WealthFactor Review & Update: December 2020

portfolio, valuation, risk, investment, sectors, yield, wealth, services, stocks, year, clients, pe, potential, layers, fixed income, return, factor, relative, terms, weighting
Good afternoon and welcome. Today, I'll be going through what is become a monthly routine, where I take a step back and think about things with a long-term perspective, but a fairly frequent cadence this month by cadence, but a long term perspective on global financial markets, and investments, investing decisions. So today, we'll be less centric as usual on the month of December and then given the uniqueness of a year calendar you're at, it gives us kind of a nice opportunity to, to think and continue to push to long, long term thinking. So before I get too far in, I'll share a few words for compliance purposes. This call is for informational purposes only and may be recorded. statements made during this call are the opinions of the speaker and are subject to risks and uncertainties, some of which are significant in scope. And by their very nature, beyond the control of WealthFactor, there can be no assurance that such statements will prove to be accurate, and actual results and future events could differ in a material way from said statements. Historical results are not necessarily indicative of future performance. I went back background. For those of you that don't know me, my name is Bill Woodruff, I founded WealthFactor, and I'm responsible for all investment strategy and investment related systems. I've been involved in investing for over 20 years, with a variety of experiences across manager research and due diligence, investment strategy, design, build implementation, and support and all elements. WealthFactor is a Lake Oswego based digital wealth manager operating as a registered investment advisor. We provide personalized, plan oriented solutions for each of our clients. Our clients can work with us in two ways. One, where they start with a holistic wealth plan, where the investment services are a component part and number two, as a where we might take a more narrow role, creating a personalized investment plan specifically, and are responsible for the ongoing implementation, management and execution of all elements of that investment plan. Our clients open accounts that an independent third-party custodian, and provide us with limited power of attorney to act on their behalf and execute on that investment plan. You unique to our business is really our fee model.
When I started WealthFactor, I started it with the my most of my experience coming from working with other investment professionals, there's always layers of management, and a financial adviser or some sort of intermediary between me and the end customer or client that the person consuming the investment advice services and and that never really sat right with me I my observation was those that were most successful, were the best at gathering assets and not necessarily the best debt. But what I think are the two most critical skill sets needed to help someone maximize the probability that they have a successful investment related outcome. And that's investment related services and then wealth planning. He really need prospectively to have some ingredients of planning to be successful, and matching and personalizing those elements to the proper, a properly constructed portfolio. WealthFactor is built around what we call risk smart. There are three component parts to risk smart being portfolio smart. And that's really a reference to, I think what the industry would define as evidence-based investing. And so we're generally looking to use indices as our starting points from portfolio perspective. And doing things that have worked historically and academic research could support or financial science could support and those, but generally that can be defined as avoiding picking stocks, timing, stock, picking sectors, and timing markets in general. Secondarily, being portfolio smart to us is being efficient in how we construct and provide our services and so while It's sometimes impractical to avoid all layers, where we actively seek to remove and eliminate as many layers of management in offering our services as we possibly can. And then in addition to that, generally, we believe that simplicity is the best solution. And connecting that to being a smart. It's my belief that high fees, force investment service providers to increase the risk taking. And it's my belief that all increased risk-taking forces increased complexity. And so high fees have a natural negative impact to the quality and the and the in the potential for the successful outcomes in reducing that, that probability those potentials. So the last component is being tax smart. It's my belief that tax smart is often an afterthought in many investments, service-related providers. But it's probably the biggest area where a outside investment service provider can provide value through their active decisions, you know, both on that front end in terms of structuring a thoughtful portfolio, one in which that can have levers that can be pulled to optimize for tax, year in and year out. So a quick update, the team at well, fabric continues to grow. We announced the two two new team members in November. And we had an additional team member Bree Valon was hired in brought on in December, she'll be responsible for heading up the client services for WealthFactor, hopefully a team that grows here and 2021 as our our unique business model and approach starts to gain attention and more and more traction. Bree and I worked together for I think almost a full decade in some of my prior experiences. And so it's a real privilege to have her accept a role at WealthFactor and for her and I to reconnect and work together again, is something I'm really excited about and and know that the, she's gonna do a much better job in providing some of the services than I could, from a from a client perspective. so pleased to have her aboard. Transitioning to what I'll be covering today, a topic perspective, kind of three main points, you know, first is just kind of looking at 2020. And acknowledging it was a year of polar extremes. We had a pandemic, that led to one of the fastest largest, steepest declines in the history of publicly traded equity markets us.
