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.
We have created and modeled multiple broad asset allocations that we use as a starting point for investing client portfolios. Currently, we have six model portfolios, each composed of DFA asset class funds and exchange-traded funds. The model portfolios range from balanced taxable to high-growth tax-deferred. The overall expense ratio of each of our model portfolios is about 30 basis points. A low expense portfolio is one of our strategic goals--we want to keep the overall cost to our client (our fee plus the fees of the underlying investments) well below that of the average equity mutual fund. While our models serve as base portfolios, each client account is unique because of inception date, cash flow, legacy securities, and specific client preferences.
How has this strategy worked so far? Very well, i.e. as expected. Our portfolios have behaved in a consistent fashion. All performance-related communication with our clients is educational and fact-based rather than promise-based. We tell clients and prospective clients that our goal is to achieve a risk-adjusted market returns in their portfolios. The specific risk-return characteristics of their portfolio, we explain, are tied to the all-important selection of their asset allocation. That decision, made jointly between client and advisor, is based upon risk preferences and financial planning outcomes. At each client review meeting, we provide a report that includes net-of-fee returns and compares the returns and risk of their portfolios with a wide variety of market indices. Since moving to an all-passive portfolio structure, we've found that setting reasonable investment expectations for our clients has become easier. The overall quality of our discussions with them has improved as well--we spend more time on elements of their financial lives that they can control or at least affect and less time discussing performance.
The downside? The process of educating clients about investments (and many other aspects of their financial lives) is an ongoing one. Some still come to meetings asking what changes we plan to make in their portfolios in response to or anticipation of the latest political or economic events in the news. Others ask us time and again about specific stocks or sectors that they have read about or heard about from family members or golf partners. We've tried to anticipate this by including an overview page in our standard client report that summarizes our service and investment approach. We briefly review this page at each client meeting to remind them that we're not stock-pickers or market-timers and that's not how we add value to their lives.
Finally, not all clients are attracted to a passive portfolio process--a fact of life that we're willing to live with. We know who and what we are (and what we aren't). When a prospective client tells us he or she is looking for an advisor who can consistently outperform the market, we quite honestly tell them we're not going to meet that standard. When it's appropriate, we might try to convince the client that they don't really need outperformance to meet their goals, or that the risk they'd assume to achieve outperformance is inconsistent with their life goals and risk tolerance. In the end, if someone is set on choosing an advisor based on a record (or a promise) of consistent outperformance we discourage them from working with us.
Our readers always ask about the tools that we use to implement strategies in our practice. For investments we use the following tools:
Money Guide Pro: This financial planning program contains a lot of historical market data and connects to Morningstar. We use it to analyze client portfolios, show asset allocation data, and connect asset allocations to the achievement of financial planning goals.
Morningstar Advisor Workstation Enterprise Edition: This version of Morningstar Workstation is available through our custodian, TD Ameritrade, and links to Money Guide Pro.
Morningstar Advisor Workstation Office Edition: This version contains a portfolio reporting and record-keeping module. We also use it to analyze current portfolios and to compare actual with model portfolios.
Finametrica: We use the version of Finametrica that is integrated with MoneyGuidePro. Clients complete a risk preference questionnaire and their responses are compared with thousands of people who have taken the test over many years. It's a nice way to quantify and confirm the qualitative assessment of risk tolerance we come to through our conversations with clients about their lives and their goals.
DFA returns program: this software provides an extensive historical database of asset class performance and correlation data. We use it for back-testing and developing our model portfolios.
Microsoft Excel: We maintain our trading log and trading worksheets in Excel spreadsheets.
A few tools that we do not yet use but have interest in:
Portfolio-rebalancing software: At some stage we would like to purchase a robust portfolio-rebalancing program to help us track our client portfolios. The two most often mentioned in the trade media are Tamarac and IRebal, the prices of which vary from $20,000 to more than $50,000 a year. Until we can afford to make that kind of investment, we're planning to test the new portfolio rebalancing tool offered on the TD Ameritrade custodial platform.
Investment policy statements: Software is available to help advisors automate and customize investment policy statements for clients. We've looked at IPSAdvisorPro, but have not made any decisions about purchase.
While we're satisfied with our current investment approach and confident that we provide an excellent value to clients, we never stop looking for better ways to do things. Recently we've had conversations with colleagues about outsourcing the investment function entirely by using a service like SEI Investments. This would free significant resources within Garnet to focus more on client service--a prospect we find extremely appealing. For now, though, we're committed to our passive investment approach, which is inconsistent with the SEI product offering. However, if it or another provider proffers a similar service with a strong selection of low-cost passive investment options, we would seriously consider taking the leap. We never shy away from change that provides an opportunity for us to efficiently give our clients more and better service.
What impact has your investment strategy made on your practice? Has it required a particular expertise, more staffing, additional resources and tools, or a decision to outsource to a third-party provider? E-mail us at firstname.lastname@example.org and let us know. Please remember that all comments will be "on the record" unless you request otherwise.