Investment philosophy

Three factors determine portfolio performance:

The long-term asset allocation between stocks and bonds.
The funds selected to represent various stock and bond types.
The total cost incurred to manage the portfolio, including taxes.

When an investor has the right asset mix, holds the right funds representing those asset classes, and keeps their total investment cost very low, they have a much higher probability of reaching their financial goal. That is what Portfolio Solutions is all about.

Active Versus Passive

There is a long-standing debate in the financial markets between active investors and passive investors. The active investors believe they can select superior investments through research and prudent trading or by selecting mutual funds that have outperformed the markets in the past. Passive investors do not believe research leads to consistent outperformance or that past mutual fund performance is an indication of future return.

The human desire to "beat the market" is a powerful force. Investors will spend a considerable amount of time and money searching for superior returns. That search is supported by a multi-billion dollar advice business that employs an army of people. The promise of high returns has no bias when it comes to the next hot tip. Investment ideas come from many sources including brokers, investment advisors, the Internet, print media, television and well meaning friends, relatives and co-workers.

Despite all the time, money and good intentions, the net result of efforts to beat the market fall far below expectations. It is not only difficult to achieve superior returns, but very few people do it consistently enough or by a large enough amount to make it worth the effort. As a group, all investors own the market. But after paying mutual fund fees, advisor fees, broker commissions and other related investment costs, an investor's return typically falls far short of the market. Astute investors realize that the deck is stacked against them in the "beat-the-market" game, and that is when the search for an alternative strategy begins.

There are two roads a person can follow when managing an investment portfolio; active management and passive management. Active management embraces the idea that a person can achieve superior returns over market indexes by hiring experts or personally conducting in-depth research and trading the market successfully. In contrast, passive management is all about achieving, as close as possible, the returns of the financial markets. Passive investors understand that market returns are good returns, and that spending time and money trying to beat the market with active management is counterproductive.

Separating Alpha from Beta

In the finance world, the return of the markets is called Beta, and any outperformance by an active manager is called Alpha. According to Alpha-Beta Separation Theory, the source of returns for any investment portfolio can be separated into market generated Beta and investor generated Alpha.

Most active managers do not earn Alpha due to high costs and a genuine lack of skill or luck. Nonetheless, fund companies and managers will routinely cover up this fact by comparing active returns to inappropriate indexes. For example, managers who buy strictly value company stocks will often show their performance against a broad U.S. stock market index rather than an index of value stocks that have comparable risks and returns.

When performance is measured correctly, the evidence is clear that passive portfolio strategies are superior to actively managed portfolios over the long term. Virtually all unbiased academic studies on the subject are in agreement. Ironically, successful active managers also agree with the academics:

"When you look at the results on an after-fee, after-tax basis over reasonably long periods of time, there's almost no chance that you end up beating an index fund.”

David Swenson, CIO, Yale University Endowment

"All the time and effort that people devote to picking the right fund, the hot hand, the great manager, have in most cases led to no advantage. Unless you were fortunate enough to pick one of the few funds that consistently beat the averages, your research came to naught. There's something to be said for the dart-board method of investing: buy the whole dart board."

Peter Lynch, Legendary Manager of Fidelity Magellan

Our clients recognize the value of passive investing coupled with our low advisor fee and a commitment to superior client service. We helped write the book on this strategy and we can make it work for you. If a passive philosophy is in line with your thinking, Contact Portfolio Solutions to learn more.

Asset Allocation Decisions

Capital markets are composed of many different security types. A group of securities with shared economic traits is commonly referred to as an asset class. A full range of asset classes may include small and large company stocks, U.S. and foreign stocks, emerging market country stocks, real estate investments, government and corporate bonds and municipal bonds (when needed in a taxable account).

Asset allocation is the method of combining different asset classes together in a portfolio to reduce investment risk, and maintenance of that allocation through rebalancing to create potential return benefits. Each asset class plays a different role in a portfolio, and the whole is often greater than the sum of its parts. This is the essence of Modern Portfolio Theory (MPT).

Harry Markowitz is a Nobel Prize winning economist at the Rady School of Management at the University of California, San Diego. He is known as the Father of Modern Portfolio Theory for his pioneering work in the area. Markowitz studied the effects of asset risk, correlation and diversification on expected investment portfolio returns. The theory proposes how rational investors will use diversification of a portfolio to optimize their outcome.

At its heart, MPT involves the selection of asset classes that have unique fundamental characteristics. These unique differences show up in risk and return data of an asset class, and the differences in risk and return create a diversification benefit. As Figure 1 illustrates, holding both stocks and bonds in a portfolio with a set allocation produces a MPT diversification benefit by lowering overall portfolio risk and increasing portfolio return relative to risk.

Portfolios are allocated among asset classes based on the rational expected risk and return of each asset class matched to clients’ financial needs and their ability to accept financial risk. Combining an investor’s financial needs with their ability to accept investment risk is a difficult and often inexact process, because the markets can be volatile and predicting investor behavior in a poor market is not an exact science. Nonetheless, it is important to have an investment strategy and remain loyal to it under all market conditions if an investor is to have the highest probability of achieving their long-term investment goals.

LEARN MORE about our Asset Allocation Decision Process.

Index Funds and ETFs

Portfolio Solutions clients have individually-managed index mutual fund and exchange-traded fund (ETF) portfolios based on their specific financial needs, goals and ability to accept investment risk. The data supporting this approach is deeply rooted in financial market returns, as measured by long established market indexes, such as the S&P 500 index. This is why index mutual funds and ETFs make ideal low-cost choices for asset allocation strategies based on MPT.

There are many types of index mutual funds and ETFs, and not all are suitable for inclusion in an asset allocation strategy. Portfolio Solutions analyzes and selects index mutual funds and ETFs that are the most suitable for inclusion based on various market exposures that offer maximum diversification benefits at minimal cost.

Some index mutual funds that are selected for clients are available to the public directly and others are advisor-access-only funds. Access to advisor-only funds provides clients with even lower cost options. For example, Dimensional Fund Advisors (DFA) is an institutional mutual fund company that offers its funds only through qualified advisors. The Vanguard Group offers advisor-only "Signal Class" shares that are lower-cost institutional shares of Vanguard's already low-cost retail mutual fund selection.

LEARN MORE about our Security Selection Decision Process.

Ongoing Portfolio Maintenance

As the markets move about, the investments in a diversified portfolio must be maintained to keep the portfolio on track with its target asset allocation. Rebalancing is the process of selling a portion of an appreciated asset class and purchasing more of an asset class that has not appreciated. Rebalancing helps clients reach their long-term financial goals because it lowers long-term portfolio risk and provides a smoother ascent toward those goals. The proprietary rebalancing method we developed is based on reviews of client portfolios and asset class tracking.

LEARN MORE about Rebalancing and Other Account Maintenance Processes.

There is no better combination than a proper asset allocation strategy of low-cost market matching investments managed by a disciplined and low-fee investment management firm. Portfolio Solutions is a recognized leader in the field. We bring full service, low-fee, institutional quality portfolio management strategies to the retail investor.

Contact Portfolio Solutions today to learn how to become a client.