Investment Philosophy

En-light-en-ed v. 1. freed from illusion

Today, the vast majority of time and effort spent on investing is centered on the concepts of picking the right stock or timing the market. Stock picking and market timing or ‘active’ investing, are methods employed by most financial advisors and mutual fund managers in an effort to beat the market. While often entertaining, these strategies tend only to lead to increased compensation for advisors and lower returns for investors. The notion that active investing helps investors generate better returns is a mere illusion.

While the benefits of active investing are illusory, however, the additional costs and taxes incurred by employing these strategies are not…they are real.

In contrast, we utilize an enlightened approach to investing for our clients. Our investment philosophy is based on systematic processes and the most compelling academic financial research available.
   
 
   
 

Following is an in-depth discussion of our investment philosophy. We hope the discussion lays out a compelling case for the use of concepts such as asset allocation and passive investment management and the avoidance of conventional investment strategies such as stock picking and market timing.

Asset Allocation – Introduction
We believe the strategic asset allocation of a portfolio is by far the most important decision for all investors. The asset allocation decision involves the choice of which asset classes, such as equity, fixed income and real estate, to include in a portfolio and in what proportions.

    Structure determines performance
Successful investing, according to convention, requires substantial time, effort, and money spent on assessing which individual securities to include in a portfolio or when the ‘right’ time is to be in the market. Leading research has shown, however, that the asset allocation decision accounts for the vast majority of total return variation. A 1986 landmark study entitled ‘Determinants of Portfolio Performance’ examined the performance of 91 large corporate pension funds in the period from 1974 through 1983. The study found that policy (asset allocation) explained 93.6% of return variation while security selection and market timing accounted for only 4.2% and 1.7%, respectively.
   
 
   
 
Following are links to abstracts of key research studies:
    Determinants of Portfolio Performance; Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower
    Does Asset Allocation Policy Explain 40, 90, or 100 Percent of Performance;Roger G. Ibbotson and Paul D. Kaplan


    World Portfolio
Once the initial asset allocation decision is made regarding the mix of asset classes, the next step is to select the equity components and the proportions of each to include in the portfolio. We believe that the base case for the equity portion of the portfolio should approximate the World Portfolio. The World Portfolio is roughly equivalent to the stock market values in each area of the world and is the most diversified portfolio. Adjustments to the World Portfolio are made according to the distinct requirements of each client.

Passive Investment Management – Introduction
Our investment philosophy is grounded in the core belief that markets, not people, drive investment performance. This belief has led us to employ ‘passive’ investment strategies for our clients. Passive investing focuses on the risks and returns of entire asset classes rather than on individual securities.

Following is a transcript of the opening statement made by Dimensional Fund Advisors co-founder Rex Sinquefield in a debate about active versus passive investment management at the Schwab Institutional conference in San Francisco in 1995. It is an excellent primer on the underlying issues between the two approaches.

The next link is an article written by Dimensional Fund Advisors co-founder David Booth which explores the research and evidence supporting the use of passive strategies.


Evidence supporting passive investment management

1. The majority of active managers fail to beat their benchmark
Many studies have shown that over time, the vast majority of actively managed mutual funds fail to beat comparable index funds. A quarterly report published by Standard and Poor’s, entitled the Standard and Poor’s Index versus Active (SPIVA) scorecard, tracks the performance of actively managed funds relative to comparable index funds.
   
 
   
 
The scorecard clearly shows that over the past five years, only about 30% of actively-managed mutual funds outperformed comparable index funds.
   
 

2.  Winners do not repeat
Some attempt to counter point one by suggesting that while most active managers fail to beat the index, some managers do and advisors are therefore appropriately compensated to try to select the best managers or the best individual stocks for their clients. This line of reasoning might be more compelling if there were a way of consistently picking market-beating managers/advisors beforehand.

