Thursday, January 1, 2015

To Tilt Or Not To Tilt Your Portfolio Design

I tilt. Do you tilt? It's OK to tilt. Many people tilt. I'm not talking about posture or politics – I'm talking about portfolio design.

A portfolio "tilt" is industry slang for an investment strategy that overweighs a particular investment style. An example would be tilting to small-cap stocks or value stocks that have historically delivered higher returns than the stock market. Overweighing to a style is always done with the expectation of achieving a higher return or higher risk-adjusted return than the market.

The research behind a small-cap and value tilting is based in part on studies by Nobel Laureate Eugene Fama from the University of Chicago Booth School of Business and Kenneth French from Dartmouth University. Their widely cited Three-Factor Model explains the risk and return of diversified equity portfolios across three risk dimensions: market risk, size risk and value risk.

Investors who employ a Fama-French tilt in their portfolio believe that overweighing small-cap stocks and value stocks provides a different return path than holding only the capitalization-weighted market itself. Fama and French view any excess return from tilting is a payoff for taking additional risk. In contrast, some practitioners claim this method is a more efficient way to invest in that it provides a free lunch, i.e., higher returns without higher risk.

Figure 1 illustrates the Fama-French Three-Factor Model. The total stock market is in the center of the figure. The horizontal axis depicts portfolios tilted to growth stocks (left) and value stocks (right). The vertical access depicts portfolios tilted to large stocks (bottom) and small stocks (top). The gold area represents increased expected risk and return over the total market when a portfolio overweighs to value and small-cap stocks.

Figure 1: Combining small-cap and value stocks using the Fama-French Three-Factor Model

Top 10 Financial Stocks To Own Right Now

FamaFrench

Source: Fama-French diagram as illustrated on the Portfolio Solutions website.

There are thousands of ways to create a Fama-French three-factor portfolio. My preferred method is to begin with a total stock market index fund and add exposure to a small-cap value index fund. Here's how to build this portfolio:

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