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How much to tilt to value and small caps
Robert T 04-13-2007, 7:56 AM | Post #2373308 | 
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How do you propose that investors decide whether they should tilt to small caps, or whether they should tilt towards large caps? How do you propose investors decide whether they should tilt towards value, or whether they should tilt towards growth? How should investors figure out whether they should tilt at all?

I can only speak for myself. This is how I decided how much to tilt.

Base on willingness and ability to take risk I selected a 75:25 equity:fixed income split. However based on assumptions of a 7% equity market return and 5% fixed income return this yields a 6.5% expected portfolio return (7x0.75 + 5*0.25). This falls short of the 7.6% return needed to achieve my investment objectives. Hence to achieve this higher expected return I tilted more to higher expected return factors (greater exposure to small and value companies). I assumed a future small and value premium of 2 and 4 percent respectively and targeted portfolio loadings of 0.2 and 0.4 for the small and value premiums. The expected returns of the equity portion then becomes:

Market beta x market factor.....1.00 x 7.0 = 7.00
Value loadings x value factor...0.40 x 4.0 = 1.60
Size loading x size factor......0.20 x 2.0 = 0.40
Expected equity return.......................9.00

So my portfolio expected return is now (9x0.75 + 5*0.25) = 8 minus expected expenses of 0.35% leaves 7.65% (8.00-0.35) which is close to my needed expected return. The reasons for using double the loading for value over size is that the value premium appears to have been historically more robust than the size premium and has a lower correlation with the market. Perhaps this is a little too simplistic but that is how I did it.

Robert

Originally posted in thread: 58568
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