The Fix The Investments Series
If you’ve read about core and satellite investing, then you have some familiarity with this well-known approach: The core holding of your portfolio is a big, cheap ETF that tracks a big index like the S&P 500 or MSCI, and the more specialized satellites orbit the big-cap core, which are typically small- and mid-cap, international, and specialty holdings.
Some investors will use this approach as a foundation for tilting. What does tilting mean? Tilting simply means overweighting the portfolio with some favored investment allocation that exceeds your allocation model’s stated percentage. For instance, if your model calls for 40% equity, and you are at 44%, you are tilted or overweight by four percentage points. If you are following the plan, you would capture those four percentage points of profit and use the cash to shore up an asset class, say bonds or real estate, that is lagging.
Some of the most popular factor tilts for ETF investors who employ a core-satellite approach are: overweighting by cap size, by investment style, by industry, by sector, and by region.
You start by establishing your standard diversified core equity position, let’s use our old friend the S&P 500, by using either the iShares S&P 500 Index (IVV) or SPDR S&P 500 ETF Trust (SP) for our example.
Your research has led you to believe that financials may be an industry that should outperform the general market over the next market cycle or cycles. So, you might add a few shares of the financial ETF as a satellite, to overweight the existing financial position that is already part of your existing SPY or IVV position. Are you with me so far?
…tilting…overweighting the portfolio with some favored investment allocation that exceeds your allocation model’s stated percentage…
You would tilt your portfolio in this manner if you have a reasonable belief or expectation of getting a higher return than the general market. But understand this: while returns may be enhanced, so is the risk.
There is ample research on this subject, the most notable being the value and small-cap studies on tilting by Nobel Laureates Eugene Fama from the University of Chicago Booth School of Business, and Kenneth French, from Dartmouth College.
Their Three-Factor Model explains the risk and return profiles of equity portfolios across three dimensions: market risk, size risk and value risk. While there are almost unlimited ways to overweight or tilt a portfolio using these and other style factors, their studies focused on value and small cap stocks.
But don’t mistake this for market timing. You are not attempting to beat the market, per se. The greater complexity of tilting is an attempt to “juice” the returns of your portfolio, and though the overall portfolio risk rises in proportion to the percentage that you overweight, it can still be considered a valid passive management approach in its own right. You might call it “passive plus,” but tilting requires research and demands caution.
…while returns may be enhanced, so is the risk…
While there are those times when it may make sense to overweight given sectors of the economy, your hunches and your research, just like everyone else’s hunches and research can prove to be wrong. There is a cost to tilting if you make the wrong moves, which is why a straightforward passive allocation approach works for most investors who seek to build long-term wealth without having to outguess the market, or even more difficult, outguessing small pieces of the market.
There are no rules, of course, to how much percentage wise makes sense for a tilt, but 1% to 5% in a tilt is probably the most aggressive you would want to go if you are an otherwise committed passive investor.
Total market index ETFs, like SPY or IVV, will give you whatever the broad market delivers, up, down or sideways, but if you are determined to try to enhance your alpha, going for a little extra return from a favored sector or industry or region, you can tilt by using the most relevant ETF.
There are no rules, of course, to how much percentage wise makes sense for a tilt, but 1% to 5% in a tilt is probably the most aggressive you would want to go if you are an otherwise committed passive investor. Total market index ETFs, like SPY or IVV, will give you whatever the broad market delivers, up, down or sideways, but if you are determined to try to enhance your alpha, going for a little extra return from a favored sector or industry or region, you can tilt by using the most relevant ETF.
Remember, too, that a tracking stock, an ETF, exhibits no tracking error, that is, the tracking stock or ETF delivers just about the exact same amount as the market it represents, minus its small fees. Any changes or enhancements to that almost perfect tracking will be out of whack. Adding an additional 5% weighting to any of the ten S&P sectors, for instance, and you will experience tracking error, either up or down.
…a portfolio that is tilted in the wrong direction can be underwater for a long time…
There is no right answer to how much you should tilt your portfolio, or if you should do it at all. But the more you tilt, you are getting very close to simply making a bet. There is a downside: if you are wrong it can cost you a lot of time and expense to get back to your original wealth creation targets.
A portfolio that is tilted in the wrong direction can be underwater for a long time, and if that turns out to be the case, you will become more likely to behave badly, and we know that bad investor behavior kills returns and subsequent wealth building efforts.
Tilting is not a short-term deal. It’s not about flavor of the month. It is to be used intelligently, and only by the most patient, diligent, disciplined and responsible investors. Higher returns sound great, until you realize that higher risks come right along with them.
There is a commitment that goes with this style of investing that will force most people out of the position long before its had the chance to do what they wanted it to do, namely, enhance their portfolio returns.
The last thing you want to hear back from a bruised portfolio is “Tilt!”