I’ve gotten many questions about slicing up the equity allocation of the Permanent Portfolio to try to capture the “value premium” by biasing the portfolio towards small cap value stocks both domestically and internationally.

Here are my thoughts:

Backtesting investing performance is dangerous. With backtesting, there is this temptation to tweak a portfolio to obtain the best possible historical returns. The one problem with this is: We aren’t going to re-live the past. We are going to live a brand new future that will be different. Even worse, you could introduce risks to the asset allocation that you may overlook as you stare mesmerized by the high annual returns you’ve discovered.

One of the changes you hear people talking about with the Permanent Portfolio (or most index investing strategies) is that some asset or another should be changed because this other asset did best in the past. After all, look at the results. If you just substituted Sub-Saharan Africa Micro Cap Value Stocks for the US Total Stock Market fund, the historical performance went up by X% a year and over Y number of years it creates a dramatic difference.

Too bad we didn’t know that information years ago when we could have actually made use of it. Now would you mind telling us what’s going to do best going forward? That’s something we can actually use.

Also, there are costs involved for taxable and non-taxable investors and many of these specialty funds have higher expenses. Further, much of the data used to sell you on the latest hot asset class performance is usually simulated because those indices never even existed over the time period covered. They were built with the benefit of hindsight.

For a taxable investor we need to incorporate not only the annual expense ratio and advisor fees, but also the tax cost ratio that Morningstar reports on fund efficiencies. The tax cost ratio reflects the amount of returns you can expect to lose in the fund due to tax impacts. When looking at the tax cost ratio, you need to look at funds with at least 10 years of data so you can see how it did through a bull and bear market. Not doing so can skew the numbers downward. Many funds in fact don’t have 10  years worth of data so their tax cost ratio can be deceptively low.

With that criteria in place, let’s look at some commonly used funds for value tilting vs. the Total Stock Market index from Vanguard:

Vanguard Total Stock Market (TSM)

Expense Ratio: 0.16% (Even lower with the ETF = 0.07%)
Tax Cost Ratio: 0.39%
Advisor Fee: 0.00%

DFA Intl. Small Value (ISV)

Expense Ratio: 0.69%
Tax Cost Ratio: 1.25%
Advisor Fee: 1% (Can range lower or higher)

DFA Small Cap Value (SV)

Expense Ratio: 0.52%
Tax Cost Ratio: 1.80% (Holy smokes that’s high!)
Advisor Fee: 1% (Can range lower or higher)

Total Overhead Costs

Vanguard TSM: -0.55% a year (or lower with the ETFs or Admiral status shares)
DFA Intl Small Value: -2.94% a year
DFA Small Value: -3.32% a year

If you are non-taxable you can eliminate the tax cost ratios. If you use a non-DFA fund you can get rid of the advisor fee. But the higher expenses are still there because small cap funds have higher turnover which means higher fees. International small funds also have these fees plus the higher trading costs associated with dealing in small markets internationally. That’s at least 0.50% a year reduction in returns under best conditions and likely larger under typical conditions.

Also, don’t forget that if you are a taxable investor and you need to rebalance each year because you own lots of funds.  On those gains you need to pay Uncle Sam his cut which is currently 15%, but has historically averaged 25% and has even been much higher.

Now the extra performance is not so clear cut. In this case you are losing perhaps 3% of the returns per year you are seeing in the spreadsheet results. At best you are probably losing close to 1% a year even for non-taxable investors simply because of higher fees.

Here’s the best part: You are losing that money whether or not the fund beats the Total Stock Market (TSM).

If your specialty funds beat TSM going forward you need to deduct the expenses. If your specialty funds lag TSM going forward you still need to deduct the expense.

So it comes back to Harry. Not Harry Browne, but Dirty Harry: “Do you feel lucky?”

You can buy the TSM and get a guaranteed low expense investing vehicle or you can go for the specialty asset classes and pay much more. If your bet pays off that’s great. But if it doesn’t (and with a 1-3% overhead it very well may not), then you’ll lose to TSM. It works out in these simple examples:

Year 1:

TSM Returns: 10%

Small Cap Value Returns: 12%

Looks like you made a good bet! Oh not so fast…

TSM Returns: 10% – 0.16% (expenses) – 0.39% (taxes)  = 9.45% to you

Specialty Fund Returns: 12% – 0.69% (expenses) – 1.25% (taxes) – 1% (advisor fee) = 9.06% to you

Winner: TSM

Year 2:

TSM Returns: 10%

Small Cap Value Returns: 9% (no guarantee you’ll win each year is there?)

