Q&A: Which Products Do You Buy and Which Do You Avoid?

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There are many “10 Questions to Ask Your Financial Advisor” lists out there on the Internet. Although some of these questions may help some people discern which professional to sign up with, we prefer our ten questions as they cut to the heart of the matter. They have an obvious correct answer (“Yes”), an obvious incorrect answer (“No”), and any professional who tries to veil their answer behind marketing nuances without giving a clear yes or no can be counted as incorrect. Our ten questions should not be hard for an advisor to answer.

That being said, I enjoy answering every set of ten questions I find. I recently found a Christian version of 10 Questions to Ask Your Financial Advisor when I was reviewing (and recommending that you avoid) their misleading directory.

Here are their ten questions:

  1. What are your qualifications and background in financial planning?
  2. What services do you provide?
  3. How does your faith affect your investment philosophy/strategy and recommendations for clients?
  4. How are you paid?
  5. How much do you typically charge?
  6. What products do/don’t you put clients into?
  7. What is your average portfolio size and life stage?
  8. What resources do you have to address issues outside your area of expertise?
  9. How do you communicate with clients? How often?
  10. Will I work with anyone else in your office?

For each question that we have already answered elsewhere, I have included a link to our previously written article. The remaining five questions I am answering in this series.

The next one is:

What products do/don’t you put clients into?

Portfolio Theory

Our investment philosophy is based on the principles of modern portfolio theory.

We believe the markets are relatively efficient over long periods of time and that asset allocation decisions (rather than market timing or stock picking) will determine most of your long-term return. As a result, we tend to recommend diversified portfolios composed of investments with low expense ratios.

Our asset classes are defined by looking at the correlation of returns. Investing in less correlated asset classes represents a greater opportunity for reducing volatility and boosting returns. We use six different asset classes: three for stability and three for appreciation. We divide the asset classes for stability into short money, U.S. bonds, and foreign bonds. We divide appreciation into U.S. stocks, foreign stocks, and resource stocks.

No asset class is risk free. Even relatively stable investments can lose money. Bonds can default or have their credit rating reduced, cash can lose its purchasing power due to inflation, and even the money market can “break the dollar” and return less than you invested. The equity markets are even more inherently volatile. Investing in securities involves a risk of loss that clients should be prepared to weather.

Beyond asset class, we identify sectors of each asset class which we want to emphasize. Our sector selections are used to overweight factors which are known to boost returns.

We advocate periodic rebalancing, which means buying more of the markets that have gone down and selling some of the markets that have gone up. Rebalancing across uncorrelated asset classes presents the best possibility for a bonus. Sector divisions are strategically less important to keep in balance because their correlations are often higher than the correlation between asset classes. However, because of their relatively low correlation or other favorable attributes, you can still receive a rebalancing bonus from moving between them.

What We Avoid

No firm, ours included, can represent, guarantee, or imply that their services or methods of analysis can or will predict future results, successfully identify market tops or bottoms, or insulate you from losses due to market corrections or crashes. No guarantees can be offered that your goals or objectives will be achieved. Furthermore, no promises or assumptions can be made that the advisory services offered by a particular firm will provide a return superior to alternative investment strategies.

Having said that, we do not generally recommend strategies that involve investments we believe would be classified as unusually risky. We also do not recommend annuities, whole life insurance, or other products that contain financial hooks. We do not advise frequent trading, which can increase brokerage costs and taxes. We do not typically recommend purchasing options or futures because these investments are hedges or bets more than they are investments. Futures and options can and do make money, but on average they are closer to a zero-sum game even before factoring in trading costs.

We do not recommend investments that are not publicly priced and traded like hedge funds, private offerings, or nonpublic limited partnerships. The value of these assets is often assumed to be their purchase price until the management company provides a new value. However, their liquidation value might be only a fraction of the investment’s presumed value. Furthermore, investments that are not publicly priced and traded cause many conflicts of interest when it comes to reporting and billing. If new clients own such investments, we will help them determine if they should continue to hold them, but we do not normally recommend purchasing them because of their inherent difficulties.

