Is there an efficient frontier for including smaller companies alongside an index fund?

aroominyork

Thrugelmir said:

Bonds in more recent decades of portfolio management have provided diversification. In that when equities fell , bonds rose in considerably in value. With the auto rebalancing of funds such as VLS60 and 80 ( in the USA).  "Expensive" bonds were exchanged for "cheap" equities. A forumula that worked for some decades. Now that link is irretrievably broken. The trade is over. 

Why do you say "irretrievably" broken? Is there evidence for that?

Thrugelmir said:

For a portfolio to be diversified. The holdings need to be uncorrelated.    If many of the US small caps you've invested in are Apple suppliers then there's far less diversification than initially appears to be the case. Likewise your portfolio will be impacted by wild swings in the £- $ exchange rate or changes to US corporation tax rate policy. 

Yes, but this isn't about diversifying the portfolio, it's about diversifying within equities and whether small caps might reduce risk while adding to returns Though as FeralHog also pointed out, diversifying within equities cannot be wholly separated from diversifying within the overall portfolio...

Deleted_User said:

... if small-cap equities offer higher risk / higher expected return than equities generally, then increasing the small-cap equities allocation could be combined with reducing the overall equities allocation (and putting more in high-quality bonds).

... and there has been plenty of discussion recently about how to construct a portfolio since the historic equities/bonds formula isn't working well these days. A different take would be that with a lack of clear fixed interest options, it would be better to have a higher equity allocation using funds with lower risk/lower return expectations, and less in fixed interest.

I watched a Jack Bogle video yesterday (I just can't get enough of him) and, with rock bottom interest making making gilts/treasuries unattractive, he favoured investment grade short-dated corporate bonds for fixed interest.

Michael121

jamesd said:

It's drawdown-specific but it might be of interest to read Small-Cap Withdrawal Magic which found a significant increase 

A more up to date version. https://rationalreminder.ca/podcast/135 I think they were talking about USA small cap not global small caps. Also ben said USA value small cap but didn't get specific.

Thrugelmir

Some might say hibernating not dead. If interest rates do eventually normalise and again offer above inflation rates of return.  

Whatever form you hold US shares in. The prime consideration has to be the total exposure to the US $ across your entire portfolio. As a softening $ won't discriminate. The value of all holding will fall in unison. If you added European small caps or Japanese mid caps, (for example) then you would be increasing equity diversfication. 

You do realise that Jack bogle died in January 2019. Any viewpoint needs to be considered in relation to the markets at the time the interview was recorded. Not years later. 

maxsteam

aroominyork said:

maxsteam said:

If you are looking for least risk, you should stick to bonds...

No, that's the whole point of the efficient frontier data. Although bonds are less risky than equities, an 80/20 portfolio is less volatile than a 100% bond portfolio.

Bonds are both less risky and less volatile than equities. The higher the proportion of equities, the higher the volatility and the higher the risk. BS about final frontiers wont change this.

aroominyork said:

 ... and definitely avoid small companies.

I've just presented data that contradicts that. Look at the data instead of what you assume 'must' be right.

Your "presentation" confirms that small company equities are more volatile that large company equities, generally falling more and rising more. Volatility and risk are strongly related concepts.

aroominyork said:

maxsteam said:

Your post seems to make the false assumption that risk can be avoided by dividing your portfolio into certain ratios.

Reduced, not avoided. It's called diversification.

What is an acceptable level of risk for you, is not acceptable to others. The 80:20 split is popular now, and if you are happy to follow what's popular, that's fine. It's not a magic ratio and just because it's often wrapped up in fancy language does not make it right. I prefer to make my own mind up about what is an acceptable level of risk for me.

aroominyork

maxsteam said:

aroominyork said:

maxsteam said:

If you are looking for least risk, you should stick to bonds...

No, that's the whole point of the efficient frontier data. Although bonds are less risky than equities, an 80/20 portfolio is less volatile than a 100% bond portfolio.

Bonds are both less risky and less volatile than equities. The higher the proportion of equities, the higher the volatility and the higher the risk. BS about final frontiers wont change this.

"Bonds are both less risky and less volatile than equities." Correct, usually.

"The higher the proportion of equities, the higher the volatility and the higher the risk. BS about final frontiers wont change this." Wrong. It depends on the time frame but there is analysis behind the concept of the efficient frontier.

maxsteam said:

Your "presentation" confirms that small company equities are more volatile that large company equities, generally falling more and rising more. Volatility and risk are strongly related concepts.

Yes, and what the FE data shows is that adding some higher volatility smaller company funds to a lower volatility index fund can result in a portfolio which has the same or sometimes lower volatility than the index fund. By all means challenge it, but challenge it based on the data instead of "surely that can't be true!"

masonic

I think the more palatable conclusion is that the inclusion of smaller companies could allow someone to increase their % equities by say 5%, without increasing volatility, or decrease their % equities by a similar amount without compromising their returns.

I've lost track who introduced the idea that smaller companies could be used to completely replace bonds in a portfolio, but I don't think anyone would argue that is a sensible thing for normal investors to do.

Prism

Here are Terry Smiths thoughts on the matter.

Fundsmith > Smithson > Financial Times - Busting the myths of investment

Thrugelmir

Prism said:

Here are Terry Smiths thoughts on the matter.

Fundsmith > Smithson > Financial Times - Busting the myths of investment

Be interesting to hear an updated view. 3 years on.  Historic comments need to considered in context. Far too often immediately become gospel at a later date. 

jamesd

I just checked and 45% of my total pension investments are in small caps, split among global 19%, UK 23% and European 3%. Another 14% of pension value is outside the pension in VCTs, also smaller or micro companies.

Michael121 said:

jamesd said:

It's drawdown-specific but it might be of interest to read Small-Cap Withdrawal Magic which found a significant increase 

A more up to date version. https://rationalreminder.ca/podcast/135 I think they were talking about USA small cap not global small caps. Also ben said USA value small cap but didn't get specific.

It's an interesting discussion but not a research paper. Handy for anyone who hasn't listened to it already, though. Yes, it'd be US value small cap unless they use their Canadian home explicitly. Not really a surprise that value small cap might beat generic small cap given the long term good performance of value in general that hasn't been seen for a fair while now in the US.

On the bond discussion in this thread, Bill Bengen had this observation about them, which I already acted on a few years ago:

"Now we're a period of time where interest rates were low and capital appreciation bonds is probably going to be negligible from here, interest rates can't go much lower so that bonds no longer offer diversification. I think so that might be given to reducing bond allocations, at least temporarily until interest rates rise to more comfortable levels. Because they ain't doing much for you. In fact, they'll cause you to lose money, which is not happy."

aroominyork

Prism said:

Here are Terry Smiths thoughts on the matter.

Fundsmith > Smithson > Financial Times - Busting the myths of investment

You've made my day, Prism! 15-20% small caps give you the lowest risk, and 35% small caps gives you a better return than 0% small caps with no extra risk. And an efficient frontier chart to go with it. Well tickle my whiskers and call me Mary!