Two great reads on portfolio construction

Just catching up on some reading after a long weekend – wanted to share two very important posts about portfolio construction that you shouldn’t miss…

In the first, Buckingham’s Larry Swedroe explains why it isn’t at all surprising that the small cap / value stock premium hasn’t shown up in recent years. He looks at the long-term data on these risk premia and uncovers several historical periods that would have been frustrating for investors who were overweighted toward smart beta factors. What he finds is that anything that works well cannot work all the time – otherwise it would seek to work at all. Bonus points for his description of “tracking error regret.”

The Mutual Fund – Industrial Complex has seized upon “smart beta” as their profit margin savior in the Enlightenment Era of passivity over active management. It’s one of only ways fund families can add value, in their own thinking, now that investors no longer believe in high-cost stock picking the way they used to. But if factor investing is being sold as a fool-proof method to garner reliable outperformance, there’s going to be a reckoning. It only works 60% of the time over five year periods, and not on anyone’s timetable.

Mystery of Vanishing Premiums (ETF.com)

The second read I’m sharing here makes a very simple but powerful case against currency-hedged international stocks. Lawrence Hamtil of Fortune Financial demonstrates that US stock outperformance is largely linked to US dollar strength versus international currencies – and vice versa. In other words, by hedging out exposure to international currencies, you’re effectively muting potential returns during periods in which international stocks are beating US stocks. When the MSCI World is beating the S&P 500, you want the currency exposure also – at least according to history.

This is now a variant perception given the popularity of currency-hedged ETFs. For the record, I think currency-hedging serves a purpose, but I’m not sold on it being the baseline posture, which is the position taken by my friend Jeremy Schwartz at WisdomTree. But by all means, make up your own mind.

Why Currency Hedging Foreign Equities Hurts Diversification (Fortune Financial)