The Total Economy Portfolio
The profits of publicly-held companies comprise less than half of all business profits earned in the U.S., according to Bureau of Economic Analysis’ (BEA) corporate profit measures. The other half of the economy is represented through private businesses. This means the stock market in its entirety is an incomplete reflection of economic activity. By making a couple of minor adjustments, your stock portfolio can become more aligned with the U.S. economy than with the stock market.
We have no say in which companies choose to raise capital through the stock market. The number of listed stocks has declined dramatically over the years. Public companies have dropped from 7,450 in 1997 to 3,750 today, and this number continues to shrink each year.
Privately-held businesses are a major driver of our economy. These enterprises range from one-person hotdog stands to major corporations that employ tens of thousands of people. They span every sector of the economy, from legal advice to real estate to manufacturing to investment management.
Filling in the Private Equity Gap in Your Portfolio
A diversified U.S. equity portfolio should attempt to include the private economy. That broadens the scope and enhances returns. There are few ways individual investors can participate passively.
One way to own private companies is through a limited partnership. These funds are available to institutions and individual accredited investors who have reached a level of wealth or income required by the government.
There are issues with private partnerships. The fees are high, and only a few top managers deliver returns high enough to justify their fee. There’s also a challenge gaining access to top talent. Unless you have several hundred million dollars in net worth and have very good connections, you’re not going to be invited to invest with the top managers.
A second way to invest in private companies is to purchase the publicly-traded stock of private equity management companies. This gives you exposure indirectly because typically these companies have an equity position in the funds they manage. The two big ones are The Blackstone Group L.P. (NYSE: BX) and Kohlberg Kravis Roberts (NYSE: KKR).
There are issues with buying stock of private equity management companies. First, there are only a few management companies that trade publicly. Second, these firms tend have diversified businesses models that included consulting and real estate management, so you’re not getting a pure play in private equity. Third, the stock performance doesn’t correlate very well with the return of private equity.
There is a third solution, an indirect method. You can make a couple of minor adjustments to your equity portfolio so that it’s more aligned with the economy than the stock market. This method offers a low-cost, diversified, easy-to-implement solution that has no wealth or income minimums. The disadvantage is that it takes some atypical thinking to appreciate why it works.
Creating a Simple Economic Tilt™
Two large segments of our economy are significantly under-represented in the stock market: small companies and commercial real estate. These two sectors have private equity values that are as large as the total stock market, yet the stock market has a tiny three percent representation in each of these two sectors.
There is a huge misalignment between the stock market and the economy. The gap can be made smaller with a couple of adjustments. Your portfolio return will better reflect the aggregate economy rather than the stock market by magnifying small company exposure and real estate exposure in your portfolio, using publicly available low-cost index funds and ETFs.
Historically, an Economic Tilt™ portfolio has delivered higher nominal and risk-adjusted returns than the stock market. Table 1 highlights total stock market and Economic Tilt™ returns. The tilted portfolio in Table 1 is composed of 65 percent in a broad stock market index, 25 percent in a small-cap value index, and 10 percent in a REIT index, rebalanced annually.
Table 1: The Economic Tilt Index™ versus Total Market Portfolio
Source: Wilshire 5000, Russell 2000 Value, Dow Jones Select REIT
The Economic Tilt™ portfolio outperformed the total stock market nominally and on a risk-adjusted basis since 1978 and during 2 out of 3 decades. The performance makes sense when you think about the events that have occurred in the U.S. equity market over this period.
The 1980s was a time of lower inflation, lower interest rates, and lower taxes. It was an ideal scenario for all stock investors. Corporate earnings accelerated and every sector of the economy participated. Accordingly, the returns to large company stocks, small-cap value stocks and real estate stock where closely aligned.
The stock market narrowed during the 1990s. Large-cap technology and communications stocks surged ahead on anticipated earnings growth in those sectors. The frenzy resulted in unprecedented multiple expansion among large-cap stocks that primarily make up the total market, beating reserved small-cap value companies by 5 percent annually, and running over REITs by 11 percent annually.
High expectations for earnings growth did not materialize in the real economy. As a result, large-cap stocks struggled during the 2000s. Small-value stocks and REITs outperformed the total market by more than 8 percent and 10 percent annualized, respectively.
Small Value Stocks Emulate Private Equity
Private investors know that privately-held companies are bought and sold at accounting multiples that are lower than publicly-traded companies. In addition, private companies tend to be much smaller than the weighted average size of publicly-traded companies. Based on these facts, over time, private companies tend to look and act similar to small-cap value companies that trade on the stock exchange.