And now, we look at the very tail end of 2020. We are on the opposite extreme from a valuation perspective. So we will spend a little bit of time on valuations, I'm going to kick things off with talking about things from the this risk Mark philosophy and, and in while perhaps, it's inconsistent to think tactically from when you when you consider yourself an index oriented, passive or evidence based investor, but my mentality is that there's really, it's unusual that the proper asset allocation for a client is 100% equities, it exists. Sometimes it makes sense, but that's rare. And so the practical asset allocation is one that combines stocks or growth assets, and other other ingredients or other investment types. And as you start to include those items, and you filter that through this idea that high fees, forces unnecessary and increased risk taking, you then have the opportunity to say, Well, if I'm doing this more efficiently, maybe I should leverage that and simply have a baseline target risk level that is less and then utilize the fact that generally I'm less exposed to risk to increase my risk when prices decline dramatically. So that's the you know, as I as well as I reflect on the first several years of building and managing portfolios for WealthFactor clients, that philosophy and that ingredient has been one of the biggest drivers to reducing risk and increasing the the returns for investors and obviously, just like anything, whether it's past buying and holding, or you have some basis for an active or tactical decision. There's the past performance is going to have little to no impact on the future potential success. However, there is a basis for approaching this the topic of building a portfolio with the idea that why take unnecessary risk. And so as I have had the opportunity to work with clients over the years, that's the biggest thing that I think that this our ruthless focus on hyper efficiency, and keeping fees low, that's the biggest potential positive benefits. So I'll spend a little bit of time talking about risk relative to reward on an asset class basis, kicking that off with fixed income. And then lastly, I'll spend a look at several slides very quickly. Try to say, you know, ask this question are valuations valuations are high, something we can mathematically measure and and try to answer the question to we act or should we care. So, this is a this is a graph, I use frequently to share the dynamics of fixed income. And so what we can see here is on the far left side is at the top are Treasury yields. And then below that are yields where there is some incremental degree of credit risk or default risk, in addition to the interest rate risk. And as you can see the yields and when you take those additional risks are generally higher. And then that's comparing the end of 2020 to the end of the 2019. You also see return there. I think that when it comes to fixed income, looking at and focusing on prior returns as a real mistake, the greater emphasis and focus should be on what is the yield, which is the biggest driver to potential returns, especially as yields are become very, very low. Because while negative yields are possible, there's an asymmetry or the potential for yields to fall and become negative versus that degree versus the potential for them to rise. So again, the the place for fixed income, and the practical challenges associated with safe yields and low yields, still exists. And we can see the 10 year Treasury as a baseline fell from 1.9. To under 1%, it bottomed out in around 50 basis points throughout the year. And so you know, this, and on the right, you see, the 10 year
Treasury point is a perfectly fine example. So if you take 10 years worth of interest rate risk in treasuries and interest rates, what rise 1%, the value of that investment is going to decline, somewhere around the magnitude of not eight to 9%. And so I guess it's going to decrease the value of the bond is going to decline 9.9 or so percent yield coupon and have a total return of approximately 8%. And so if you start to think about the dynamics of investing in safe, fixed income, you have to go out a fair amount in terms of taking an interest rate risk of returning risk, and your net impact of 1% rises, illustrating that there's quite a bit of risk involved, and the potential for return reward at a 1% yield is fairly low. And then tying this back into the concept of the piece marks. If you think about the traditional way in which investment advice services are being delivered, where there's a organization that provides a set of services, and they have, they hire salespeople, the industry likes to call nancial. Advisors, I call salespeople and they and they get paid, you know, stuff, let's call it 1%. And we've got a couple layers there, they might use mutual funds, ETFs, you amaze various different separately managed accounts. And there's another layer there where there might be a set of fees. And so you can quickly see how the gross fee level becomes 1% or potentially dramatically higher. And if you have a a safe point of, of investing in return have a yield of 1% or less. The it's not hard to then connect the dots that