How do we model the historical development of finax portfolios?
Finax often uses the long-term historical development of its portfolios. It is always a modelled development, and in this article, we will explain why we work with modelled performances, reveal in detail, how we achieve them, what methodology we use, and what is their bases.
Radoslav Kasík | Our process | 7. February 2020
Finax, o.c.p., a.s. began its official business journey on January 10th 2018. On this day was the company registered. We launched the Intelligent Investing portfolio service two months later.
However, on Finax's website whether in articles, on our main page, in webinars or presentations, you will notice that our portfolios have significantly longer performance period, encompassing even the period before the foundation of our company.
Each case represents a modelled development, not the performance actually achieved by Finax clients. We will reveal how we get this performance, clarify the modelling process, and explain why we use these models.
Finax's credo from the beginning is total transparency. In this spirit, we also provide an explanation of the historical performance presented and reveal in detail the on methodology to avoid any doubt.
Why do we model historical performance of portfolios?
There are several reasons for using modelled performance in our communication.
First of all, we started to work with them in order to obtain a sufficiently long history of sample portfolios, needed for portfolio and product management. If we wanted to bring an unrivalled investment product to the Slovak market, we had to prepare and verify it extensively.
We needed to verify all of our assumptions, on which we planned to build the Intelligent Investing. Does passive investing really earn more than most of the actively managed solutions? Does rebalancing increase returns and reduce portfolio risk?
We would not be able to answer these questions, unless we had an indicative historical development of the underlying instruments. Only after that, could we test different ways of rebalancing and choosing the eligible one.
The regulations of managed portfolios today require an outlining of the expected return on investment, as well as development in case of a pessimistic and optimistic scenario.
The expected future development in all three of these scenarios must be based on the historical portfolio performance to be relevant. Only with large set of historical data is it possible, to create a representative estimate. This is the reason why we had to model development.
If we derive the future performance from developments over the past 10 years, it would be significantly overvalued and, on the contrary, undervalued, if we take into account last 20 years. Neither of these cases would be representative.
Our models go as far back as the beginning of 1988. More than 30 years of history represents a sufficient sample of market developments, while still offering relevant indices that are essentially the same or corresponding to the individual instruments used in our portfolios.
In the case of the Intelligent Wallet, which we launched in July 2021, its modeled development begins in 2000, meaning it has a history of more than 20 years. Modeling farther into the past was impossible due to the lack of relevant indices in the area of inflation-protected bonds and real estate funds.
More information on our client registration algorithms and expected revenue can be found in What is a Robo-Advisor article?
The third reason for modelling, is the need of communication of the achieved results. Investment broker creates a separate asset account for each client, which is then used to manage client’s portfolio. We do not manage a fund or other form of single portfolio. We manage thousands of portfolios.
Despite consistent investment strategies, each Finax account is individual. Due to different discounts, different timing of deposits or rounding, our clients' accounts differ from each other. Thus, the composition, development, and performance of two accounts with the same strategy may also slightly differ.
If we want to communicate the performance of Intelligent Investing, we need to work with a universal portfolio.
Modelling is the only possible way of reporting the performance of the portfolio while also maintaining discretion towards clients and covering the longest possible time horizon, that truly shows what the investment strategy is capable of.
The fourth reason are the marketing purposes. How else could we show people that passive investing is more profitable in the long run than using a demonstration of its historical performance.
The goal of modelling is to reveal that financial markets reward passive investors. There is no science-fiction behind modelling, only facts. Modelling does not distort nor adapt history to our needs, but only exposes it to the public.
