Executive Summary

For simple diversification of relatively small investment capital accounts, mutual funds (and the like) are typically used. However, as investment capital for the client grows over time, the inherent inefficiencies of mutual funds become apparent. The solution to this is a discretionary advisory managed portfolio relationship that enacts a proper selection of direct stock ownership.

Discussion

Generally, individuals open and fund investment accounts in small amounts, typically less than $100,000. The overwhelming investment choice in these cases is mutual funds. While this is certainly a start to eventually building retirement investment capital, in a relatively short period of time the inherent inefficiencies of mutual funds become apparent. The recent trend of retirement investment capital being built within qualified accounts has masked these inefficiencies somewhat.

The first inherent problem is the Portfolio Creation problem. Typically, a proper question to ask a portfolio manager is “How do investments get selected for inclusion into the portfolio?” This is the “How” question. This is not the only influence upon such managers, however. Mutual fund managers are constantly measured against some seemingly relevant performance index. The relevant index may be set by management, by some outside consulting / review service, or by the expectations of the shareholders themselves. This causes, the portfolio manager to engage in “Am I willing to lose my job?” portfolio creation. There are two possible outcomes. The first is should the manger own securities in different weights relative to the index and out-perform, he potentially gets a bonus or promotion to a larger fund. The second is should he under-perform, he may be fired or demoted to a smaller fund. What can make this type of investment selection worse is when his constituents are not even all focused on the same index and the portfolio manager is aware of this dichotomy. In essence, this is the true “Why” question that the portfolio manager must first answer before finalizing his “How” answer. “The Why behind the How”, is the single greatest question that needs an answer when analyzing portfolio creation.

The secondary problem is the Over-Diversification problem. It has been proven time and time again that proper diversification can be statistically achieved with approximately forty (40) separate investments. Given this well-known theorem, why does almost every mutual fund seem to own almost ten times (10x) this number? While a broad market index may contain 500 separate investment securities, why do mutual fund portfolio managers persist in owning an excessive number of securities when they know that it is not providing any substantial diversification? Warren Buffet has been quoted as parlaying a Mae West quote into one of the most insightful, yet light-hearted investment quips of all-time. It goes, “Too much of something can be a wonderful thing.”

Then there is the Asset Allocation problem. Since using hundreds upon hundreds of equity securities didn’t already provide a ridiculous amount of over-diversification, the mutual fund industry has decided to segment itself into two additional categories: equity security sub-groups within the overall group of equity securities (hence the use of the monikers Large Cap, Mid Cap, Small Cap, Growth, Value, Core, International, etc.) and the addition of fixed income, real property and commodities-related funds. The mutual fund industry has expanded its product offering to meet this contrived Asset Allocation “need”. Indeed, it is not only the mutual fund industry which profits from Asset Allocation, but also most Advisors; as they are only advisors and not active investment managers. Historically, simple Asset Allocation and the rebalancing of its investments have provided slightly better returns and slightly less risk as measured by the organizations that promote it. What they fail to measure is the tax effect of rebalancing, the friction costs as measured in commissions, fees and expenses, and define risk as simple deviation of price movements of the securities themselves and not of the economic investments those securities represent. In essence, the mutual fund portfolio managers, in collaboration with others in the investment trading world, determine short-term security prices; which then influences both the returns and the risks of the exact items they are measuring and then promoting to clients.

