By Ryan Gilmer, CFA – VP Investment Management – TOPS ETF Portfolios
The interwoven network of the world’s global financial markets is inherently complicated.
Likewise, the investment strategies investors carry out are often laced with complexity, including sophisticated algorithms and computer driven trading carried out in milliseconds.
Despite the complexities of investing, many investors would be well advised to focus on 3 simple elements:
- Asset Allocation
- Costs
- Discipline (Behavioral Management)
When describing our strategies we tend to favor simplicity and we rely upon the proven principles that underline our decisions. As such, we rely on things like the law of parsimony, a principle stating that the explanation of an event should be made with the fewest possible assumptions. Perhaps you’ve heard of Occam’s razor, which similarly states that the assumptions made in explaining a thing must not be more than is necessary to fully explain it. Both principles have the same theme: the optimal solution should be simple and principles based.
Simplicity is important, but that doesn’t mean it is easy. For example, the concept of moving a 1 ton boulder a distance of 25 feet is simple. Anyone can look at the boulder sitting in one location and visualize it instead sitting 25 feet away. However, that doesn’t mean it is easy to move it.
In investing, these 3 simple elements may help to lay the base for sound investment strategy. However, we recommend utilizing an experienced investment team with a disciplined investment process to help navigate the complexities on global markets, as it is not easy.
Asset Allocation
Each of our portfolios has defined strategic allocations to equities and fixed income. But within these broad categories, our investment team analyzes over 30 underlying asset classes, all with different risk and return expectations and correlations to each other.
According to the Investment Company Institute, there are over 1,400 exchange traded funds (ETFs) domiciled in the United States. We can use these products to assemble asset allocation portfolios to fit different investor goals and objectives ranging from conservative, balanced, or aggressive growth.
Our research shows the various asset classes we use (including bonds, international stocks, emerging markets, commodities, REITs, and international bonds) provide diversification benefits through different risk, return and correlation attributes. Our ultimate goal is to combine these asset classes in a manner to optimize the risk/return equation for each level of portfolio risk. This simply means we strive for the highest amount of expected return possible for the risk we take. As such, we feel portfolios allocated only to only US stocks and bonds may be missing potential risk adjusted return opportunities over time.
Costs
Over the past few years, investors and researchers alike have debated the merits of index versus active investing. Typically, index strategies mirror a market index at a low cost. Active strategies typically charge higher costs, attempting to add value by beating index returns or by reducing drawdown in bear markets.
In both cases, however, the charges you pay to invest directly decrease your rate of return. Investors should be cognizant of the fees they are paying and should realize that higher fees equate to a higher probability that they forfeit a larger portion of their returns.
Trading costs and taxes are other fees that eat away at the investor’s rate of return. Again, ETFs have become increasingly popular because they score well in all three areas: lower annual costs (expense ratios), better tax treatment and lower turnover (which leads to typically lower trading expenses).
For example, the iShares S&P 500 Value ETF (IVE) charges just 0.18%. Vanguard FTSE All-World ex US ETF (VEU) and Vanguard Emerging Markets (VWO) charge just 0.13% and 0.15% respectively. Likewise, none of these three ETFs passed along fund level cap gains in the last 5 years.
Discipline (Behavioral Management) – Rebalancing and Tactical Allocation
Human beings tend to be bad at investing. We have a host of intellectual and behavioral biases, including recency bias, which make us bad gut feel investors. Recency bias leads us to assume recent performance will continue indefinitely, when in reality, returns tend to mean revert in the long run.
Carl Richards, the founder of Behavior Gap, visually depicts bad investor behavior with the following two graphs:
Maintaining a static asset allocation will help with this problem, but not solve it – after all, if you never trade, you can’t make bad trades. But smart investors realize that there is opportunity to add value by rebalancing underperforming assets back to their targets, or by strategically adjusting exposure to various asset classes over time.
The difficulty often lies in the slippery slope between static allocations and market timing. While we don’t encourage investors to maintain static allocations that never adjust, we likewise don’t encourage investors to employ active market timing. We feel the sweet spot is to be in between those two extremes, a process we call A Strategic Approach to Active Indexing™.
Disciplined strategic investing can lead to desirable results. For example, investors who diligently purchased emerging markets or commodities over the past few years have been rewarded as those asset classes have rebounded this year. The iShares MSCI emerging markets ETF (EEM) was down 3.7% in 2013, down 3.92% in 2014, down 16.18% in 2015, but is currently up 17.25% year to date as of September 30th.
Conclusion
Setting a base for successful long term investing can be simple. Likewise, investors should avoid investment strategies that do not utilize asset allocation, low cost vehicles, and discipline. However, investing is not easy and we encourage investors to select proven investment strategies designed to achieve long term success.At times the boulder can feel heavy and difficult to move, but these principles can help provide the strength to continue to make progress towards the goal.
Ryan Gilmer, CFA, is VP Investment Management at TOPS/ValMark Advisers, a participant in the ETF Strategist Channel.
Important Disclosure
IVE, VEU and VWO have been, may be and/or are currently held in several TOPS Portfolios.
ValMark Advisers, Inc. (“ValMark”) is a federally registered investment adviser located in Akron, Ohio. ValMark and its representatives are in compliance with the current registration and notice filing requirements imposed upon federally covered investment advisers by those states in which ValMark maintains clients. For registration or additional information about ValMark, including its services and fees, a copy of our Form ADV is available upon request by contacting ValMark at 1-800-765-5201.
This article provides commentary on current economic and market conditions and is not directly relevant to any particular client account. The information contained herein should not be construed as personalized investment advice or recommendations to buy or sell any security. There can be no assurance that the views and opinions expressed in this article will come to pass. Investing involves the risk of loss, including the loss of principal.
Past performance is no guarantee of future results. Information contained herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Indexes are unmanaged and cannot be directly invested in.
Diversification cannot assure a profit or guarantee against a loss.
Source: Bloomberg for historic price and return references.
TOPS® is a registered trademark of ValMark Advisers, Inc.