to these dimensions of return they are comfortable with, keeping in mind that the greater the expected long-term return, the greater the potential risk exposure.
Stock Factors of Return
A Portfolio for the Long Term
When you are investing for up to a 30-year time horizon with a goal of not outliving your money, your implementation plan can be very important. Whatever happens in the economy and in markets over that time — recessions, recoveries, bear or bull markets — your portfolio has to be able to provide you with income.
So how do you put the odds in your favor?
If you simply invested all your money in a “market” index fund that tracks the S&P 500, you could miss out on the potential long-term benefits of a globally diversified asset class portfolio.
Let’s see what the potential results could be for a newly retired couple…
How can your portfolio increase your chances of retirement success?
Source: Morningstar Direct 2019. Investors cannot invest directly in an index. Indexes are unmanaged and reflect reinvested dividends and/or distributions, but do not reflect sales charges, commissions, expenses or taxes.
The portfolio allocations are based on a Loring Ward model portfolio, which may not be suitable for all investors. It may not reflect the impact material economic and market factors might have had on decision-making if clients’ money were actually being managed at that time.
The performance data quoted represents past performance. Past performance does not guarantee future results. Portfolio returns are the weighted average returns of the respective funds, rebalanced annually. Actual rebalancing may be different. The performance quoted reflects the reinvestment of dividends and capital gains distributions.
Portfolio returns are after fund’s internal expenses and Loring Ward’s max investment management fee of 0.90% for all periods prior to April 1, 2017 and of 0.65% after April 1, 2017. Management fee may be lower depending on the assets under management. Portfolio performance does not reflect the deduction of any fees charged by an independent investment advisor or other service provider to an individual account. Such fees, if taken into consideration, will reduce the performance quoted above. The model performance information reflects various allocation changes made over time. Therefore, the underlying mutual funds used in calculating the portfolio performance may not represent the trailing returns of portfolios and/or the mutual funds currently available.
Diversification neither assures a profit nor guarantees against loss in a declining market.
International markets involve additional risks, including, but not limited to, currency fluctuation, political instability, foreign taxes, and different methods of accounting and financial reporting. As a result, they may not be suitable investment options for everyone.
How Do Returns Compare?
Let’s look at an example of a globally diversified asset class portfolio — in this case a “moderate” portfolio that is 65% stocks and 35% bonds — and compare it to the S&P 500 from 2000 through 2018, one of the worst times to start investing since there were two major market corrections and a recession.
Over this time period, the Moderate Risk Portfolio had an annualized rate of return of around 4.92%. The S&P 500 returned 4.86% per year. In addition, there was less volatility (ups and downs in price) in the asset class portfolio than in the S&P Index: 12.74% versus 17.65%.
Asset class investing and diversification do not guarantee a gain or protect from a loss. Utilizing asset class investing involves risks, including the loss of principal, that cannot be guaranteed against loss by a bank, custodian, or any other financial institution.
Source: Morningstar Direct 2019. Hypothetical value of $500,000 invested on January 1, 2000, and kept invested through December 31, 2018. Withdrawal is 5 percent of initial hypothetical value ($25,000 of initial $500,000 starting value) taken out at the start of each year, growing by 3% per year. Investors cannot invest directly in an index. Indexes are unmanaged and reflect reinvested dividends and/or distributions, but do not reflect sales charges, commissions, expenses or taxes.
The performance data quoted represents past performance. Past performance does not guarantee future results. Portfolio returns are the weighted average returns of the respective funds, rebalanced annually. Actual rebalancing may be different.
The portfolio allocations are based on a Loring Ward model portfolio, which may not be suitable for all investors. It may not reflect the impact material economic and market factors might have had on decision-making if clients’ money were actually being managed at that time. The performance quoted reflects the reinvestment of dividends and capital gains distributions. Portfolio returns are after fund’s internal expenses and Loring Ward’s max investment management fee of 0.90% for all periods prior to April 1, 2017 and of 0.65% after April 1, 2017. Management fee may be lower depending on the assets under management. Portfolio performance does not reflect the deduction of any fees charged by an independent investment advisor or other service provider to an individual account. Such fees, if taken into consideration, will reduce the performance quoted above. The model performance information reflects various allocation changes made over time.