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Methodology behind the modelling of historical development of Finax portfolios
When modelling the historical portfolio development, we used the following assumptions, portfolio methodology and parameters that fully correspond to the actual management of client portfolios in Finax:
- The development of Intelligent Investing portfolios is calculated on the basis of a one-off investment from 31 December 1987, the development of the Intelligent Wallet from 31 December 1999,
- Initial portfolio composition comprises of the actual allocation of the 12 Finax managed portfolios offered, as shown in the Optimal (Initial) allocation of Intelligent Investing portfolios above, and in the Optimal (Initial) allocation of Intelligent Wallet portfolios above,
- Following data are used to model the historical development of individual tools that the Finax portfolios consists of (more information on the source of data down below):
- ETF rates during their existence,
- Value of the underling ETFs in the period prior to the ETFs themselves,
- Values of identical (virtually the same) indices, focused on the same or very similar class of assets in terms of their economic characteristics, returns and risks in the period preceding the emergence of the underling indices,
- For the most accurate modelling of historical data of financial instruments, the development of all of the indices used is adjusted by the actually achieved tracking difference of ETFs in relation to the underlying indices as of 31.8. 2017,
- All of the dollar equity indices are converted each month into euro at the euro-dollar exchange rate, dollar bond indices are not recalculated, as all of the financial instruments of the bond component are denominated or are currency secured in euro,
- The source of all of the data used is the Bloomberg news agency,
- Some of the data used are modelled by Bloomberg (e.g. the exchange rate of the euro against the dollar before its creation, the Stoxx 600 and Stoxx Small indices)
- Finax portfolio development is always modelled on the last day of the month,
- At the end of each month, a full Finax portfolio management fee is deducted from the modeled portfolios, 1,2% p.a. in case of the Intelligent Investing portfolios and 0,5% p.a. in case of the Intelligent Wallet. This is based on the average value of the portfolio at the end of the month and the value of the portfolio at the end of the previous month,
- The value of cash in the Intelligent Investing portfolios ranges from 1.5% to -0.5% of the portfolio value, after falling below the -0.5% of the portfolio value at the end of the month, 2% of each position in the portfolio is sold,
- The initial cash weight in the Intelligent Wallet portfolio is 38%, which is matched only by rebalancing (positions in ETFs are not sold off only due to a change in the cash weight),
- Portfolios are subject at the end of the calendar month to rebalancing in accordance with the terms and conditions of Finax portfolio management (Finax’s investment strategy),
- In case of indices, please note that their names may have changed over the past two years.
The key and the most sensitive part of portfolio modelling is the gathering of data of the individual instruments before their creation. The ETFs making up our portfolios were established between February 2008 and March 2017, so there is no fund covering the entire Finax portfolio models.
In an effort, trying to design the modelling of portfolio as accurately as possible, we have always tried to find the same instrument, or relatively the same instrument, whose economic nature, risk and return achieved correlates with the financial instrument used in the managed portfolios of Finax (ETF). We substituted the development of the ETFs in the period before their creation with indices.
The following chart and table accurately depict, when was which index used for each financial instrument. The blue colour in the graph shows the period, in which the ETF exists and we worked directly with the stock market prices. The dark grey colour illustrates the period, in which we modelled the development with the underlying index that copies the ETF.
Lighter grey colours represent periods of individual instruments, in which we had to reach for a similar index focusing on the same or similar asset class. All specific indices are listed in the Used Indices table in the modelled development of Finax portfolios prior to the ETF creation (see below).
We would like to emphasize that by using indices in order to model the development of individual financial instruments we have also adjusted their values to reflect the actual ETF tracking difference during the existence of the funds. Tracking difference is the difference between ETF performance and the underlying index it imitates. It can be either positive or negative.
When choosing the indices, we tried to preserve as many characteristics of the asset class underlying the financial instrument in the Finax portfolio as possible. In many cases, the underlying indices have been replaced by the same indices. However, with these indices, we only used the value without dividends. This results in our modelled performance being underestimated.
For large US companies, the entire modelled development is based on the S&P 500 index, which is also the basis of the ETF. In the case of medium-sized companies, the underlying S&P 400 index was replaced in the early years of modelling with the Russell Midcap index, whose focus is the same. Small American firms are covered throughout the horizon by the Russell 2000 Index.
In case of equities of large European companies, we use the Stoxx 600 underlying index, and for small companies the underlying MSCI Europe Small index is complemented by the identical Stoxx Small index at the beginning of modelling. Developments of equities in emerging market are covered by the MSCI EM index throughout the period.
A slightly more complicated situation occurs with bond indices that do not have historical data due to more complicated composition, securities maturities and frequent changes in index providers. Likewise, their data is not always freely available.
In case of world government bonds, no problems occurred. There are alternatives to the underlying Citi World Government Bond Index, which is now under the wings of FTSE.
We were forced to replace EUR companies bond indices in the first 10 years of model with US companies’ bonds. When comparing the economic nature and risk, they are essentially the same instruments.