In a recent working paper, Private Equity Performance: What Do We Know?, Robert S. Harris, Tim Jenkinson and Steven N. Kaplan compare the returns of a private equity fund to the returns of the S&P 500 (large-cap), Russell 3000 (broad market), Russell 2000 (small-cap), and Russell 2000 value (small-cap value). They divide the data into two groups: buyout funds and venture capital funds. The findings were enlightening.
When measured against the S&P 500 and Russell 3000, the average buyout and venture capital fund performed about 1.2 times the return of the indices since 1984 (for example: if the S&P 500 earned 10 percent, then private equity earned 12 percent, net of fees). However, the median fund (50 percentile) performed much closer to these indices. This suggests that there were a few very successful funds and many more mediocre ones. This was true for both buyout funds and venture capital funds.
The relative performance of both buyout and venture funds fell substantially when compared to the Russell 2000 and the Russell 2000 value index. The comparable performance of the Russell 2000 value index relative to the buyout funds was most interesting to me. The average of all funds earned only 1.07 times the small value index, the median private equity fund underperformed the index, and the median venture capital fund fell significantly below the index.
I contacted author Robert Harris, Stewart Sheppard Professor at Darden School of Business, University of Virginia about the idea of using a small-cap value index in a portfolio, in lieu of private equity. He agreed with my thesis that an individual investor could emulate private equity returns to a reasonable degree by including a concentration in a low-cost small value index fund or ETF.
Real Estate and REITs
The U.S. commercial real estate market is huge. It stands at roughly the size of the U.S. stock market, which is about $15 trillion today. See Slicing, Dicing and Scoping the Size of the U.S. Commercial Real Estate Market, by Andrew C. Florance and Norm G. Miller, for more information on the size of the U.S. commercial real estate market.
A generous portion of commercial real estate covering larger buildings is owned and occupied by publicly-traded companies and used in their operations. These assets are accounted at cost on corporate balance sheets. The value of corporate real estate affects stocks prices only to a minor extent. More often than not, it only becomes a factor during restructuring or liquidation.
Pension funds, limited partnerships, insurance companies, banks, and private investors represent a second large group of commercial real estate owners. The buildings in these portfolios are leased out for the rents they generate.
Publicly-traded real estate investment trusts (REITs) are a third rail of real estate ownership, although a much smaller one. The value of all U.S. equity REITs totals only $400 billion according to the National Association of Real Estate Investment Trusts (NAREIT). This represents less than 5 percent of the commercial real estate market and less than 3 percent of U.S. stock market value.
There are three different types of REIT funds available in the marketplace: equity, mortgage and hybrid. Investors can increase their ownership in real estate by increasing the amount they hold in a low-cost equity REIT index fund or ETF. This avenue offers inexpensive access to a diverse portfolio of multi-family housing, office, retail, healthcare, warehouse and industrial buildings.
Real estate is a significant part of the economy, but only a small part of the stock market. A portfolio can be enhanced to more closely align with the economy by magnifying the amount in real estate through an equity REIT index fund or ETF.
Creating an Economic Tilt™ in Your Portfolio
Total market index funds and ETFs provide broad U.S. equity exposure at very little cost. They are an excellent way to represent the public equity market and should be the cornerstone of every U.S. equity portfolio.
Unfortunately, total market index funds and ETFs do not provide a complete picture of the U.S. economy. They only include companies whose corporate boards have decided to access the public markets for capital. As I mentioned earlier, the number of U.S. companies accessing the public markets through equity has been cut in half since the 1990s.
An Economic Tilt™ portfolio attempts to negate some of the discrepancy between the economy and the stock market by magnifying a couple of under-represented sectors. Table 2 highlights three ETFs that we include in clients’ accounts at Portfolio Solutions® to accomplish this task. I also personally own these funds.
Table 2: The Economic Tilt™ Portfolio
Source: Portfolio Solutions®, Vanguard and iShares
(Past performance does not guarantee future results.)
The portfolio example in Table 2 does not represent a large tilt. It only enhances one-third of the portfolio. As more small-cap value exposure and REIT exposure is added, the more the portfolio moves in that direction.
I believe in moderation to control the tracking error of the portfolio against the broad market. This is important when there is a prolonged bull market in large-cap stocks, and people forget the reason for the tilt.
The index funds and allocations I’ve selected are not your only options. There are other allocations and different funds depending on your preferences and fund access. In addition, an Economic Tilt™ can be added to your international holdings to better align it with the global economy.
Creating an Economic Tilt™ in a portfolio using simple index funds shifts the focus to better align with the economy, rather than the stock market. Historically, this strategy has generated higher nominal and risk-adjusted returns both in the U.S. and internationally, although there have been long-periods of under-performance. Employing an Economic Tilt™ takes an open mind, a lot of patience and a long-term commitment.