When we explain our investment philosophy, we tend to focus on “big picture” ideas such as diversification, discipline and the long-term power of capitalism. But practical implementation is also essential to the success of an investment strategy, so it is worth describing how we select the funds we typically employ.
Round One: Speculative vs. rules-based strategies
Our selection process is like a highly personalized, single-elimination tournament. We still consider the entire mutual fund universe and its thousands of possible contenders. But it is relatively easy to eliminate the vast majority of them in the early rounds, with only the strongest surviving as viable candidates.
In the first round, we want to distinguish between speculative fund managers and rules-based fund managers. We can eliminate the speculative fund managers from contention, as they are playing an entirely different game from what we have in mind.
Speculative strategists try to forecast the upcoming performance of securities, sectors or markets and trade accordingly. Speculative individuals may do this by gazing at a fund’s “star” rating or acting on seemingly hot tips from any number of sources. Fund managers may hire well-heeled analysts to probe the universe for secrets about to unfold, and issue buy, sell or hold recommendations accordingly. Either way, these are not exercises that we expect will beat the market, especially after the costs involved in trying.
Instead, a rules-based fund manager can simply hold the entire universe of securities and be part of its expected expansion. Speculative fund managers may be working very hard at what they’re doing, but it’s an exercise that is more likely to detract from than add to your goal of building and preserving durable wealth in volatile markets. By eliminating those who are engaging in speculative tactics from our recommended playlist, we can readily knock out a wide swath of would-be fund selections in the opening round.
Round Two: Passive vs. rules-based strategies
Once we disqualify speculative fund managers, that still leaves a relatively large (and growing) collection of funds that seek to efficiently capture various dimensions of the market’s expected long-term growth without engaging in seemingly fruitless and costly forecasting.
“…the final step is to match the best funds with the most important factor of all: you and your individual goals.”
In this category, you’ll find two broad types of funds: First, passive index funds, which track popular benchmarks such as the S&P 500 or the Barclay’s Global Aggregate Bond, which in turn track particular market asset classes such as U.S. large-cap stocks or global bonds. Second, rules-based funds, which seek to wring the highest expected returns with the least expected risk out of these same asset classes in a more flexible, but still rigorously disciplined manner.
The goals of passive and rules-based strategies are similar, mind you, making it harder to choose among these second-round contestants. Each emphasizes the importance of minimizing wasted efforts and maximizing the factors we can expect to control. Still, all else being equal we typically favor rules-based funds for the core of our clients’ portfolios. We feel they are structured to do an even better job at participating in relatively efficient markets over time. By being freed from slavishly following a popular index benchmark and other restrictive parameters, they can focus directly on the fund management factors that matter the most. This includes most effectively capturing markets’ expected returns, while minimizing trading costs and taxes, and dampening some of the noisy volatility along the way.
Round Three: You and the rules-based strategy
Once we’ve narrowed down our fund choices to a manageable group, the final step is to match the best funds with the most important factor of all: you and your individual goals. This is one of many reasons why we create for our clients a personalized investment plan that addresses the appropriate level of risk to be taken, the level and timing of cash flows needed, and the strategy for minimizing taxes.
For example, investing heavily in even the best small company stock fund may be a poor choice for you if your primary goal is to preserve the wealth you already have accumulated. Conversely, an excellent conservative bond fund may not be appropriate if you are seeking aggressive growth and are willing and able to take on considerable market risk to do so.
A solid fund selection strategy
Our final round involves forming the remaining contenders into a unified team of funds that is optimized to reflect your unique goals and risk tolerances. Then, we help you maintain the discipline to stick by your carefully constructed portfolio, not just for a game or two, but over the seasons of your life.
When we talk about fund selection, we deliberately emphasize the qualities that decades of empirical and practical evidence have indicated are worth pursuing over time, and we explicitly downplay the more reactionary antics found in the financial media. Celebrity fund managers – with their glittery victories and agonizing defeats – may be interesting to read about, but we believe that the best investment selections are the ones that help you achieve your own hopes and dreams by keeping your financial footing on a solid, rules-based ground.