We employ a “passive” asset allocation investment strategy which seeks long-term, tax efficient growth while simultaneously controlling risk and volatility. We feel it is impossible to consistently predict the short-term movements of the stock market or the economy; therefore we do not utilize market timing or short-term trading.
Our investment philosophy is based upon the work of world renowned professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College, who have developed an academic approach to investment management based upon statistical analysis and financial economics rather than Wall Street marking hype.
The equity portion of our investment portfolios typically use passive index ETFs, and low-cost mutual funds offered by Dimensional Fund Advisors (DFA). DFA mutual funds are not available to the general public. Rather, they are offered only to institutional investors or through a select group of fee-only financial advisors. We encourage you to visit the DFA website (www.dfaus.com) to learn more about what makes DFA mutual funds the best choice for many investors.
For the fixed income portion of our investment portfolios, we prefer using individual bonds rather than bond funds. More information on the benefits of using individual bonds and our fixed income strategies can be found at www.pdxfis.com, our website dedicated to fixed income investing.
The well-known efficient market theory says that fundamental data is too quickly reflected in prices to allow such data to be used for “beating the market”; and that professional money managers cannot outperform markets in any meaningful sense.
Research supporting this theory comes from the nation’s universities and privately funded research centers, not from Wall Street firms, powerful banks, insurance companies, active managers, and other groups with a vested interest in the huge profits available from active management. Results from this research are clear and indisputable; passive investment management decreases costs and increases returns compared to active investment management, and passive investments are more tax efficient.
In 1992, University of Chicago economists Eugene Fama and Kenneth French published a paper pointing out that portfolio returns are influenced by three factors. Their Fama French Three-Factor Model maintains that a portfolio’s expected return increases not only as a result of increasing the allocation to stocks in general, but also as a result of increasing the allocation to small-cap stocks and/or value stocks.
Factor 1 – The Stock Market– Fama and French compared stocks against the risk-free one-month U.S. Treasury bill rate, for the years 1991-2010. They found that global stocks returned excess gains of 0.43% per month above and beyond the T-bill rate on average. Asia Pacific had 0.86% monthly excess gains. Clearly stocks were shown to be a good investment when compared to a risk-free benchmark such as U.S Treasury bills.
Factor 2 – Small Stocks vs. Big Stocks – Size is the second factor in the Three Factor Model. This factor compares the weighted average market value of the stocks in a portfolio to the weighted average market value of stocks on the market. Small stocks tend to act very differently than big stocks in almost all market conditions. In the long run, small stocks have generated higher returns than large stocks, although the extra return is not free. There is more risk in small stocks.
Factor 3 – Value Stocks vs. Growth Stocks – Fama and French then compared value to growth stocks by examining companies with low price-to-book ratios (i.e. value stocks) to companies with high price-to-book ratios (i.e. growth stocks). Interestingly, on average, value stocks outperformed growth stocks during 1991-2010 by 0.46% per month. Thus, the research showed that value stocks provided greater potential returns than growth stocks.
Fama and French then went on to establish that while the average value stock delivered returns 0.46% higher than growth stocks, further research showed that small value stocks outperformed large value stocks. In fact, small value stocks provide excess returns over growth stocks to the tune of 0.67% monthly, while large value stocks only beat the average growth stock by 0.25% monthly. Fama and French found that the combination of all three factors explained 95% of a diversified portfolio’s return.
The academic researched described above is the core of our investment philosophy, but there are two other factors that we find as important as the other three: tax efficiency and cost.
Tax efficiency is a measure of how much of an investment’s return is left over after taxes are paid. The more that an investment relies on investment income – rather than a change in its price – to generate a return, the less tax-efficient it is to the investor.
We know passive investments are inherently more tax-efficient than actively managed investments. Proactive tax planning, strategic placement of the right investments in the right accounts, and a thorough understanding of tax law can make a significant difference in after-tax investment returns.
Investments taxed at the highest rates belong in your tax-deferred or tax-free Roth accounts. Those include taxable bonds, CDs, and REITs. Efficient investments such as passive index funds and municipal bonds belong in your taxable accounts. That’s because dividends are taxed at a lower rate, and capital gains can be deferred by holding the investments.
By buying and selling the right investments at the right time using tax loss harvesting, we can limit the recognition of short-term capital gains, which are normally taxed at higher federal income tax rates.
The higher the investor’s marginal bracket rate, the more important tax efficient investment planning becomes. An investor in a 35% tax bracket receives more benefit from tax efficiency on a relative basis than an investor in a 15% bracket.
All things being equal, passive and actively managed funds will both underperform the market by the amount of their expenses. Active investors must overcome many costs to match the returns of the average passively managed portfolio. These include trading costs, much higher management fees, and commissions. We primarily use commission free index ETFs and low cost DFA funds to minimize expenses.