The Dimensions of Investing
We believe that free markets work. That assets generally reflect correct prices and you cannot reliably find undervalued securities or overvalued markets.
Active Management includes both security selection and market timing. Security selection is the attempt to select mispriced securities within an asset class. The active manager believes they are mispriced so he/she can buy the security at a low price when it is undervalued and sell it at a high price when it is overvalued. This assumes that the market, the consensus of all investors, has failed to price the security at its true value and that the active manager can predict the future consensus of investors that they themselves cannot yet see.
Market timing is the attempt to determine when an entire market is under or overvalued. The active manager attempts to shift assets from overvalued markets to undervalued markets at a profit to investors. This assumes that the active manager can predict the direction of entire markets. We do not dispute that if market timing were possible you could achieve tremendous gains. However, market timing’s premise is on overvalued/undervalued markets or asset classes and requires an ability to predict interest rates, government action, consumer sentiment, and the other ambiguous drivers of market fluctuation. In effect, market timing requires an ability to predict the future.
We believe that market timing in any form, even subtle shifts in asset allocation based on predictions of market movements, is futile and is not a sound strategy for investing its clients’ assets. Studies show that in most recent years, less than half of money managers perform better than their asset class index. The “out-performers” are different money managers each year and over longer periods, there are a decreasing number of index “out-performers”. The number of managers who beat the indices is about what you would expect statistically, by chance.
Finally, active management often causes excessive trading which results in higher expense ratios, brokerage commissions, taxable gains, and bid/asked spread costs. The costs of active management would require excess returns above market returns. The evidence, however, is that active management does not improve market returns and costs the client dearly.
Passive Index Strategies do not attempt to predict the future and instead buy all securities of the market or of a certain index. Thus, passive management does not use security selection or market timing to outperform the market. It instead selects all securities in the index it is attempting to duplicate. Most passive index strategies trade strictly according to the index but do not focus on trading costs. Passive index strategies also do not select specific dimensions of the market that academic studies and modern portfolio theory have proven can add value to a portfolio.
Structured Market Portfolios, use precise asset classes, which capture the returns of unique dimensions of the market. By combining asset classes with offsetting correlations, clients’ portfolios gain diversification as described in Markowitz’ Nobel Prize-winning theory. In creating Structured Market Portfolios, we use asset class strategies, which, like passive index strategies, do not attempt to predict the future. In contrast to index strategies, these asset class strategies are not necessarily attempting to duplicate an index, but to capture empirically proven dimensions of the market that provide unique returns to investors. For example, we specifically target asset classes such as international small high book to market stocks, U.S. 9th and 10th size deciles stocks, or five-year maturity U.S. Government bonds. Unlike passive index strategies, the asset class strategies in our Structured Market Portfolios focus closely on trading costs and do not place trades strictly to adhere to targets but to take into account both the assets needed and the trading costs associated with acquiring them. Structured Market Portfolios provide investors with efficient portfolios, because they focus on both the return and correlation of specific asset classes while keeping trading costs to a minimum.