Building a Long-Term Equity Portfolio

Market timing via factor investing

November 2021. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • With a long-term time horizon, investors should consider alternatives to the market-cap weighted equity indices
  • A valuation-based approach for creating an equities portfolio may seem more sensible
  • Using EBITDA / EV yield seems to avoid some of the quality issues of other value metrics

INTRODUCTION

All the evidence points to active management providing negative alpha and most investors being best off by simply holding an ETF for their equity allocation. The cost for a market cap-weighted global equities index has become negligible and the position would only require occasional rebalancing within a diversified portfolio. Sweet and simple.

However, in the context of a long-term equity allocation, a market-cap-weighted index can be viewed as sub-optimal. Although market-cap-weighted indices like the S&P 500 have been the winning methodologies of portfolio construction over the last two decades, expanding the horizon to almost a century highlights that equal-weighted portfolios have performed better (read Equal vs Market Cap-Weighted Portfolios in Stock Market Crashes). 

The downside of market-cap-weighted indices is that these often become expensive as the multiples of the largest companies tend to be above average, which has been particularly astute in recent years. Various market ratios like price-to-sales or cyclically-adjusted price-to-earnings show the S&P 500 trading at record valuations.

Adopting an equal-weighted equities portfolio will mitigate this partially, but with a long-term investment horizon, we can also consider a factor-based weighting methodology that will likely result in an even greater tracking error to standard benchmarks. 

In this research note, we will create a global equities portfolio based on a value approach. The aim is to create a portfolio that is supported by academic research, easy to implement, maintain, and hold across a market cycle.

VALUE FIRST APPROACH

We define the investible universe as all stocks globally trading with a market capitalization above $1 billion, which results in almost 1