when you hire somebody with that business model, they are in turn in a position where they are largely forced to recommend to you more risk. And that's the simplest example. You know, it's my belief that plays true throughout all investment types. And you know, if you look at the return for the 10 year Treasury at 10% in 2020 Well, why was why was it 10% when the yield was only point nine today. Well that's that that impact of appreciation because of following Market yield. And the average Wall Street's really built around this, you know, finance, financial sales, people being able to take those all of those complexities, and use it to mask what is, you know, really a, a bunch of inefficiency. And so the other day, that's, that's the biggest driver behind, you know why WealthFactor exists is to, to try to bridge that gap between doing things with efficiency, and getting people the investment and wealth planning oriented services that actually do provide benefit. So moving on to equity markets, you know, so we just, we just kind of look at fixed income and said, you know, gosh, the risk relative to the reward is in a challenging place. So, I believe that's one of multiple factors that's driving equity prices higher today, even certainly, global central banking, stimulus, and monetary policy, are likely contributing to upward pressure on asset prices in risky areas, including the stock market. So I have a series of graphs on valuation and I rather than and really describe what these graphs are in great detail, I'm just going to quickly go through them. But you know, this one's kind of showing the overlaying valuation point on inflection points and the up and down extremes. And again, you can kind of draw some relative comparatives at the PE today, as of the end of the year for the SP was over 22. And we can rewind to march 24, of 2004, the PE was 27. So you know, I think that it's natural for the human mind to try to look at something like this and draw up patterns and, and try to say, oh, that pattern is going to help me make a decision. You know, the practical reality is, I don't philosophically subscribe to that, you know, their financial markets might rhyme. But repeating is something that I experienced, they don't generally do from a pattern perspective. So moving on to the next, just in the in the sake of being efficient, you know, this is looking at just the 25 year average for PE, the SP and looking at that as a plus or minus one standard deviation, it kind of stayed that the, the one thing to take away,
I would draw your attention to on this particular page, is that when in 97, likes around 1987, when the PE went above that one standard deviation threshold, it stayed there for quite a while. And those that, you know, if you were to try to use valuation as a predictive tool, that was a very painful thing. And there's a lot of people at that time that certainly did, and said, Oh, you should be going out and chasing those growth stocks and those, and the valuations of overall markets, you know, two years or more of being very wrong. And so, you know, we're just, we've just seen TVs tick back up above that one standard deviation, Mark. And, you know, certainly that probably provides some headwinds. But you know, again, I don't, I would caution somebody for saying, oh, prices are high, or valuations are high, I'm going to deviate from my investment plan because of that. So this is this graph is, you know, takes that and all those data points, and does a regression analysis to try to do statistically, they did their significant, statistically significant relationship between valuations and future returns. And, you know, you can see on the left, that when you're talking about the next one year, there's an incredible amount of deviation from high valuation to negative performance or a link there, you can't see what the downward shape of the line that there is some relationship, it's just a fairly loose one. And then when you do it on the right, with a five year time horizon, you know, the data comes together much more tightly, and you do tend to see, you know, that that that sort of relationship. You know, the practical reality, though, with this sort of analysis, it's dependent on historical data. In this particular exercise is looking at data over the prior 25 years, I believe, and the you know, the practical reality is the risk free rate or the yield that you could get if something like a 10 year Treasury or most of this was substantially higher. So, you know, all things in global financial markets are supply and demand oriented, and risk relative risk oriented and so there's certainly a case to be made that as long as the risk free investment yield and potential for return stays Very, very low, it's more supportive of a higher on average valuation, relative to history for equity, risk and equity assets. So, this is something that I think this is diving in a layer deeper. And this is something that, you know, does influence the way in which I build portfolios. And so what this does is two things, it looks at the valuation for the top 10 stocks in the s&p 500, which effectively represents because its market cap weighted, the