Therefore, the underlying mutual funds used in calculating the portfolio performance may not represent the trailing returns of portfolios and/or the mutual funds currently available.
Most Investors Need Their Portfolios to Provide Income in Retirement
Most retirees need to make regular withdrawals from their portfolios to sustain their lifestyle. This is why your portfolio should be able to sustain regular withdrawals throughout your retirement.
Using the same portfolios over the same time period (2000-2018), let’s consider a newly retired 65-year-old couple with a $500,000 portfolio.
At the start of every year, they withdraw 5% of the initial value ($25,000 of initial $500,000 starting value). This withdrawal is increased 3% each year to help the couple’s income keep pace with inflation.
By 2018, the 65% stocks/35% bonds portfolio would be worth $237,239 (and this is after withdrawing $627,922 in income).
Meanwhile, the S&P 500 portfolio ran out of money.
What Asset Class Investing Can Offer
When it comes down to it, we think there are two numbers that matter above all else: 1 and 30. You may only have 1 chance to put together an investment plan that will last you 30 or more years in retirement.
You need an approach that you can believe in and understand, one based on research, analysis, and evidence — not luck or prognostication.
Asset class investing can offer:
- Low overall costs
- Tax efficiency
- Global diversification
- Consistent risk exposure to an asset class
- Long-term performance that can potentially outperform index returns
Because you can’t control the market, you need a plan that gives you the highest probability of being able to achieve your long-term goals. Do this by using asset class investing, along with the guidance and experience of a dedicated financial advisor.
Asset class investing does not guarantee a gain or protect from a loss and involves risks, including the loss of principal.
Data Appendix
Standardized Performance Data
Source: Morningstar Direct. Data as of December 31, 2018.
Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission and is unaffiliated with Loring Ward.
Consider the investment objectives, risks, charges and expenses of the funds listed carefully before investing. The prospectus and, if available, summary prospectus, contain this and other information about the funds.
To obtain a DFA Funds prospectus, summary prospectus, additional information about the DFA Funds, or performance data current to the most recent month-end, please call Dimensional Fund Advisors collect at 512-306-7400 or visit www.dimensional.com.
Please read the prospectus and summary prospectus carefully before investing.
Performance Disclosures
* The fund’s prospectus contains more information on fees and expenses.
The performance data quoted represents past performance. Past performance does not guarantee future results, and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance information quoted. To obtain current month-end performance information, please call, toll free, 1-800-366-7266.
Portfolio returns are the weighted average returns of the respective funds, rebalanced annually. Actual rebalancing may be different. The portfolio allocations are based on a Loring Ward model portfolio, which may not be suitable for all investors. It may not reflect the impact material economic and market factors might have had on decision-making if clients’ money were actually being managed at that time. The performance quoted reflects the reinvestment of dividends and capital gains distributions. Portfolio returns are after fund’s internal expenses and Loring Ward’s max investment management fee of 0.90% for all periods prior to April 1, 2017 and of 0.65% after April 1, 2017. Management fee may be lower depending on the assets under management.
Portfolio performance does not reflect the deduction of any fees charged by an independent investment advisor or other service provider to an individual account. Such fees, if taken into consideration, will reduce the performance quoted above. The model performance information reflects various allocation changes made over time. Therefore, the underlying mutual funds used in calculating the portfolio performance may not represent the trailing returns of portfolios and/or the mutual funds currently available.
Risk Disclosures
Diversification and implementing an asset class or market-based investing strategy does not guarantee a profit or protect from a loss. All investing involves risk, including loss of principal.
