Optimize Asset Allocation: To provide the appropriate balance for growth and stability, we work with our clients to develop an optimized allocation among stocks and other risk assets, bonds and other types of fixed income, and cash.
Prefer Direct Holdings to Funds: To reduce costs and provide greater control and transparency, we prefer direct holdings of securities as opposed to funds.
Manage Tax Consequences of Any Restructuring: We consider carefully the tax consequences of any restructuring of a client’s taxable accounts.
The most important determinant of returns and risk is asset allocation. Based on our understanding of a client’s objectives, risk tolerance, and current circumstances, we develop for a client a customized equity allocation target. Our goal is to lay the foundation for solid long term returns, yet keep risk and volatility within reason.
We normally recommend that the balance of the accounts be in fixed income with virtually no cash. Quite simply, cash has never yielded less so return prospects are minimal.
Having a defined asset allocation serves as a mechanical prompt to rebalance portfolios when market fluctuation causes the mix to deviate from plan. Rebalancing reduces risk by subtracting from the outperformers, and presumably more expensive asset classes, and adding to the laggards, and thus less expensive asset classes. If the outperforming asset class tanks, you’ll have less exposure. If there is a significant pullback, you’ll have some dry powder to put to work.
We create spreadsheets for our clients to show how we would apportion this asset allocation among their accounts.
Prefer Direct Holdings of Stocks and Bonds to Mutual Funds/ETFs:
Our investment approach normally recommends that a client allocate most of his or her monies into direct holdings of stocks and bonds instead of funds. With direct holdings you (i) minimize costs by not incurring the ongoing fees and other expenses like trading costs and market impact costs typically borne by mutual fund holders, all of which can total 2.25% or more annually; (ii) in taxable accounts, minimize taxes by establishing your own, current tax basis for your securities (instead of inheriting the fund’s basis in its securities), and control taxable turnover of the positions; (iii) improve transparency by knowing exactly what you own at all times; and (iv) improve return and risk by being able to customize your holdings, instead of just accepting what the fund has and does.
Fund investing becomes even more problematic when you have several of them. First, each fund operates in its own silo. The funds do not coordinate their holdings. The same security may be held, inefficiently, in a number of funds. One fund may be selling that security, another buying. The end result is many transactions that may cancel each other out, imposing unnecessary costs and unlikely to achieve superior results.
Bottom line, we create a custom designed investment portfolio for each of our clients, planned to avoid the costs of mutual funds but still provide their diversification benefits.
Be Wary of Market Cap Indexing:
Indexing via a market cap weighted index, like the S&P 500, sounds good, but over the long haul a client may leave significant profits on the table. That’s because in market cap weighting, the more expensive the stock, the greater the emphasis, while the cheaper the stock, the lesser the weighting. That’s counter intuitive to most investing, which seeks to deemphasize the more expensive and the overpriced, while rotating into the less expensive, the bargains.
An alternative is to weight each stock equally, for instance buying 0.2% of each of the 500 stocks. While you’ll still have some exposure to the “mistakes” in the index, you’ll reduce your exposure and risk to any one stock because of the smaller weighting.
It’s been shown that this equal weighted approach outperformed the market cap weighted index approach over the last 40 years, before trading costs. That’s too much to leave on the table. Still, few of us want to manage 500 different stocks.
Bottom line, we advise our clients to avoid index funds. Use individual stocks to accentuate the less expensive equities, the bargains, and exit or reduce exposure to the overvalued, the more expensive.
Equity Investment Strategy:
Our equity investment approach is first to ensure that a client’s portfolio is diversified over the major industrial sectors. We then choose the specific equities for each industrial category by searching for those that appear inexpensive relative to their fundamentals. We look for investments that maximize the earnings to which each dollar of investment outlay is entitled. Of course, we also take into consideration other fundamental factors including market position and strategy, quality of management, growth prospects and margins. We try to minimize exposure to companies with excessive debt levels. We want to know what the companies are doing with their cash flow and that they are making use of it in an appropriate manner. Based on historical research, we believe a value based approach will deliver superior returns with less risk and more income.
Fixed Income Investment Strategy:
Our approach for investing in fixed income in a client’s tax sheltered accounts is to use high quality taxable fixed income securities, including US Treasuries, agencies, taxable municipals, and bond funds that invest in these securities. While we do recommend investing in some corporate bonds, in order to be as diversified as possible we advise that clients with lots of exposure to equities (which are issued by corporations) minimize exposure to corporate bonds.
If the fixed income is to be held in taxable accounts, we’ll typically use tax exempt fixed income if our analysis indicates that on an after tax basis the client will come out ahead. Tax exempt fixed income from a client’s home state will typically permit sidestepping state and local taxes.
Where possible, we’ll use zero coupon bonds, which means that instead of income being paid out currently, it is in effect reinvested back into the bond until maturity. Their advantage is their typically higher yields.
Although an important consideration in selection of fixed income is the size of the payouts, capital preservation is also critical. As a result, our selections give due consideration to credit and interest rate risk. Credit risk is the chance of default. Interest rate risk involves the chance that interest rates rise, which makes less desirable existing bonds issued when interest rates were lower; of course, if rates decline existing bonds become more valuable as they sport rates higher than the newer, lower rates.
We always develop an analysis for a client of the tax implications upon restructuring the portfolios.
We typically recommend that our proposed restructuring be done gradually, perhaps over a three month period. This allows the client to avoid restructuring everything in what could turn out to be a top or inopportune time. We suggest that there be a specified day each month for changing a specified portion of the portfolio, to be as disciplined as possible.