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Dispatches from the Desk
As summer turns to autumn and temperatures begin to drop, restaurants often feature hearty soups and stews on their menus, which include many ingredients that work well together. Designing investment strategies is similar to cooking a great stew: combine the best “ingredients” into a diversified portfolio that can stand the test of time. At United Income, our approach has been to create balanced portfolios using various “ingredients” or strategies that have historically outperformed. (From 1999 to 2018, the MSCI USA Minimum Volatility Index, MSCI USA Sector Neutral Quality Index, MSCI USA Momentum Index, MSCI USA Enhanced Value Index and MSCI USA SMID Cap Index have all outperformed the MSCI USA IMI Index, measured using annualized compound return (gross dividends). There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies. Mutual funds, exchange-traded funds, and other securities are subject to risk, including loss of principal. All investments have inherent risks. Past performance does not guarantee future results.) Since we don’t know which strategy will outperform in the future, we blend them all together to increase the likelihood that your portfolio is exposed to a winning strategy. (Davey Quinn, “Our investment philosophy”, United Income, Jan 2018)
But, just like some diners like a drop of hot sauce or an extra sprinkle of salt in their stew, some investors also have a specific preference for their own portfolio, such as an extra focus on U.S. stocks instead of a global portfolio. Since specific preferences can have a lower expected future rate of return, we don’t recommend these strategies for everyone. However, we understand that some people invest for reasons other than maximizing their future risk-adjusted investment returns.
For these reasons, we are excited to announce that we will be releasing support for additional investment strategies and preferences later this year. You will be able to find these strategies in your United Income account and can talk to your wealth manager or our investment management team about them in more detail. I want to devote this column as a preview of the exciting innovations coming to you soon. First, though, let’s review the academic literature on the expected wealth consequences of investment preferences that deviate from a strict focus on maximizing risk-adjusted returns. We think this is critical information for anyone with preferences to understand.
Academic Evidence Concerning the Wealth Costs of Preferences
There are at least two lines of academic work that provide important context for those considering a taste or preference that is less balanced than the core United Income portfolio.
The first is from Eugene Fama, a Nobel Laureate who still teaches at the University of Chicago. Back in 2012, I completed his PhD course on the ‘Theory of Financial Decisions’ during my graduate studies at the university. According to his work, investors with a taste for certain assets can earn a lower investment return over time compared to those who invest in a diversified, market portfolio. (Eugene Fama and Kenneth French, “Disagreement, tastes, and asset prices”, Journal of Financial Economics, 2007) To see this, let’s consider investors that exhibit a strong preference for owning environmentally friendly stocks. While this preference may square with their values, the downside is that this concentration can reduce their portfolio diversification. Historical data highlights the economic shortcomings of such an approach. (As of August 31, 2019. Comparison between DSI, an environmentally friendly exchange-traded fund, and IVV, an S&P 500 exchange-traded fund. )
Over the last 10 years, an environmentally friendly strategy underperformed by 0.78% per year compared to a more diversified approach.
However, investors with an environmental preference may have received non-economic value from owning these companies (for instance, they may be happier knowing their portfolio is aligned with their values), which could have outweighed their lower wealth accumulation.
A second line of critical work to understand before biasing your investments toward a specific preference comes from Nobel Laureate Daniel Kahneman, who was based at Princeton for much of his career. He found that some people have a strong preference to avoid decisions that could result in losses, even if the expected outcome was positive. (Daniel Kahneman, Jack L. Knetsch, and Richard Thaler, “The endowment effect, loss aversion, and status quo bias”, Journal of Economic Perspectives, 1991) For instance, Kahneman found that some people would not risk losing $10 in a coin flip, even if they stood to gain $20! Even though these folks would earn more than they lost in half of the coin-flips, they would choose not to participate. (Carl Richards, “Overcoming an aversion to loss”, New York Times, Dec 9, 2013; https://www.nytimes.com/2013/12/09/your-money/overcoming-an-aversion-to-loss.html) For these individuals, the fear of losing something they already own was more painful than the dollar amount lost alone. These discoveries about “loss aversion” were fundamental in understanding why human behavior often contradicts the optimal choices that traditional economic models suggest.
