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

edited 6 September 2021 at 11:56AM in Savings & Investments
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  • bostonerimusbostonerimus Forumite
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    jamesd said:
    Prism said:
    For convenience: "there is no doubt that adding a small/mid-cap element to a portfolio can achieve the seemingly impossible feat of generating additional return whilst reducing risk ... if you changed 35 per cent ... of your portfolio to MSCI World Small Cap you would get a higher return for the same risk. For any lower percentage, the higher return would be accompanied by lower risk".
    And just for good measure, here is the efficient frontier graphic published in the Terry Smith article.



    Interesting. This plot is to the upper right of the well known US based plot for various S&P500 and US bond allocations, just as you might expect. ie higher potential returns with bigger SDs. Many people will focus on the greater returns possible and forget about the increased variation about the mean of those returns.
    So by combining the two graphs - and using the historic average efficient frontier curves - we learn that the lowest risk combination of equities and bonds is 80% bonds, 16% large cap; 4% small cap. Hands up anyone who holds that?
    Maybe we need to update things for a low interest rate environment.
    “So we beat on, boats against the current, borne back ceaselessly into the past.”
  • aroominyorkaroominyork Forumite
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    jamesd said:
    Prism said:
    For convenience: "there is no doubt that adding a small/mid-cap element to a portfolio can achieve the seemingly impossible feat of generating additional return whilst reducing risk ... if you changed 35 per cent ... of your portfolio to MSCI World Small Cap you would get a higher return for the same risk. For any lower percentage, the higher return would be accompanied by lower risk".
    And just for good measure, here is the efficient frontier graphic published in the Terry Smith article.



    Interesting. This plot is to the upper right of the well known US based plot for various S&P500 and US bond allocations, just as you might expect. ie higher potential returns with bigger SDs. Many people will focus on the greater returns possible and forget about the increased variation about the mean of those returns.
    So by combining the two graphs - and using the historic average efficient frontier curves - we learn that the lowest risk combination of equities and bonds is 80% bonds, 16% large cap; 4% small cap. Hands up anyone who holds that?
    Maybe we need to update things for a low interest rate environment.
    Yes, if you want to move away from historic data and guess what will happen in future. But say rates stay low, and bonds and equities are more positively correlated than in the past. Would you separate fixed interest into gilts/Treasuries and corporate bonds, with lower risk (estimate future SD) for the former and higher for the latter?

  • ThrugelmirThrugelmir Forumite
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    jamesd said:
    Prism said:
    For convenience: "there is no doubt that adding a small/mid-cap element to a portfolio can achieve the seemingly impossible feat of generating additional return whilst reducing risk ... if you changed 35 per cent ... of your portfolio to MSCI World Small Cap you would get a higher return for the same risk. For any lower percentage, the higher return would be accompanied by lower risk".
    And just for good measure, here is the efficient frontier graphic published in the Terry Smith article.



    Interesting. This plot is to the upper right of the well known US based plot for various S&P500 and US bond allocations, just as you might expect. ie higher potential returns with bigger SDs. Many people will focus on the greater returns possible and forget about the increased variation about the mean of those returns.
    So by combining the two graphs - and using the historic average efficient frontier curves - we learn that the lowest risk combination of equities and bonds is 80% bonds, 16% large cap; 4% small cap. Hands up anyone who holds that?
    Maybe we need to update things for a low interest rate environment.
    Yes, if you want to move away from historic data and guess what will happen in future. But say rates stay low, and bonds and equities are more positively correlated than in the past. Would you separate fixed interest into gilts/Treasuries and corporate bonds, with lower risk (estimate future SD) for the former and higher for the latter?

    Fixed interest is generally regarded as Gilts. As that's where the tradeable market is. Blue chip corporate bonds are generally highly illiquid stocks. Once bought by institutions such as pension funds, insurance companies, they are rarely traded. The BOE ( and other Central banks) are buyers of corporate bonds as part of the QE exercise which is a factor in driving available maturity yields to extremely low levels. 
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  • aroominyorkaroominyork Forumite
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    jamesd said:
    Prism said:
    For convenience: "there is no doubt that adding a small/mid-cap element to a portfolio can achieve the seemingly impossible feat of generating additional return whilst reducing risk ... if you changed 35 per cent ... of your portfolio to MSCI World Small Cap you would get a higher return for the same risk. For any lower percentage, the higher return would be accompanied by lower risk".
    And just for good measure, here is the efficient frontier graphic published in the Terry Smith article.



    Interesting. This plot is to the upper right of the well known US based plot for various S&P500 and US bond allocations, just as you might expect. ie higher potential returns with bigger SDs. Many people will focus on the greater returns possible and forget about the increased variation about the mean of those returns.
    So by combining the two graphs - and using the historic average efficient frontier curves - we learn that the lowest risk combination of equities and bonds is 80% bonds, 16% large cap; 4% small cap. Hands up anyone who holds that?
    Maybe we need to update things for a low interest rate environment.
    Yes, if you want to move away from historic data and guess what will happen in future. But say rates stay low, and bonds and equities are more positively correlated than in the past. Would you separate fixed interest into gilts/Treasuries and corporate bonds, with lower risk (estimate future SD) for the former and higher for the latter?

    Fixed interest is generally regarded as Gilts.
    No! Fixed interest includes all bonds - government and corporate. I just ran a few Google searches and each and every one (of six) confirmed that.

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