Finding the right approach takes time, effort, and willingness to change.
Recently at Garnet we have been discussing investment strategies--strategies in general and our own investment strategy in particular. Investments have been on our minds, as Veena has been asked to share her expertise through several NAPFA forums. In September and October, she taught the basic investments course for NAPFA University at the West and Northeast regional conferences. In February she will participate in a panel discussion at the 2008 NAPFA Advanced Planners Conference. The panel, moderated by Bob Veres, brings together four veteran NAPFA members who take very different approaches to investing within their firms and examines the broader impact an advisor's investment model has on the practice as a whole.
As we do with almost every aspect of our practice, we have from time to time cast a critical eye upon our investment strategy. While we are happy with our current investment approach and its seamless fit into our practice, we are always looking for ways to improve and refine the service we provide to our clients.
We arrived at our current investment approach through an evolutionary process. As our regular readers know, Veena, a CFA with many years of investment experience (much of it institutional), sets investment strategy and oversees all trading in the Bethesda office.
Veena's background in money management has always been on the quantitative side. Years ago, in her job at a pension fund, she managed indexed bond portfolios. Later, working for a money manager, she managed core and core-enhanced bond portfolios. In both of these jobs, however, she had significant exposure--in practice and in concept--to active management of fixed income and equities. Most of the assets within the pension fund and the money manager's portfolios were actively managed. Through her years of firsthand experience in these institutional shops, Veena developed a broad understanding of the costs and benefits of various approaches to investing and money management.
When we first began managing money for clients we used a core/enhanced approach. About 80% of the assets were allocated to broadly diversified index funds (low-cost, no-load funds and ETFs). The enhanced portion, the remaining 20%, was allocated to active mutual funds run by managers whom we had identified as capable of adding value in their respective sectors. Our reasoning was that the large core portion would ensure that the overall cost (average expense ratio) was low and would provide exposure to the wide set of asset classes we felt was needed to achieve good risk-adjusted returns.
A few years ago we began using DFA (Dimensional Fund Advisors) funds in the passive allocation categories in many of our client accounts. Since then we've continued to add more DFA funds to our portfolios, substituting them when appropriate for other passive funds and ETFs. We like their low-cost, quantitative approach to investing--it fits perfectly with our belief in asset allocation and efficient markets. DFA also gives us access to cutting-edge research and detailed historical investment data.
Around the same time we began using DFA funds, we also began to trim back the active components in our portfolios. By carefully selecting a hand-picked set of active managers we had hoped to increase alpha. Over time, though, this effort proved to be fruitless; we did not achieve the anticipated increase in alpha on a consistent basis. Further, the sharper ups and downs of our active group were actually increasing the volatility of our client portfolios. We also concluded that by incorporating both strategies--passive and active--within our investment model we were communicating an inconsistent message to our clients. In our initial consultations and periodic review meetings we would explain that performance is determined largely by asset allocation and that the key to successful investing (for individual investors) is finding and sticking with the right allocation based on risk tolerance and other key factors. The inclusion of a sizable allocation to actively managed funds seemed to contradict our belief in these tenets.
Ultimately, we have eliminated all but a few trace remnants of any active fund holdings from our portfolios. While we continue to believe that active management has its role in the investment world and that there are very good active managers out there, we've chosen to stick with a strictly passive approach in our client portfolios. Given our needs--style consistency, reduced volatility, the ability to model and to back-test--a broadly diversified passive asset class strategy is the best approach for us.