Academic research has shown that asset allocation makes the biggest difference in long-term returns from investment portfolios. A key to allocation is the selection of the portfolio’s component investments from thousands of options.At the 2018 investment outlook seminar for Landaas & Company clients, Kyle Tetting explained the importance of selection and what he looks for as research director. A transcript of his presentation (edited for length) follows.

Kyle Tetting: My job at the firm is kind of to go through the investment options that are available to us, to take the conversations really that we have as a firm – in this room but also in the weekly meetings we have and conversations we have with investment professionals around the world – to get a better idea for all of you about what that actually means in terms of how you invest.

There’s a lot of ingredients to portfolio construction. There’s a lot of things that we could use for you. And the challenge, of course, is how do we get that list down? And that’s where that first piece of asset allocation comes in.

We know that academic studies that asset allocation is 90% or more of the variability of portfolio return. It’s 90% of the difference between one portfolio and another. That’s not stock selection. That’s not market timing. All those pieces add a little bit of value, but if all we do is look at how was one portfolio allocated – stocks, bonds, non-U.S. stocks, all the different pieces you can put in it, vs. another portfolio – 90% of the difference. Purely asset allocation.

But, selection matters. Selection informs all those other pieces. Selection is the building block for asset allocation.

So, the first step here is to look at what are we trying to buy? Are we trying to buy stocks or we trying to buy bonds? Are we trying to buy U.S. stocks or non-U.S. stocks? Those are the asset class decisions.

But there’s also some style decisions. Are we trying to buy those high-quality bonds that Bob talked about, the stuff that tends to be a little more stable, or are we maybe shopping for lower-quality stuff because there’s opportunity?

And so you know, we can get that list down maybe to a couple of hundred names pretty quickly just by saying, OK here’s what we’re actually looking for now.

And then the challenge becomes how do we get it from a hundred names down to the one or two that we might actually use for you? And so, it comes down to a lot of quantitative factors. Right?

What is the actual cost of this fund? We know that if you have two identical investments, the lower cost investment is going to be the one that performs better. And of course, the challenge there is show me two identical investments, and the reality is that that doesn’t exist.

So it’s more than just cost. Cost maybe is the most important stand-alone factor when you’re looking to pick something, but there are more.

And so we look at historical risk and return. And a big asterisk on that historical risk and return: “Past performance not indicative of future results.” That’s the piece that tells us we can’t just look at historical returns and say this is what we should expect. But the returns are what actually influence how we determine whether or not a manager has skill.

A couple of other pieces we can measure quantitatively:

  • How do they look relative to their peers? And in particular, in good years and in bad years how do they look relative to their peers? Because that tells us a little bit about what their management style is. A fund that does really, really well in bad years relative to their peers is probably going to be a little more defensively positioned historically than, you know, the fund that’s doing a little bit more poorly in bad years.
  • And then, of course, capture ratio is a way for us to say in those good and bad markets how much of the return are those managers actually capturing?
  • And last, and I think most important, on this list is how consistent are those returns? You want to know that the things that build your portfolio are going to be there for you when you need them to be there for you.

If we look at the qualitative factors, the actual quality of the underlying management of those investments, that’s the piece where we can really start to add some value.

Anybody can look at those historical data points and say, yeah this looks like a great fund. It doesn’t tell you much about skill vs. luck. It’s all this other stuff that tells you OK, is there actually some skill here? Are we actually adding some value?

And so most importantly, is there a consistent and articulate strategy to this particular investment? We’re pretty clear on what it is we’re doing for you, that you have some objective and we have some strategy to obtain that objective. It’s really difficult to be a successful investor if you don’t know what you’re trying to accomplish.

It’s really difficult to be a successful investor if you don’t know what you’re trying to accomplish.

And so that’s always the first step when we have conversations with management teams. We talk to a number of our portfolio managers pretty regularly to get an idea of, you know, how they view the world, what investments look like right now. And communication really is key to all of that.

Communication isn’t just those conversations it’s shareholder letters, annual reports, semi-annual reports, even just reading an interview that happened with one of the managers you’re working with. Those can all be very useful tools.

We’re really looking for companies and investments that align their interests with all of our interests.

We want investment managers that invest in their own funds alongside of all of you that are investing in those funds. We want funds that are going to close to new investors when the assets get so large that they can no longer manage them. And there’s a really good study, actually a couple of studies out there that point to the two determining factors in outperformance for mutual funds being the alignment of shareholder interests with the management of the fund and cost. Those two things seem to drive much of the outperformance.

The last piece on this list: Return attribution. It’s this idea that returns and risk in your investments come from somewhere. And how do we attribute where that risk and return came from? The point of this is that that piece allows us to verify all the other stuff that we’ve looked at: That the returns are actually coming where the managers say they’re coming from; that the risk is actually coming from where the managers are saying it’s coming from.

Learn more
Mutual Fund 101, a Money Talk Video playlist
Talking Money: Allocation, a Money Talk Video with Kyle Tetting
Making the most of mutual fund fees, a Money Talk Video with Isabelle Wiemero
Sorting through investment fund managers, a Money Talk Video with Kyle Tetting
Investment results: Success or luck? a Money Talk Video with Kyle Tetting

You know, the communication piece informs that attribution. So if we’ve got a large-cap value manager, you know, traditionally managing utilities and financials and those dividend-paying stocks that are supposed to be the bedrock of your portfolio, at least on the stock side. And they’ve had a really great year. Now we want to look at why they had a great year. And that’s where attribution comes in.

So as we look to kind of build your portfolios, as we look to build portfolios more broadly, those are the pieces that, you know, I think really make it better than just average.

And I think that’s the key here is it’s really easy to say the average fund isn’t going to outperform the index. It’s really easy to say that it’s difficult to beat the benchmark. But the reality is that if you look at just a few key pieces and really study them hard and really engage with those investments that you’re making, you don’t have to beat it by much, but you can beat it by enough.

So, done poorly it can be difficult to assess the sources of return. It can be difficult to assess how well you’re actually doing – when you don’t have that clear strategy, when you don’t have consistent communication about what’s going on. But done well, that selection piece is the piece that informs everything else we do.

Kyle Tetting is director of research and an investment advisor at Landaas & Company.

(initially posted Sept. 24, 2018)

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