After expenses:

TSM Returns: 10% – 0.16% (expenses) – 0.39% (taxes)  = 9.45% to you

Specialty Fund Returns: 9% – 0.69% (expenses) – 1.25% (taxes) – 1% (advisor fee) = 6.06% to you

Winner: TSM

Etc.

You may think I’m being unfair to prove a point. Yes, I’m aware there are tax-managed versions of these funds that could decrease tax costs. Yes, I’m also aware that there are even some cheaper funds recently introduced. But these things will never make them as cheap and tax efficient as the Total Stock Market fund. Also, there is the chance that your value funds may beat the market, but there have been very long stretches of times where they didn’t. For instance: From 1979-1999 Large Cap stocks returned 17.2% CAGR vs. Small Cap Value 15.9% CAGR (before costs).

This period covers the greatest bull market in US History for stocks. Yet, it was the big companies that walked away the winner. That’s 20 years lagging before the small value bet paid off starting in 2000.

I’m aware that you could rebalance between funds to capture excess returns on down years (of course keeping in mind the expenses of doing this). The problem is the value indexing phenomena is just not reliable enough that I’m willing to wager on it. In fact, as more people become aware of value indexing it is less likely any significant outperformance will continue. The markets are very efficient and have a way or making these types of advantages disappear. Heck, a few years ago I remember a broker from a major firm pitching to me the advantages of value investing and how that’s the strategy the brokerage was recommending for all their clients. Now with that many people in on the secret what are the odds it’s going to pay off as it did in the past? Certainly a lot less.

Here’s the most important thing you need to remember in all of this:

With the Permanent Portfolio your diversification comes from your Stock, Bond, Cash and Gold split and not from owning different stock asset classes.

As 2008 showed, owning multiple stock asset classes provides negligible diversification benefits in a bad market. They all did poorly together. It’s much more important to focus on keeping your stock, bond, cash and gold allocation and don’t worry about eeking out every last possible ounce of performance from your stocks based on backtests.

But, if you just have to value tilt I offer this advice: Buy the cheapest value index fund you can and is not actively managed. Vanguard and IShares offer funds that do this (S&P 600 Value and Vanguard Small Cap Value are good choices). Avoid funds wrapping the index up in some new gimmick like “Fundamental Indexing” which simply runs the costs of the fund up and may not produce tangible benefits. Lastly, be aware of all the costs involved if you are holding the funds in a taxable account and be aware that history does not repeat and you could be waiting a long time for the value premium to show up.

Or, just include these funds in your variable portfolio as a speculative play.

For my money, I own a Total Stock Market fund and a very small allocation to a Total International-style index fund which is the most I really gamble with stock asset class selection. Other than that, I don’t worry about my stocks. With the Total Stock Market, I own large stocks, small stocks, value stocks and growth stocks so I don’t care which one does best because I own them all. Even better is I own them for the cheapest possible price and that’s guaranteed money in the bank each year in investment cost savings. My advice: Keep it simple.

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* The spreadsheet I use for backtesting I call “The Backtesting Spreadsheet from Hell.” It has not only historical data, but also includes typical expense ratios of funds, Morningstar tax cost ratio for funds (with at least 10 years worth of data to capture bull and bear markets), and variable long term capital gains rates to deduct when you rebalance each year (so you can simulate a 15% rate vs. 28% for instance). Also the capital gains rates can use historical rates so you can actually see what the tax losses were for each year when you rebalanced (US avg long term capital gains rate is around 25%). It is designed not to provide the best case rosy scenario of a portfolio, but the worse case cost and tax burden on a strategy. I don’t care when things are going great as much as I care about when things are going poorly.

What I found with my spreadsheet is that more complicated portfolios with specialty asset classes largely do no better than simpler portfolios. Investors who load up on risky funds hoping to get higher returns generally give those extra returns to Uncle Sam, an advisor or the mutual fund company. In essence, you are taking on the risk, but others are getting the rewards.

I am not releasing the spreadsheet because I don’t want to support it. However I think anyone doing backtests should incorporate these expenses at a minimum to get an idea how their strategy performs under real world conditions. The conclusions I drew from it were “Keep It Simple” and “Costs matter.”

** “The Backtesting Spreadsheet from Hell” – Name based on William Bernstein’s “Retirement Calculator from Hell“. My spreadsheet has similar goals of looking at what happens when the investment returns touted in marketing brochures meet reality.

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