We Used Better Data to Build a Different Kind of Portfolio

Maybe you're wondering what happens when you press that “Start Investing” button on the Wealthsimple website. Do gears start moving inside a little black box locked in a vault buried beneath the financial district in New York? Does a robot named Gary who loves Fig Newtons pick a bunch of mutual funds based on which character in “Game of Thrones” you most resemble? Or does a sophisticated algorithm designed by our engineers help tailor a portfolio our investment team built to be superior to just about anything else you could invest in?

(Pssst. The answer is the last option.)

We asked Yasser Mawji, Wealthsimple's Head of Research, to explain how he and his team built a next-generation portfolio that has lower fees — we use only low-fee ETFs and eliminate a whole lot of the fat that big banks suffer from — but also performs better. Here's what he had to say.

We don't fall for tax-free bonds

The only things in life that are certain are death and taxes (and that someone is going to say that phrase to you). But it turns out there’s an exception to the latter: holders of municipal bonds (known as munis) can escape the tax man. Munis are issued by towns, cities, and states to fund local initiatives, and they’re entirely tax-free if held in personal accounts. The catch is that munis can be riskier than regular government bonds: it's far more likely that a small town will go bankrupt than the federal government. Some of our competitors have decided to lay very large gambles on munis, adding a layer of heightened risk in order to capitalize on those high after-tax yields.

We’ve taken a more level-headed approach. Wealthsimple uses a formula that mixes a portion of munis along with a diversifying range of other bonds. We achieve virtually the same yield as our competitors, with greater diversification.

We exploit the most vibrant part of the Japanese economy

Japan has the second largest equities market in the world, eclipsed only by the United States. If you're going to build a geographically diversified portfolio, it's inevitable you're going to have some exposure to Japanese stocks — the market is simply too large. The problem with investing in Japan, of course, is that Japan has been mired in a three-decades-long economic slump. There are lots of reasons for it — demographics, questionable economic policies, and a heavy debt load – but the problem seems intractable at the moment. There’s a silver lining, though: Japan has a vibrant export sector. Companies like Toyota, Toshiba, Nintendo and lots of others are thriving because their market isn't domestic, it's the rest of the world where economies are growing at a healthier clip. For its US portfolio, Wealthsimple selected a Japanese ETF that has greater exposure to the export sector than the simpler Japanese ETFs favored by our competitors, which invest only by geographic location. That way we can give you more diversity and growth.

We don't buy European bonds

Let's say you lend your friend some money. But instead of your friend paying you interest on that loan, you have to pay him for the privilege of holding onto your money. Doesn't sound like a great deal, right?Well, that’s exactly the situation with a huge portion — $11 trillion worth — of government bonds. Because of the fiscal policies in Europe, bonds in many countries in that part of the world actually carry a negative interest rate. It's a consequence of the European Central Bank's policies — they so badly want businesses to spend money that they're essentially charging a fee to keep money sitting a bank.

A lot of online-only investment portfolios hold European bonds in their clients' portfolios. They do it for the sake of diversifying portfolios. Wealthsimple excludes these bonds from our US portfolios. We figure that investors often hold bonds because they are looking for income — an actual stream of money they can live off of right now — rather than growth in the value of assets. We believe US dollar denominated bonds offer solid diversification and provide more income.

We use a potent cocktail of value investing and small cap stocks

Let's start with what's called value investing. Warren Buffet famously said, “Be greedy when others are fearful, and fearful when others are greedy.” This dictum lies at the heart of value investing. It's pretty simple: buy companies that, for one reason or another, are relatively cheap compared to their fundamentals. Companies, for instance, that have fallen on hard times, but have the potential for a strong recovery. Plenty of research demonstrates that the market underestimates the long-term prospects of those firms that are trading at a lower price than their fundamentals suggest they should, making them a bargain. Value stocks are also good diversifiers. They tend to fall less when the market declines, perhaps because the worst has already been priced in.

Now let's consider small-cap stocks. Some companies are considered large-cap — they have a value of more than $5 billion. Others are considered small-cap — usually companies with a value between $300 million and $2 billion. In the long term, according to the vast majority of research, these two classes of investments behave like David and Goliath. By that we mean that the small ones eventually beat the big ones, at least in terms of growth. One of the reasons is that, with small-caps, you have a much better chance of finding companies with enormous growth potential that no one's realized is there yet. Some of our competitors include large-cap stocks in their value investing portfolios, which have proven not to perform as well. Others don't include small-cap stocks at all.

With us so far? Good. So not only do we invest in both of these classes of securities, we do one better. Research shows that small cap stocks that are also value stocks achieve superior returns to either class on its own. By putting both filters on stock selection, you amplify the results. So we invest in an ETF that features these kinds of companies.

Source: Bloomberg

We believe in fallen angels

When a company borrows money, it, like that municipality we talked about above, can issue a bond. And the corporate bond market has become like a popularity contest. Everyone wants to hold bonds that are deemed high quality (aka “investment grade”) by rating agencies, whereas supposedly lower quality (aka “high yield”) bonds are left by the wayside.

Wealthsimple knows the best research shows that some of these ugly ducklings actually perform much better than their higher-rated, more popular peers, even after accounting for their higher risk. A class of these bonds, bonds that are downgraded from investment grade to high yield, are known as “fallen angels” and have stellar risk-adjusted returns.

It's not hard to see why these bonds perform so well. A lot of individual investors sell when bonds are downgraded from investment-grade to high yield. And a lot of very large investors — such as insurance companies and pension funds whose portfolios are regulated — must sell downgraded bonds in order to comply with regulations. When that selling pressure is triggered by a downgrade, these “fallen angels” become a bargain. Since fallen angels were previously highly rated, it’s also more likely that they will eventually return to their former glory, generating outsized returns for investors.

Source: VanEck

The bottom line

Wealthsimple’s US portfolios were designed to be better. We spent thousands of hours designing them before our US launch. If you want to know more about them, or find out exactly what your portfolio might look like, feel free to reach out to us at help@wealthsimple.com

Wealthsimple uses technology and smart, friendly humans to help you grow and manage your money. Invest and save in a better, simpler way

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