Investors display other preferences that similarly may reduce potential returns over time. One example we often see is a bias towards owning more U.S. stocks than a global index would suggest. Another typical example is concentrating your portfolio in a handful of stocks, instead of owning a more diversified set of holdings in an exchange-traded fund or mutual fund. Both preferences provide you with a more recognizable set of holdings – Microsoft and Visa instead of MTUM and VLUE, for instance. But, both preferences also reduce diversification, which, research has found can lead to lower expected returns over time.
In pure economic terms, investment preferences can reduce wealth over time. But, the non-economic value investors earn from exercising their tastes can outweigh their performance loss.
Our Investing Principles
There are literally hundreds, maybe even thousands of potential preferences and investment strategies that we have the technical and intellectual capacity to build portfolios around. As we were evaluating which of these to adopt, we let our investing principles guide this thinking. We have shared these principles with you before, but we wanted to repeat them here since they are central to how we believe people can safely and effectively build wealth.
- Evidence-Based: Our investment strategies and the investment products we select have a basis in academic and practitioner research, aiming to increase wealth for our clients using reliable, time-tested methods.
- Cost-Effective: The approaches we employ focus on total cost of ownership and seek to reduce investment expenses and transaction costs.
- Tax-Smart: Our trading process and the investment products we select aim to minimize taxes for our clients. This tax-minimization goal is pervasive throughout our approach, from the advice we give to the securities we trade to the products we choose.
- Systematic: We aim to take the emotion out of investing, so you can stay on track. Each of our investment strategies and the daily routine to keep client portfolios balanced follow a process-driven approach alongside our trading experts.
Diversified Core Investment Strategy
These principles led us to create diversified core investment strategies for clients that we believe have the most persuasive academic and data support. Within stocks, the sub-strategies that comprise a core strategy include:
- Defensive Equity focuses on less volatile stocks, which have historically held up well in down markets, although they have tended to lag in bull markets. (Alex Bryan, “Defensive equity under the microscope,” Morningstar Inc, Sep 2, 2015; http://www.morningstar.com/articles/713494/defensive-equity-under-the-microscope.html)
- Quality focuses on companies that consistently deliver reliable financial results. Academic studies have demonstrated that these companies can outperform the market in the future. (Robert Novy-Marx, “Quality Investing”, May 2014 (revised))
- Momentum focuses on stocks that have recently been outperforming the broad market. Research has found that these high-flying stocks can continue to climb in the near future. (Clifford S. Asness, Andrea Frazzini, Ronen Israel, and Tobias J. Moskowitz, “Fact, fiction and momentum investing”, Journal of Portfolio Management, Fall 2014)
- Value focuses on stocks with low prices relative to financial metrics, like earnings. These stocks can outperform their more expensive peers over time, but patience is required. (
Thorsten Hens and Klaus Reiner Schenk-Hoppé, “Patience is a Virtue - In Value Investing”, Swiss Finance Institute, Mar 21, 2018)
- Small-Cap focuses on smaller companies, generally with less than $2B in market value. These stocks help diversify your portfolio and can outperform the market in the long-run. (Steve Dean, “30 years of U.S. small cap investing”, AXA Investment Managers, Apr 2018)
Within bonds, the sub-strategies that make-up a core strategy include:
- Duration focuses on bond maturities. Generally, the longer the duration, the more risk your portfolio is exposed to and the higher your expected return, and vice versa.
- Credit Quality focuses on creditworthiness. Corporations often have lower credit quality than Governments, and with lower credit quality comes higher expected returns. (“Everything you need to know about bonds”, PIMCO; https://www.pimco.com/en-us/resources/education/everything-you-need-to-know-about-bonds)
Diversified strategies blend together different investment strategies that have been popularized by academics and investment professionals.
We implement our strategies generally using exchange-traded funds (ETFs) because they are often more tax-efficient and lower cost than comparable mutual funds, although both provide diversification. When evaluating a strategy, we evaluate three criteria: returns, risk, and costs. We use data to inform our decisions, however, some investment products have a short trade history, so we need to use some intuition and take performance results with a grain of salt.
Next, we introduce two strategies that use very similar products to a Diversified Core approach, but accommodate two preferences, one that reduces volatility and the other that reduces tax liability. This is only meant as a preview. When we release these strategies later this year, you will be able to find more information in your United Income account and by talking to your wealth management team.