The easiest way to explain the faults of asset allocation investing is to attack it's most obvious flaw. Every economic transaction conducted every day, everywhere is based on one thing. This one thing is the "Price-to-Value Relationship". The buyer is willing to pay a certain price for perceived value. The seller believes they own or have created something of value and is willing to sell it for a certain price. Homes and autos are bought for a certain price because of the value they will bring the new owner. Similarly, stocks, bonds, investment real estate and commodities are bought because of a belief in their value. Whether the eventual value of the item purchased is less than or greater than the initial price paid, is something that isn't determined until some period of time has elapsed. The flaw in Asset Allocation investing is that the components used to determine an individual's asset allocation is typically their age and investment risk profile. The Asset Allocation model is never done with an analysis of the current "Price-to-Value Relationship" of the assets used to perform the investments. Instead, the model relies on at least six implicit assumptions related to this lack of analysis on the current "Price-to-Value Relationship": The first assumption is that the "Price-to-Value Relationship" of stocks/bonds/real estate/commodities/whatever is currently in balance, individually, for all of the asset classes used. Their current price is neither overvalued, nor undervalued to it's eventual terminal value. The second implicit assumption is that the "Price-to-Value Relationship" stays within a modest range of normal during the period the client is using asset allocation as an investment strategy. The third implicit assumption is that the "Price-to-Value Relationship" is normal at the end of the client's usage of asset allocation. The fourth, fifth and sixth implicit assumptions are that the risk profile of each of the asset category used is normal at the initial starting point; stays within a normal range during the asset allocation duration; and is normal at the end of the asset allocation time frame.

All of these implicit assumptions need to be tested by the Investment Advisor at all times. As such, it is vital for all Investment Advisors to have extensive Investment Management experience so that they may properly test these implicit assumptions before giving advice to their investment clients. Typically, they do not.

There is a second problem with Asset Allocation as a marketed investment strategy. This problem is enormous in scope and is the running joke on Wall Street. On Wall Street, there's a sick joke that goes like this: "If you try to steal a lot of money, from a few people, in a short period of time, you go to jail. But if you steal a little bit of money, from a large segment of people over an extended period of time, you get rich". Asset Allocation is the "Lie, Deceive and Steal" strategy of client money.

The Asset Allocation Lie starts like this, "Studies have shown that over the long-term it is not your individual investments that determine your investment results, but your investment allocation." Now let's step back and think on this for a second. Warren Buffet is generally considered the greatest investor ever. In one sentence, every Financial Advisor has just belittled and indeed, insulted, his life work. They have not only insulted his investment decisions and results of the past six decades, but also his lifelong desire to teach the public at large about how to invest appropriately. This insult continues on to his shareholders who invested in his company on the belief that they might reap excess investment rewards in the future. Every Hedge Fund Manager, every Portfolio Manager, that has utilized proper stock selection, like Mr. Buffet, as their investment strategy and has achieved success with that investment strategy is being insulted. Every one of their investors, who invested with them in the belief that they could utilize proper stock selection as an investment strategy, is also being insulted. And there is one final person who is also insulted by this entirely false concept, and that is: everyone else, literally. Every individual investor who has not invested with or even heard of Warren Buffet is being insulted by almost every financial firm and advisor in the industry since these strategies, enacted by the successful investment managers, are not being presented as options to the public at large. This is the Lie.

Then there is the Deception. The deception uses the Lie to get you, the unknowing individual, to trust the Financial Advisor (or more accurately described, the Salesperson) and utilize their services as well as their firm. Because as long as you don't know about the other, more effective investment strategies of elite investment managers, you'll turn your money over to idiots. The idiots are active investment managers who are incapable of beating relevant benchmarks over a reasonably significant period of time.

Finally, there is the Steal. The firm and the advisor charge what seems to be a "low fee" in relation to historical returns, but is in fact a very high fee for the actual services they perform for the client. This "low fee" grows over time as you save and invest more capital and have some positive investment returns. As the "low fee" grows, the compensation to the firm and advisor grows while they continue to do effectively nothing. The effectively nothing is not a comment on their effort, but rather their investment underperformance. In addition to underperforming, they also charge fees, creating even more of a negative wealth effect for each client. And some of the fees they charge current clients is marketing expenses to gain new clients. This is the second part of the joke in action, "But if you steal a little bit of money, from a large segment of people over an extended period of time, you get rich." Who gets rich? Not the client, but the firm and the advisor.

