Understanding the Smart Stack Approach™

16 August 2022
Understanding the Smart Stack Approach™

Stack aims to deliver a service that simplifies and automates investing. Stack’s philosophy is actualized by our investing principles. The returns you get from investing are roughly proportional to the risk you take. Consequently, the more risk you allocate to diversifying assets, the higher your return-to-risk ratio will be. The passive low-cost diversified portfolios we curate aim to outperform active investors with low-fees passive ETFs over high-fees active funds. The Smart Stack Approach™ employs 5 simple steps to create such a passive portfolio -

  1. Asset Class Selection to allocate risk.
  2. Select the most appropriate ETFs/MFs to represent each asset class.
  3. Apply Modern Portfolio Theory i.e. maximize the expected post-tax return for each level of portfolio risk.
  4. Determine your risk tolerance to select the allocation that is most appropriate for you.
  5. Monitor and periodically rebalance your portfolio.

Research consistently has found the best way to maximize returns across every level of risk is to combine asset classes rather than individual securities. We consider each asset class’s long-term historical behaviour, risk-return relationship conceptualized in asset pricing theories and expected behaviour based on long-term secular trends and the macroeconomic environment. Asset classes fall under three broad categories: Equities, Fixed Income and Commodities.

Historically, equities exhibit a high degree of volatility but provide some degree of inflation protection. Developed market equities remain a core part of any asset allocation aimed at achieving positive returns as over the long term they have outperformed bonds on a risk-adjusted basis. Fixed income remains a positive way to dial down the overall risk of a portfolio. To leverage various risk and reward tradeoffs associated with different kinds of bonds, we include a variety of them in our portfolios. Commodities (such as Gold, Silver, etc.) provide inflation protection and diversification.

Stack uses low-cost, index-based exchange-traded funds (ETFs) to represent each asset class. We periodically review the entire population of ETFs to identify the most appropriate ones for use in our portfolio construction. We attempt to choose the ETFs with the lowest expense ratios and are expected to have sufficient liquidity to allow purchases and sales at any time.

Stack determines the optimal mix of our chosen asset classes by using Mean-Variance Optimization (Markowitz, 1952), the foundation of Modern Portfolio Theory. The output of the optimization is a collection of portfolios that generate the maximum return at each level of targeted risk, or equivalently, minimize the level of risk for a specific expected return.

We ask prospective clients questions to evaluate both their objective capacity to take risks and subjective willingness to take risks through a risk questionnaire and combine this with behavioural economics research to simplify our risk identification process. Our overall Risk Score combines subjective and objective risk tolerance, with a heavier weighting to whichever component is more risk averse.

Stack monitors the portfolios and periodically rebalances each portfolio when a deposit or withdrawal has been made, or if market movements in their relative allocations justify a change while continuously monitoring and periodically rebalancing our clients’ portfolios to maximize returns while maintaining their calculated risk tolerance. We believe following this process will lead to outstanding long-term financial outcomes for our clients.