As a starting point, an index fund is simply a basket of stocks or bonds that aims to replicate a market index (e.g. S&P 500) and match the performance. Overall, we believe index funds can be useful tools in implementing an investment strategy for many people. The benefits of index funds include:
- Very low explicit costs (i.e. expense ratios of index ETFs & mutual funds)
- Low turnover of the underlying holdings, which can create greater tax efficiency relative to higher turnover strategies
- Broad diversification
- Limited risk of investment underperformance
These are all good things!There are many core principles of index fund investing that have a high correlation to strong investment outcomes. So why would anyone differ from this strategy?
I believe there are two good reasons to differ from owning purely index funds – 1) Risk Management and 2) Expected Returns.
When constructing an investment portfolio, I believe it’s important to take into account one’s human capital alongside of their financial capital. For many individuals who I serve, equity in their company makes up a meaningful portion of their total financial portfolio or annual compensation package. This concentrated stock position creates an additional risk factor within the investment portfolio and broader financial plan. To help manage this risk, I believe it’s prudent to complement this concentrated position with an investment portfolio that emphasizes stocks that possess different characteristics than your company stock. For individuals with stock in a pre-IPO company, this could mean having more exposure to highly profitable and lower valuation companies, which tend to be the opposite characteristics of venture-backed companies.
In addition to managing the risks associated with concentrated stock exposure, I believe pursuing higher expected returns is another valid reason to deviate from an index-based investment strategy. That said, it’s important to unpack how I pursue higher expected returns. Unlike many portfolio managers who seek outperformance through selective stock picking or speculative positioning based on economic forecasts, I focus on pursuing an evidence-based approach that is backed by data on what drives returns in capital markets. This approach is designed to outperform index fund investing over the long run, at a lower cost than traditional, actively managed funds.
What does this mean for client portfolios?
- They are low cost. The investment solutions I use have expense ratios in the bottom quartile of their asset class. This means you keep more of the returns.
- They are well-diversified. We live in a global economy and these strategies target exposure to thousands of companies across the globe, reducing the impact of any one company on investment outcomes.
- They’re designed to outperform the market over the long run. The strategies I use are backed by strong theoretical and empirical evidence, putting the odds of success in your favor.
- They’re transparent. Knowing what you own and what you’re paying for these investments are core tenets in a long-term investment strategy
- They are intentional. There is a return, risk, or cost based rationale for every position and action in your portfolio.
I don’t believe that I (or anyone else for that matter) can reliably predict market movements, which is why I focus on controlling factors that are in our control, such as tax efficiency, asset location, global diversification, and liquidity management.
The financial plan I build is the lens through which I develop the asset allocation and investment strategy I ultimately pursue within your portfolio. I aim to position your portfolio to take the least amount of risk that will enable you and your family to achieve your financial goals and sustain the lifestyle you desire throughout your life.
Lastly, the investment portfolio that I help to build and manage on your behalf is not the “swing for the fences” portfolio. Rather, it is structured in a way to produce reliable investment returns that correlate with the assumptions I’ve built within your financial plan. Your human capital is a unique asset, and if you desire to take a big swing by launching your own business, joining an early-stage company, or investing in / advising a startup, my objective is to manage the rest of your financial portfolio in a manner that promotes these pursuits.