Similarly, there is no data available for EUR high-field and emerging markets bonds until the late 1990s. Again, we used the US high-yield bond indices that were similar in nature, returns and volatility to the financial instruments in Finax's portfolios.
If needed, we would be pleased to provide, to those interested, with in depth information on modelling and accurate calculations that led to the final development of the modelled portfolios.
Comparing the comparable - classification of Finax portfolios into risk classes based on the SRRI methodology
The main goal or parameter of a good investment is to maximize returns while taking acceptable risk. Every investment carries a certain degree of risk.
The return on investment is always directly proportional to the risk taken. There are instruments that can adjust the risk, but only partially.
Investments can be composed of different financial instruments, built on different asset classes, and can implement a number of investment strategies. By combining these elements, we get thousands of different investment opportunities.
Every investor wonders, which investment is the most suitable for him / her. However, a wide range of investments makes it difficult to compare them. Because of this, the EU has adopted rules for assessing the riskiness of financial instruments. These can be then used by the investors to compare the returns and risks of even seemingly different investments.
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In compliance with these regulations, we have classified Finax's portfolios into risk classes according to the Synthetic Risk and Reward Indicator (SRRI) developed by the European Securities and Markets Authority - ESMA.
Mutual funds are obliged to classify financial instruments into risk classes under SRRI. You can always find information about risk in a very useful Key Investor Information document that asset management companies must disclose for each mutual fund.
Investment brokers that manage individually managed portfolios do not have this obligation. But Finax again went a step further in terms of fairness and transparency. We assigned a risk class to each of our 12 portfolios based on the historical modelled developments in accordance with the SRRI methodology.
The financial instrument is categorized into risk category based on volatility (variation). ESMA allows you to calculate the volatility of weekly or monthly returns over the past 5 years. The volatility rate then determines the degree of risk of the financial instrument.
In order to categorize Finax portfolios into risk classes, we used the volatility of modelled monthly development returns. The following table, which is used as the base for comparisons in articles published on the Finax website since June 2021, shows the risk of individual strategies. It is based on 5-year modeled data as of June 2021.
Why are our models trustworthy?
Finax uses a passive investing strategy. It represents investing in the whole market. The portfolio structure reflects the distribution of global capitalization of financial markets. If that was not the case, we would not offer a passive approach, thus going against our own philosophy.
The basic prerequisite for building Finax's portfolios is to copy the distribution of global financial markets. We do not use a specific investment strategy that would be applied based on back testing. In Finax, all 11 portfolios were allocated first, and only then, had we begun with the modelling of historical developments, not the other way around.
If US equities have a share of the world stock market of more than 50%, than they also represent the same portion in our equities.
The same applies to other asset classes, with a few of them being omitted to achieve product simplicity, reduction of the administrative burden of portfolio management, reduction of investment costs and potential error rates. Therefore, the weight of some asset classes is slightly increased compared to their market share.
The situation is different for the Intelligent Wallet portfolio, the composition of which was determined on the basis of back-testing thousands of combinations of different portfolios composed of various asset classes with diverse weights so that we achieve a targeted return while minimizing risk - limited volatility and maximum declines.
The ETFs from which we compile the Intelligent Investing portfolios were here before Finax, and even before that, there were their underlying assets, whose development was described by different indices. You can read more about the ETF selection and the reasons for allocation of portfolio here.
Finax's portfolios reflect global financial markets, and our modelled performance only reflects the evolution of financial markets, reduced by our fees and adjusted for regular rebalancing.
Neither past returns nor modeled returns guarantee future returns. Investing is risky and may result in a loss as well. The displayed portfolio might not be suitable for you in terms of risk.
With our model there is no need for uncertainty. We have a precise investing strategy - we invest in the whole market regardless of what is happening in the world. The markets have only one history that is the reason why our models are reliable.
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As we have shown, we have taken great care in choosing the underlying tools that are entered into model and have not left out any details of modelling portfolio management and development, whether ETF tracking difference, fees, rebalancing or exchange rate movements.
In the end, the actual performance of portfolios in our clients' accounts corresponds to the modelled appreciation and confirms all our assumptions, differences and advantages over competing investment solutions.