We Avoid:

  • Annuities
  • Whole Life Insurance
  • Financial Hooks
  • Frequent Trading
  • Options
  • Futures
  • Hedge Funds
  • Private Offerings
  • Nonpublic Limited Partnerships
  • High-Cost Funds
  • Physical Precious Metals (Gold or Silver)

What We Recommend

We do craft individual portfolios tailored to your needs. That includes analyzing your current holdings as well as additional investment choices. Although there may be other appropriate investment vehicles that we could use, we most often recommend low-cost exchange-traded funds (ETFs) and mutual funds.

We call the specific set of securities we use to implement our strategy our “Buy List.” We call it this because it is what we would ideally purchase if a client came to us all in cash. We regularly review our Buy List as we are always looking for even better securities to implement our investment strategy. The securities on our current buy list are exclusively ETFs and mutual funds.

The primary criteria we use to judge securities for our buy list are:

  1. The investment should be diversified within its sector.
  2. The expense ratio should be low.
  3. Ideally, it should have low trading costs.

We Recommend:

  • Low-Cost Exchange Traded Funds
  • Low-Cost Mutual Funds

Low Cost

This focus on keeping costs low is a strong feature of our investment philosophy.

Morningstar did a study to see which was a better indicator of a fund having better returns in the future: having a low expense ratio or having more Morningstar stars. They determined that having a low expense ratio was a better indicator than Morningstar stars.

Low expense ratios help you earn more when markets go up and lose less when they go down. Over time, this can significantly affect the value of your portfolio.

The return of an index fund is simply the return of the index plus or minus tracking error minus fund expenses. This is why having a low expense ratio gives you the best chance of having higher returns.

Currently, the average asset-weighted expense ratio for a stock mutual fund is 0.59%. This cost has been dropping over the past decade as funds have to lower costs in order to compete for market share. In most cases, a good investment advisor can significantly reduce the cost of the funds used to diversify your portfolio. We regularly build portfolios with low expense ratios, and many of the revisions we make to our Buy List are moving towards lower cost funds. Our Investment Committee currently builds portfolios with average expense ratios of about 0.17%. This has dropped from 0.24% over the last year.

Diversification

In addition to a focus on low expense, we also believe in diversification.

In any given month, a diversified portfolio will never perform better than all of its components. Asset allocation will never “win.” Not even one month. This is an obvious result of diversification. The diversified portfolio is a weighted average of its underlying components. It will always lose to something. On average, it comes in third or fourth (of the six asset classes) each month.

However, diversification is prudent. It is the difference between being willing to break every bone in your body as an Olympic skier and safely skiing with friends. The goal is to support your financial needs not come in first, which is why we recommend that your portfolio construction include diversification.

Furthermore, diversification is the means of achieving a rebalancing bonus, a boost in returns and decrease in volatility due to moving between low correlated investments. This bonus is highest when the correlation is lowest, but even correlated assets which often move in sync over the long run experience different volatility and returns over any given year.

For this reason, our Buy List investment selections strive to be as diversified as possible within the targeted sector.

Such diversification is not easily achieved with individual company stocks. To use U.S. large-cap stocks as an example, you would need over 60 individual stocks to achieve only 86% of the diversification. Diversification via individual stocks is even more difficult for small and mid-cap stocks and impossible to accomplish for foreign stock categories using U.S. stock exchanges.

For this reason, our buy list is funds — exchange traded funds (ETFs) or mutual funds — rather than individual stocks.

We favor funds with a large number of holdings and believe there is no such thing as “over-diversification.” A fund with 200 small-cap value stocks is better diversified than one with only 75.

We also favor funds where the top ten holdings represent a smaller percentage of the fund. A small-cap value fund whose top ten holdings represent 75% of the fund is less diversified than one where the top ten holdings only represents 25% of the fund.

