To construct our portfolios, we use an asset class investment approach. Details of our investment philosophy and the different types of investing are outlined below for your information.
Our core investment beliefs:
- Managing core wealth is not about stock selection or picking winners, rather the process of maximising the certainty of an outcome.
- Asset allocation determines long-term performance, rather than market timing and stock selection.
- Diversification is the key – with the benefit of hindsight, every investor would invest in last year’s best performing asset class. Diversification manages uncertainty by substantially reducing risk with minimal impact on returns.
- The use of active (or forecast-based) fund managers increases the risk of ‘getting it wrong’, and is just as likely to detract from value as add value. Their management and transaction costs contribute to average performance.
Background
The investment approach a fund manager uses to make choices in the selection of securities for the fund’s portfolio is typically called ‘Investment Style’. Traditionally, a fund manager can be categorised as either an Active manager or an Index manager.
Active managers focus on individual security selection and market timing, and their objective is essentially to add ‘Alpha’, or in simple terms, ‘beat the market’.
Active managers will typically hold a portfolio with a limited number of stocks (e.g. 80 – 100 for an Australian Share fund). Although this can offer some advantages if this type of fund forms a small part of an overall portfolio, it is essentially the antithesis of diversification.
In the past, we have predominately used Active funds within our portfolios. Whilst we believe this has been successful to a point, it has become virtually impossible to predict who the best performing fund manager is going to be in advance. The success of an Active fund manager is often based on the talents of a ‘star’ investment professional, which is quite fragile in today’s environment because we never know how long the ‘star’ is going to remain employed by a particular fund manager.
The risk of staff turnover and an Active manager’s stock selection are two areas that can have a negative impact on performance (i.e. Manager risk). The stock turnover within an Active style managed fund creates realised capital gains, which are then distributed as income to the unit holders. This income is assessable in the hands of the unit holder and may give rise to unnecessary taxation, which effectively reduces the actual rate of return.
One way to reduce the risk of staff turnover with Active Managers is to adopt a ‘Multi Manager’ approach, which provides fund manager diversification. Whilst this has proved successful, there is an added level of complexity and cost that comes with this approach.
Essentially, the result of investing in Active funds or via a Multi Manager strategy is that you often ultimately receive index style returns, whilst still paying a higher level of ongoing costs.
Index managers on the other hand, focus on constructing a portfolio that tracks a market index. Index funds typically hold many securities, however, the objective is simply to generate market return by matching a particular benchmark (e.g. S&P/ASX 200 index).
A key negative in relation to an index fund is that it will typically have high transaction costs and in many cases, realisation of capital gains due to the necessity to track a chosen index.
For example, if a company has a fall in share price, which results in the stock dropping off an index (i.e. the S&P/ASX 100 index), then the fund manager has an obligation to replace the stock in the fund. If this company’s share price rebounds the following day, the fund manager will have to repurchase the stock and sell down whichever stock it has replaced.
Our investment approach
Our alternative to an Active, Index, or Multi Manager approach, is the ‘Asset Class’ style of investment management based on sound academic principles. This matches our long-standing investment philosophy of a buy-and-hold approach to money management.
This approach means investing literately in asset classes via portfolios that capture, in their entirety, the various asset classes under consideration. For example, Australian Large Companies, International Small Companies, or Emerging Markets.
Although we can use index managers in order to gain exposure to passively managed funds, one group, DFA Australia Ltd (“Dimensional”), departs from traditional management by structuring portfolios through financial science.
Unlike index funds that follow commercial benchmarks, in the asset class style fund, Dimensional define an eligible universe of all traded stocks of real operating companies and then apply filters to exclude stocks that do not fit the asset class of the fund, or that have specific pricing or trading concerns.
Rather than replicate an index in mechanical fashion, they permit deviations from market cap weightings and allow for the integration of stocks among asset classes. This flexibility also allows them to reduce transaction costs caused by counterproductive trading. For asset classes defined by size, a slightly higher hold or “buffer” range allows Dimensional to retain securities that commercial indexes are forced to sell, which reduces turnover and can increase returns.
Accessing this approach through Dimensional’s range of funds allows us to build scientifically based portfolios that are highly diversified, with significantly reduced ongoing management fees and Manager Risk i.e. the risk of poor performance resulting from the investment decisions of a fund manager.