Defensive Core Strategy
A Defensive Core strategy is very similar to a Diversified Core Investment approach but seeks to reduce some volatility within a client’s stock exposure, smoothing out some of the swings up and down in portfolio value over time. Although this strategy can accomplish that objective, it will likely lead to a lower return over time as a result.
To implement this strategy, we increase the weight to lower volatility stock strategies, like Defensive Equity and Quality, as your allocation to stocks increases. The same ETFs are used as in a Diversified Core Investment Strategy, but the weights to each differ.
A Tax-Focused Strategy follows a similar investment approach to a Diversified Core Investment Strategy but replaces taxable bonds with tax-exempt municipal bonds in your taxable accounts. Generally, tax-exempt bonds earn less interest than comparable taxable bonds, but the after-tax return can be higher for investors in a high income tax bracket. Before investing in this approach, carefully consider your tax situation and consult your tax advisor.
The next two strategies use quite different investment products than a Diversified Core approach, accommodating a preference to be environmentally friendly and to hold individual stocks.
An Environmentally-Focused Strategy focuses on gaining exposure to investments with positive ratings on environmental factors. This differs from the Diversified Core Investment approach because it does not target the proven investment strategies outlined above, but instead just focuses on broad exposure to environmentally friendly securities. The global index provider MSCI Inc scores companies based on several factors including carbon emissions, climate change vulnerability, water stress, and toxic emissions. (https://www.msci.com/esg-ratings)
More focus on environmental factors may align with your non-economic values, but one downside is that it could reduce diversification generally. An environmentally-focused strategy is most appropriate for investors that consider green and sustainable values more important than maximizing risk-adjusted investment returns. Although it is not necessarily a relevant trade-off for these individuals, academic work and historical data indicate there is a possibility that clients will generate less wealth using this approach. (“Sustainable investing: a ‘why not’ moment”, Blackrock, May 2018; https://www.blackrock.com/corporate/literature/whitepaper/bii-sustainable-investing-may-2018-international.pdf)
Individual Stock Strategy
Exchange-traded funds and mutual funds have simplified investing since they bundle many securities into a single purchase. Yet, some investors have expressed a lack of connection to their portfolio when they review their account because the names are less recognizable. For this reason, an Individual Stock Strategy that invests in U.S. large cap stocks instead of ETFs or mutual funds may be appropriate. By targeting fewer stocks (say, 50 to 100 companies), an Individual Stock Strategy could still be broadly aligned to the academic-driven approach featured in a Diversified Core Investment Strategy, but with less diversification. This is suitable for investors who like seeing individual names in their portfolio and are comfortable with the risk of concentration and potential underperformance associated with less diversification.
Other investment strategies may have lower returns, higher risk, higher costs, and less diversification compared to a Diversified Core Investment Strategy. But, we could design new strategies in such a way to accommodate preferences while still focusing on returns, risks, and costs.
Implications for your Portfolio
David Booth, the founder of Dimensional Fund Advisors, has famously said “The most important thing about an investment philosophy is that you have one you can stick with”. (https://www.ifa.com/quotes/david_booth) We couldn’t agree more. Investors are often their own worst enemy, selling after the market has dropped or buying after a big run up. Our goal in creating new strategies is to provide different combinations of portfolios that resonate with investors. Hopefully, these combinations help clients stay disciplined throughout market ups and downs. A better aligned portfolio is one less thing to think about when reviewing your account.
Each new strategy we build can align with your preferences to deliver a well-balanced, cost-effective, and tax-smart portfolio.
The strategies we outlined above differ from a Diversified Core Investment Strategy - some are different flavors from this approach and some feature quite different products. The Environmentally-Focused and Individual Stock Strategies, for instance, reduce diversification across stocks which can potentially lower future returns.
These new options reflect a desire to continue serving your needs. We have aimed to do so while still relying on our core investment principles that have generated wealth for clients. Please contact your wealth manager, or service team member, to discuss your investment preferences and additional approaches available – or call (202) 539-1039.