Global Investments

Some advisors have a strong bias towards investing in their home country. Here in America, that means a strong bias towards investing in only the United States. However, diversification among many different countries provides a more consistent return than investing entirely in the United States. The same benefits that arise from other portfolio diversification are there for global diversification.

For over a decade, we’ve been advocating freedom investing, the idea that investing in countries rated high in economic freedom should produce better returns than investing in countries with more controlled or repressed economies.

Every year the Heritage Foundation evaluates all the world’s countries using their Index of Economic Freedom, where a high score correlates to nearly every positive measure of a country. We use this analysis to craft our Foreign Stock investment strategy that we call “Freedom Investing.” We use efficient frontier analysis to determine appropriate sector allocations.

In addition to the countries high in economic freedom, we have an allocation to emerging markets. Over the past three decades, the correlation between the S&P 500 and emerging markets has been a low 0.53. Low correlation between volatile assets produces the biggest rebalancing bonus. The rebalancing bonus to portfolio returns of blending emerging markets into an otherwise all U.S. portfolio might be as high as 0.33% or 0.35%.

Domestic Investments

When it comes to U.S. stocks, not everything is on the efficient frontier. It seems that small-cap growth has both higher volatility and lower returns than every other style-box category. Whatever the reason, we reduce allocations to small-cap growth. On average, this move should boost returns and lower volatility.

We tilt small and value, including a healthy allocation to mid-cap value for downside protection, in a strategy called “Value Investing.” Size and value are two of many known factors which we may choose to overweight when possible to boost returns or decrease volatility.

We use our sector allocations to overweight the factors which are known to boost returns.

Resource Stocks

Resource stocks, sometimes called “Hard Asset Stocks,” include companies that own and produce an underlying natural resource such as oil, natural gas, precious metals, base metals such as copper and nickel, coal, or even lumber. They can provide protection against inflation because their largest expenses are the purchase of extraction rights. Inflation then can’t meaningfully increase the cost of production until extraction rights expire because they’re purchased only once for a long period of time. Real estate investment trusts (REITs) are resource stocks for the same reason – their expenses were paid up front with the purchase of property and don’t inflate unless you buy more property while rental rates can increase with inflation.

Investing in resource stocks is not the same thing as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment directly in raw commodities and their volatility. The optimum asset allocation to physical gold and silver is 0% since the average return is just inflation whereas the expected standard deviation (risk) is very high. A gold mining company’s profits behave differently, making it a resource stock investment.

We segment resource stocks into their own asset class because they have a unique set of characteristics. First, the movement of resource stocks is generally less correlated with the movement of other asset classes. Second, resource stocks have a unique (and positive) reaction to inflationary pressures. And third, there are periods in the longer term economic cycle when including resource stocks helps boost returns.

The beauty of resource stocks is the fact that they are not highly correlated to U.S. large-cap stocks as a whole. Low correlation between volatile assets produces the biggest rebalancing bonus.

Furthermore, the correlation between resource stocks and bonds is even lower and may even be negative. A negative correlation means that bonds and resource stocks, as separate asset classes, are often moving in opposite directions. Balancing a bond portfolio with resource stocks can help hedge the risk inflation poses to a bond portfolio.

For this reason, we recommend the resource stock sectors of energy, U.S. REIT, and foreign REIT.

Conclusion

The selection of what products we purchase or avoid for clients is based solely on what we believe gives our clients the best chance to meet their goals.

Because we are fee-only financial advisors, we have no incentives to prefer one set of investments over another on account of how we get paid. We avoid investments we deem too risky or laden with fees and seek instead a well balanced, low-cost, diversified portfolio.

Photo by Laura Ockel on Unsplash

Follow Megan Russell:

Chief Operating Officer

Megan Russell has worked with Marotta Wealth Management most of her life. She loves to find ways to make the complexities of financial planning accessible to everyone. Her most popular post: The Complete Guide to Your Washing Machine

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President

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)