We are all familiar with the common disclaimer “Past performance is not a guarantee of future results”. Despite this warning, however, when researching investment opportunities, most investors will ask “what is the fund’s/advisor's track record?” In fact, advisors and mutual fund portfolio managers often promote themselves based on their investment performance track record. While the idea of selecting managers/advisors based on past performance is intuitively appealing, the reality is that we can not predict future investment performance based on previous results. In fact, research demonstrates that superior actively managed mutual fund performance does not persist.

In order to research the performance persistence of top-performing actively managed mutual funds, we looked at two five year periods. For the first period, we sorted mutual funds by average annual total return for the period 1996-2000. We then looked at the performance of the top fifty mutual funds from the first period over the subsequent five year period (2001-2005). The following table shows the result of our study.

     
 
The summary data at the bottom of the table starkly illustrates the detrimental impact of using track records to select investments. The top fifty performing mutual funds from 1996-2000, as a group, underperformed 66% of all mutual funds in the subsequent five year period. In fact, only 6% of the top funds in the first period, could be considered top performers (top 10%) in the 2001-2005 period.
   
 
3. The costs of active management
One of the primary reasons active investment management underperforms passive investment management is the substantial difference in costs associated with these strategies. The following table contains 10-year return performance and associated expenses for the average actively managed large cap blend fund, adjusted for survivorship bias, and the Vanguard S&P 500 index fund.
   
 
 

Note that the data exclude the impact of sales loads/commissions and taxes on distributions, both of which would increase the advantage of passive vs. active management.

The table demonstrates that the difference in performance is almost entirely explained by expenses. We believe this makes sense from a logical perspective. If we assume that all investors together are 'the market', then the return realized by all investors is the market return net of expenses. As a group, passive (low expense) investors should outperform active (high expense) investors.
   
 
Dimensional Fund Advisors – Introduction
We build client portfolios primarily using mutual funds from Dimensional Fund Advisors (DFA). The firm manages $150 billion (as of 6/30/07) in both institutional and private client assets. DFA was founded in 1981 by two classmates from the University of Chicago Graduate School of Business, based on the concept of applying leading-edge academic research to real world investment solutions.
   
 
DFA Philosophy
DFA mutual funds are managed based directly on the results of leading-edge academic research. Following are three characteristics which summarize the firm’s philosophy:
       
 
1. Markets are efficient: Competition for capital by companies and investors forces market values towards fair value. As a result, attempts to outperform the market tend to reduce investor returns.
Note: This is the core philosophy underlying passive investment strategies
   
2. Risks worth taking are those that reward investors over time:
     
   Multifactor Analysis  
   
I.
Equity Market- Stocks have higher  expected returns than fixed income.
 
II.
Company Size- Small company stocks have higher expected returns than large company stocks.
 
III.
Company Price- Lower-priced “value” stocks have higher expected returns than higher-priced “growth” stocks.
       
 
3. Portfolio strategies should focus on asset classes, not commercial indexes:
 

While philosophically similar to traditional index funds, Dimensional adds value for investors beyond index funds. The firm adds value by focusing on maximizing asset class returns rather than on minimizing tracking error to commercial indexes such as the S&P 500.

The goal of traditional index fund managers is to deliver returns that track the underlying index as closely as possible. In order to achieve this goal, the fund manager must buy and sell securities due solely to changes in the underlying commercial index. This causes the fund (and fund investors) to incur additional trading costs which reduce realized investment returns. In addition, index changes are often announced ahead of the actual change date which allows short-term traders to buy ahead of stocks entering the index and to sell ahead of stocks exiting the index. This factor also reduces index fund returns relative to the potential asset class return. Dimensional avoids these problems by focusing on asset classes which are defined by objective size and valuation criteria rather than on commercial indexes.

The impact on performance of DFA’s trading strategies compared to traditional index funds can be seen in the following table. The data show average annual returns of comparable DFA and Vanguard mutual funds.
   
 
 
Comparing the returns of five assets classes, DFA funds outperformed Vanguard by an average of 1.33% per year for the period of 6/30/98 – 06/30/08