At United Income, we are always focused on helping our members generate wealth. We always like starting with your financial plan and goals because it helps your wealth manager to create strategies that can generate wealth in multiple ways. In addition to investment returns, we focus on tax savings, increasing the value of your retirement benefits, and keeping costs low because they can generate a more sustainable wealth return for you, our member. (We refer to clients of the United Income Wrap Program as our “customers”. Performance information regarding our customers in this letter does not include information from clients of our Traditional Portfolio Management Services or Traditional Wrap Fee Program.)
Here you will find data highlighting the power of this unified approach.
9 of the 19 ETFs that we use to build portfolios in member accounts outperformed relevant benchmarks over the trailing 3 months. Our diversified investment approach focuses on multiple strategies that have historically performed well and strategies that can help to minimize your risk. As we expand our investment strategy offering, you will have even more investment options to choose from and we will report on how each strategy has fared.
For members that joined United Income more than 6 months ago, their average tax savings has been 18 bps or 0.18%; members that joined United Income in the last 6 months, average tax savings has been 2 bps or 0.02%. (Estimated tax savings are measured as 17.5% x (long-term losses realized) + 24% x (short-term losses realized) across all taxable member accounts divided by ending account balances. These realized losses are reflective of trades where cost basis information was available and recorded within United Income. These rates reflect a middle-tier of the tax rates that are applicable to members. Individual member tax rates could be higher or lower than the rates we use in our estimated tax savings calculations. Actual tax savings will depend on the specific circumstances of each member and may differ significantly from amounts calculated. United Income does not represent in any manner that its tax-loss harvesting strategy will result in any particular tax consequence or that specific benefits will be obtained for any individual investor. The tax-loss harvesting service is not intended as tax advice. Members should consult their personal tax advisor as to whether tax-loss harvesting is a suitable strategy, given the member’s particular circumstances. The tax consequences of tax-loss harvesting are complex and uncertain and may be challenged by the IRS or any other tax authority. The internal revenue code, as well as judicial and administrative interpretations of it, are subject to change and could have a material impact on the consequence of United Income’s tax-loss harvesting approach. There is limited authority governing whether an ETF is “substantially identical” to another ETF for the purpose of the wash sale rule. Accordingly, there can be no assurance regarding how the IRS would resolve this question in specific contexts. There are no guarantees that a portfolio employing these or any other strategy will outperform a portfolio that does not engage in such strategies. Past performance does not guarantee future results. ) We are currently forecasting this will add up to an average of $10,000 in extra wealth for each $100,000 invested, or an estimated tax savings of 10%, in taxable accounts for the average member over their lifetime. (The average member is defined as 60 years old with life expectancy of 83 years old, based on Social Security’s Actual Life Table; https://www.ssa.gov/oact/STATS/table4c6.html)Good things come to those who wait!
On average, members that have disclosed their previous advisor’s fee rate have saved $169 per month, or $2,026 per year, in advisory fees. We are currently forecasting this will add up to an average of $46,602 in extra wealth for the average member over their lifetime. (The average member is defined as 60 years old with life expectancy of 83 years old, based on Social Security’s Actual Life Table; https://www.ssa.gov/oact/STATS/table4c6.html and account balances are estimated to remain flat.) In addition, a 60% stock/40% bond portfolio comprised of the ETFs we use to build member portfolios can save 0.16% per year in expense costs, relative to the average mutual fund. (Morningstar US Fund Fee Study, 2018. Average mutual fund fee calculated based on the asset-weighted mutual fund fee for a portfolio of 34% US Equities, 26% International Equities, and 40% Taxable Bonds, which is the same allocation a United Income member electing 60% equity and 40% fixed income would receive in their portfolio. The fund fee from Morningstar is the average of Active and Passive for each category. ) We are currently forecasting this will add up to $18,400 in extra wealth for each $500,000 invested for the average member over their lifetime. (The average member is defined as 60 years old with life expectancy of 83 years old, based on Social Security’s Actual Life Table; https://www.ssa.gov/oact/STATS/table4c6.html)
On the Horizon
As we enter the last quarter of the year, it's time to think about taxes! Our technology team is working on capability to review charitable giving strategies. From charitable donations of cash to gifting of appreciated securities, there are many ways to make an impact. Our aim is to help you make the most impact with your gift by considering all possible approaches. In the meantime, you can work with your wealth manager to review which charitable giving strategy may be right for you.