Stock investing involves risks, including increased volatility (up and down movement in the value of your assets) and loss of principal. Securities of small companies are often less liquid than those of large companies. As a result, small-company stocks may fluctuate relatively more in price.
International and emerging market investing involves special risks such as currency fluctuation and political instability, and may not be suitable for all investors.
Bonds (fixed income) are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and as issuer’s creditworthiness declines, and are subject to availability and changes in price. REIT investments are subject to changes in economic conditions and real estate values, and credit and interest rate risks.
Additional Information for Data and Charts on Previous Pages
Page 1
Source: Social Security Administration period life table
Page 4
Percentage of Active Funds That Outperformed Their Index 2009-2018
Source: Standard & Poor’s Indices Versus Active Funds
Scorecard (SPIVA), 2019.
Index used for comparison: U.S. Equities — The S&P 1500 Index: The S&P Composite 1500® combines three leading indices, the S&P 500®, the S&P MidCap 400®, and the S&P SmallCap 600® to cover approximately 90% of the U.S. market capitalization. It is designed for investors seeking to replicate the performance of the U.S. equity market or benchmark against a representative universe of tradable stocks. International — The S&P 700 Index: The S&P 700 measures the non-U.S. component of the global equity market through an index that is designed to be highly liquid and efficient to replicate. The index covers all regions included in the S&P Global 1200 except for the U.S., which is represented by the S&P 500®. Emerging Markets — The S&P/IFCI Composite Index: The S&P/IFCI is a liquid and investable subset of the S&P Emerging BMI, with the addition of South Korea. While the S&P Global BMI and S&P Frontier BMI are designed as comprehensive benchmark indices, the S&P/IFCI indices are designed to be sufficiently investable to support index tracking portfolios. The S&P/IFCI has a long and established history going back to 1988. U.S. Fixed — Government Short, Barclays 1-3 Year Treasury Bond Index: The index measures the performance of U.S. Treasury securities that have a remaining maturity of at least one year and less than three years. Global Fixed — Global Income Funds, Barclays Global Aggregate Index: The Barclays Global Aggregate Index is a flagship measure of global investment-grade debt from twenty-four different local currency markets. This multi-currency benchmark includes fixed-rate treasury, government-related, corporate and securitized bonds from both developed and emerging markets issuers.
Outperformance is based upon equal weight fund counts.
Page 6
Active/passive as determined by Morningstar database.
Page 10
As of December 31, 2018. Monthly data, June 2006-December 2018. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes.
The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
Page 12
The MSCI EAFE (Morgan Stanley Capital International Europe, Australasia, Far East) Index is an unmanaged index comprising
over 1,000 companies representing the stock markets of Europe, Australia, New Zealand and the Far East.
The S&P 500 Index (Standard & Poor’s) 500 Index is an unmanaged market value-weighted index of 500 stocks that are traded on the NYSE, AMEX, and NASDAQ.
Page 16
Allocation is 100% S&P 500 TR, and 65/35 mix represented by: 2% (Cash), 16% (DFA One-Year Fixed Income DFIHX), 17% (DFA 5-Year Global DFGBX), 15% (DFA US Core Equity 1 DFEOX), 12% (DFA US Large Cap Value DFLVX), 8% (DFA US Small Cap DFSTX), 4% (DFA REIT DFREX), 14% (DFA Intl Value DFIVX), 7% (DFA Intl Small Cap DFISX), 5% (DFA Emerging Markets Value DFEVX).
Pages 18-19
Allocation is 100% S&P 500 TR, and 65/35 mix represented by: 2% (Cash), 16% (DFA One-Year Fixed Income DFIHX), 17% (DFA 5-Year Global DFGBX), 15% (DFA US Core Equity 1 DFEOX), 12% (DFA US Large Cap Value DFLVX), 8% (DFA US Small Cap DFSTX), 4% (DFA REIT DFREX), 14% (DFA Intl Value DFIVX), 7% (DFA Intl Small Cap DFISX), 5% (DFA Emerging Markets Value DFEVX).