Tuesday, March 28, 2017

Equity Management #7 : Taking on more risk from a benchmark portfolio.

Most investors are normally fixated at their returns from ordinary asset classes. You take on the risk of equity for 8% returns and moderate your equity position with a bond position which is stable but only gives you only 2%.

Professionals don't have that luxury.

If market returns from equity are like an act of God then individual returns which deviate from the market benchmark would be the act of Man.

Professionals use Information Ratio (IR) as a measure of their skill - calculated by how much excess return (called alpha) is generated for each unit of residual risk. Most professionals get about 0.5 but an exceptionally good professional manager can get 1.0. As I still am not an accredited investor yet, I have yet to ask professional money managers what has been their information ratio for the past 5 years.

For the other readers, here how you take on increasing residual risk and subsequently have a bigger chance of outperforming or underperforming the benchmark :

a) Hold the STI ETF ( ES3 )

At the lowest level of residual risk, you hold the STI ETF and track is almost perfectly. The only tracking error you get is probably the amount paid to rebalance the portfolio when a new stock enters the index and a negligible management fee. If you just want to have average market returns, this is the best choice and supported by many financial bloggers.

b) Shift to an equal weightage STI portfolio

If you have more capital, you can hold each STI component stock in equal proportions. At this stage, your portfolio will no longer track the STI but you will no longer be over burdened with banking stocks and won't hold stocks based on how large STI companies are.

In the US, the equal weighted RSP index fund has outperformed the capitalisation-weighted SPY index for over a decade.

c) Smart Beta

If you want to take on more even more risk, you may wish to start looking at Smart Beta ETFs which will eventually show up in Singapore one day. One example of such an index is one which weighs each stock based on dividend yields or earnings yields (to exploit low PE outperformance). At this stage even more risk is taken and you stand a greater chance of deviating from the market benchmark.

Until the Smart Beta ETFs actually show up, you can take the counters in the STI ETF, take the reciprocal of the P/E value and own a proportion of stocks based on this earning yields number.

Eg. You will own twice as much stock with a P/E of 10 than a stock with P/E of 20.

d) Personal Active Management 

If you can stomach even more risk than that, you will get back to square one as there is a low of solid analysis on individual stocks in the financial blogosphere. You can just focus on stock picking and ignore the market benchmark altogether.

If you are a reader and an intermediate reader, you do not need to make the jump from buying and holding the STI ETF to owning a portfolio of individual stocks based on recommendations you read about.

There are intermediate means to contain your risk by varying the proportion of STI stock in your portfolio - Too bad the ETFs here have not evolved to that stage yet.

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