After all this, there is still the Valuation Analysis problem. This takes several forms with respect to how the client and his advisor evaluate his portfolio. When the client is directly invested in mutual funds, it is very difficult to build a valuation analysis on a portfolio with numerous investment securities. There is no way for the client and his advisor to possibly be current on the Financial, Operational, Managerial and Competitive issues facing each individual security when there are hundreds of investments within one mutual fund and the client probably has investments in other mutual funds that would also need this analysis. Additionally, a client’s risk tolerance needs to be examined precisely with a current valuation analysis of the client’s holdings. Most advisors, and their firms, engage in basic 101-level thinking when it comes to equity, fixed income, real property and commodity allocations. A conservative person should own “bonds” or other types of fixed income in preference to equities, in their view. What they fail to ever factor in is the "Price-to-Value Relationship" of such securities. A numerical example of this is: If bonds are yielding 1% returns, in an inflationary, economic growth environment with equity securities yielding 100% (yes, as an example only, 100%) returns, those advisors, usually at the express direction of their firms, will not ever change their recommendations. They will not even consider the "Price-to-Value Relationship". Thus, they would convince the client that the safest portfolio is one filled with “bonds” and not "stocks". These advisors are specifically prevented, by both their firms and regulators, from ever exercising judgment, which is precisely what the client thinks he is paying for. Finally, there is the matter of what future investments within each mutual fund, whether it’s stock, bond or otherwise comprised, will be. So, not only is it extremely difficult to perform a Valuation Analysis on the many mutual funds the client owns, it is near impossible to keep up with the future changes of the comprising securities; especially since they are only reported quarterly and with delay.

The Long-Bias problem is one that most clients and advisors don’t even realize exists, until it’s too late. Over long periods of time, investments do tend to increase in value, though not without ups and downs. Advisors and worse, regulators, believe therefore that the only counsel clients need is on what is typically referred to as the “Long side” of investing. Buy and hold. While every investor should meaningfully participate in an appropriate buy and hold strategy of diligent, thoughtful stock selection, the Advisor who is ignorant of the reverse trade, or what is known as “Shorting” (or the “Short side”) is missing a key piece of his own education and is therefore utterly incapable of properly advising his client on even the “Long side” itself, as the two are symbiotically linked. The discipline of finding, researching, following, investing and consistently profiting on the “Short side” by the Advisor, in his investment management role, exponentially increases his wisdom when selecting “Long side” investments. Even if that Advisor never recommends Shorting to any of his clients, knowledge of the concept and wisdom of its experience provide for a vastly improved selection process of Long-only investment strategies. Shorting can be risky, and is usually much riskier than being Long. However, there are times when it is in fact less risky. Most Advisors and again, regulators, have little understanding of this fact as their own lack of education on the subject leads to improper analysis of it and most importantly, improper analysis of the Long strategy they so desperately cling to.

Finally, there is the Taxation Control problem. Each individual client has a unique tax situation. While there are common generalities, like tax rates and deductions, a client’s financial life is not stagnant. Income levels can change over time. Individuals' sometime change the manner in which they are compensated either in operational or financial or legal terms. Families grow up and change in composition. Expense levels can change drastically over a multi-year period, both up and down. Individuals live a life outside their portfolios. All of this effects their tax situation. Their investment capital growth, depending on the manner and rate in which it has grown, also contributes to their tax situation. Indeed, in some ways it is an almost circular function itself. Thus, an individual will have many tax planning related changes over time. Exacerbating all this is that some of these changes are predictable and others are surprises. Allowing someone else to conduct trades and create realized, taxable events outside of the control of the client and his advisor, is akin to handing someone the keys to your house and then leaving for a week. You have no idea what your outcome will be. You will be required to deal with it, however.

As individuals grow their investment capital base over $100,000, they require a change in investment philosophy and potentially their professional investment relationships. These individuals should look for an Investment Advisor that has Investment Management wisdom.

Please have an Alpha Investment Advisor contact me.