Over the last several years, my investment approach has become more systematic and disciplined. In place of stock picking or manager selection, I believe clients are better served by a focus on strategic asset allocation. Today, we offer investors a series of 5 portfolio models, using ETFs (Exchange Traded Funds) and mutual funds. This approach offers a number of benefits, including diversification, low cost, transparency, and tax efficiency.
This evolution in approach occurred gradually as a result of continued research, personal experience, and pursuing the goal of a consistent client experience. In my previous position, I managed $375 million in client portfolios, performing investment research, designing asset allocation models, rebalancing and implementing trades. I am grateful for having this experience and want to share the reasons why I believe investors are best served by the approach we’re using today.
My investment approach is underpinned by three academic studies. These studies look at long-term investment performance, are updated annually, and offer great insight into what is actually working or not working for investors. As an analyst, I am very interested in what data tells us, and how this may differ from what we think will work or what should work in theory. But even if you aren’t a numbers geek like me, these studies instruct us about investor behavior and where you should focus your efforts and energy. I’m going to give a very brief summary of each study and include a link if you’d like to read more.
Sometimes, I hear that Small Cap or Emerging Market funds are better suited for active management because they invest in smaller, less efficient markets. This sounds plausible, but the numbers do not confirm this. The data from SPIVA shows that 66.77% of small cap funds lagged their benchmark and 80.00% (!) of Emerging Market funds under performed over the past five years.
The lesson from SPIVA is that using an index fund or ETF to track a benchmark is a sensible long-term approach. Indexing may not be exciting or produce the best performance in any given year, but it has produced good results over time and reduces the risk that we select the wrong fund or manager. Our approach is to use Index funds as a core component to our portfolio models.
The other conclusion I draw from SPIVA is that if large mutual fund companies, with hundreds of analysts, cannot consistently beat the benchmark, it would be foolish to think that a lone financial advisor picking individual stocks could do better.
The S&P Persistence Scorecard looks at mutual funds over the past 10 years. At the 5-year mark, the scorecard ranks funds in quartiles by performance and looks at how the funds’ returns were in the subsequent five years. This tells us if a top performing fund is likely to remain a leader.
Of the funds in the 1st Quartile in 2008, only 22% remained in the top category in the following 5 years. 29%, however, fell to the bottom quartile or were merged or liquidated in the following 5 years. So, if your method is to go to Morningstar and find the best performing fund, please be warned,past performance is no guarantee of future results. In fact, the Persistence Scorecard tells us that not only is past performance not a guarantee, it isn’t even a good indicator of future results. The results above aren’t much different than a random chance of 1 in 4 (25%). Albeit disappointing and counter-intuitive, the reality is that past performance offers virtually no predictive information.
These three studies are so important that I carry excerpts from the reports with me to discuss with investors. They’re fundamental to my investment approach, and hopefully, their significance can easily be grasped and appreciated by all our clients.
While we’ve focused exclusively on investment philosophy in this post, I would be remiss to not add that the benefits of working with a CFP(R) practitioner are not limited to portfolio management. A comprehensive financial plan includes many elements, such as savings/debt analysis, risk management, tax strategies, and estate planning. The investment management component tends to get the greatest attention, but the other elements of a personal financial plan are equally important in creating a foundation for your financial security.