largest 10 versus the remaining stocks. And you can see that, you know, if you have a 22, pe, on average, the top 10 have a 33.3 pe, whereas the remaining stocks have a 19.7. And so, and then you can also see that in terms of the percentage weighting as well on that the top right graph where the weighting of the top 10 has become an enormously concentrated part of, of a of the index. And that has a ripple effect across almost all portfolios where, you know, and it says here, the disclaimer, the footnotes, Apple 6.8%, Microsoft 5.3%. So, you know, that, to me, the I don't think about this in terms of, well, those are overvalued, or or I think that those are going to be better or worse than the remaining 490 s&p 500 stocks. But I think about that more from a risk dynamic perspective, I would much prefer to, I think in times like these, shifting away from this is probably the biggest case against market capitalization weighting in that just from a risk and diversity perspective, I don't think it makes sense to have 28% of portfolio and 10 in 10 positions, I think that there's no reason not to achieve better diversification. Same concept here, just a slightly different way to think about it in that this is over 25 years, but it's taking the middle point for PE, and looking at how why the dispersion is between the between the valuations. And so you can see that, not only is that, you know, as we saw on the last page, that the top 10 stocks have a disproportionately high PE relative to that, that, you know, if you look at that, you look at it, in terms of dispersion of those with the highest and those with the lowest PE that amount of dispersion is far higher than normal as well. You know, there's I've shared in prior calls some some analysis on value stocks versus growth stocks, and the relative valuation historical basis. And, you know, I always like to get reiterate that, that those sorts of things really can't be used as, as predictive readings, but are you tools. But you know, I think it's good to be mindful of these sorts of things in terms of maintaining, maintaining a balanced approach to risk dynamics in portfolios. So, this, this graph is a little bit tacked on to be perfectly straightforward. And the reason why I'm adding this is one of my favorite clients, enjoy conversations with Nick very much, you know, he listens too much to these monthly calls. And, you know, every time it's, you know, I love the insight. But you know, you never talk about sectors, you know, what's going on, and in particular sectors and, you know, to, to continue to hammer home the same concept. My focus is really one of the risk efficiency and structural decision efficiency as well. It's my, I don't believe one can add value through actively trying to pick or time sectors. And so I choose to focus my energy on things where I think I can add value, driving efficiency through the investment services, component parts, as as my biggest focus and so, you know, on that day, no, we, you know, we had an incredibly diverse, volatile year, and lots of dispersion and we can see that in in sectors version as well. But, you know, I didn't spend the energy to look at what that dispersion look like relative to historical years. But it wouldn't surprise me that the amount of dispersion is dismissed is fairly standard, in that there's going to be some sectors that do very poorly, and there's going to be some sectors that do really well. And and as I think about And if you look at this relative to a pandemic, online retail technology are the top two, right, and then airlines in the bottom retail rates in the bottom hotels at the bottom. Right. So, you know, all of the sorts of sectors that you would have wanted to avoid it had you had crystal ball to predict that a pandemic was going to be the theme of the year. So again, you know, the aggregate for all this was up, you know, 16 16%, sort of overall market, despite all of what had happened in throughout the year with the incredible volatility. So, you know, in terms of when we build a portfolio, where we are generally thinking about what's our risk structure dynamic from a sector level perspective, and, you know, the exercise that I do, when I build a portfolio, the starting point is almost always sp 500. And then, you know, they look at the s&p 500. And I say, Okay, well, I don't like the idea that I have a bunch of concentration and single names, in the second part is starting to happen as well, where I don't really like to have a bunch of concentration in technology sector. You know, do I mind being overweight? You know, that's a natural part of buying and holding and the stocks that do well, the sectors do well increasing in both in the overall percentage of portfolio, but at some certain point, and I think that, you know, this is probably the theme, as I think about building portfolios and structuring portfolios are shaping them from a risk perspective, the market cap weighting, it now probably not ideal from a risk reward for having a market cap weighted portfolio as a starting point. So that largely concludes kind of a summary updates prepared slides.

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