We favor low-cost, fiscally efficient, diversified, liquid and simple investments. Many investors often encounter problems when investing in things that do not have these five characteristics. Investments with these five characteristics have been profitable over time, but are generally not very interesting. There is usually no “hot story to act on now” associated with them.
The financial services industry generally does not favor this type of investment because it generates very little profit. We are in the business of helping maximize the wealth of our clients, not the financial services industry. Please note that this list of investment features is not exhaustive. Other factors to consider in investments can be an attractive valuation, a low correlation with the rest of your participation a good return on dividends or interest income, an inclination towards areas of the market that have produced higher yields, such as stocks of value, an adequate level of risk for you, etc.
Low cost. We normally invest in funds based on low-cost indices and exchange-traded funds (ETFs). The funds we invest in have an average spending rate of only about 30% per year. The typical actively traded equity mutual fund has an average expenditure rate of 1% or more. With mutual funds, the best predictor of future relative performance is the fund’s expense ratio; the lower the better.
Hedge funds typically have an annual expense ratio of 2% plus 20% of earnings earned. Some “investments” in variable annuities and permanent life insurance may have annual expenses of 2% or more. By closely monitoring the costs of our investments, we can save our clients significant amounts of money each year and help them achieve higher returns over time (everything else is the same). With investment products, you don’t get a better return on a higher-cost product, in fact, you usually get a worse return.
Tax efficiency. Our investments (index-based funds and ETFs) are extremely tax efficient and allow the investor to have some control over the timing of taxes. These types of funds have a low turnover (commercial activity), which is a common feature of tax-efficient investments. We recommend avoiding investment funds with high turnover due to their fiscal inefficiency.
After the recent large increase in the U.S. stock market, many working capital mutual funds have “embedded” capital gains of up to 30%-45%. If you buy those mutual funds now, you may end up paying capital gains taxes on those implied gains, even if you didn’t own the fund during the increase. ETFs typically do not generate distributions of short- and long-term capital gains at the end of the year, and do not have built-in capital gains like active mutual funds. Hedge funds are often tax inefficient due to their high turnover.
In addition to investing in tax-efficient products, we also do many other things to help keep our clients’ taxes to a minimum, such as collecting tax losses, keeping our turnover/operation low, placing the right type of investments in the right type of accounts (tax location), using losses to offset capital gains, using shares with large capital gains for donations, investing in tax-free municipal bonds, and so on.
Diversified. We like to invest in diversified funds because they reduce the specific risk of your stocks and the overall risk of your portfolio. Bad news published about a stock can cause it to fall by 50%, which is horrible news if that stock is 20% of your entire portfolio, but it will barely be noticed in a fund of 1,000 stock positions. We tend to favor funds that typically have at least a hundred holdings and often several hundred or more holdings.
These diversified funds give you a broad representation of the entire asset class you are trying to expose yourself to, while eliminating stock-specific risk. For example, they are not likely to invest in the more recent Solar Energy Company Equity Fund with 10 positions in shares. We do not believe in assuming any risk (such as stock-specific risk) that you will not be paid with a higher expected return.