Equius Principles: Portfolio Structure Matters, Part 1

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Since 1993, Equius has followed a set of foundational investing principles based on the best academic research available and confirmed by decades of experience. These principles have remained constant over the past 28 years and have served our clients well through all the volatile market cycles that have ensued. As a reminder for clients who have stayed the course with us through many of these cycles, as reinforcement for newer clients, and as an introduction for prospective clients, I’ll outline these principles—in no particular order—in a series of new Asset Class articles. For this article, I’ll focus on the importance of mutual fund/ETF portfolio structure.

Large vs. Small; Growth vs. Value

The foundational principle here is that risk and return are related: Small cap stocks have historically outperformed large cap stocks because they’re riskier (thus investors in small cap stocks rightfully expect a higher return for risk taken over time) while value (lower-priced) stocks have historically outperformed growth (higher-priced) stocks over time based on the same reasoning.

So, if we are to optimize an asset class investing strategy that tilts more (compared with the total market) toward small cap and value stocks in order to increase portfolio returns, our challenge as advisors is to find and stay with funds that are structured to better capture the higher expected returns of these asset classes over time.

We can’t use actively managed funds for this purpose because there’s little consistency—and therefore no predictability—in the structure of these funds (plus they’re expensive and they underperform).

So instead, we use highly diversified and highly structured index funds as a much more reasonable alternative. But we go a step further. Since traditional index funds are too structured in important ways (e.g., publicly announcing specific portfolio changes and when they’ll occur) and place much less emphasis generally on how far they reach into the small cap and value risk factors, we look to firms like Dimensional to provide our clients with better alternatives.

And since we refuse to play the destructive game of predicting asset class trends and jumping back and forth among fund providers, we need to stick with the best-structured funds through all market cycles. This was tough during the run-up of large growth stocks in the late 1990s (but paid off in spades later) and maybe even tougher recently given the companies that have outperformed (Apple, Netflix, etc.). But just like in the late 1990s and that period’s aftermath, we are now starting to see this discipline pay off.

Below are the returns over the past 12 months for the S&P 500 Index and select Vanguard and Dimensional index mutual funds that tilt toward value and small cap stocks. The comparative returns are a bit mixed, but you can clearly see the advantage of better structure when small cap and value stocks outperform.

Whether this overall performance trend continues in the short run remains to be seen, but we’re very confident of small cap and value outperformance over the long term given the higher risk of these asset classes. As long as these index funds stay true to their structure (which we monitor regularly), we’ll stay invested in the better structure.

This is especially true given the current proposal to dramatically increase the capital gains tax. Another good reason to stay the course (hat tip to Barry)!

Equius Partners, Inc. is a Registered Investment Advisor.

Past performance is not a guarantee of future results. The data and information set forth herein are provided for educational purposes only and should not be considered tax, legal or investment advice; a solicitation to buy or sell securities; or an opinion on specific situations – as individual circumstances vary. There is no guarantee an investing strategy will be successful. Investing involves risks, including possible loss of principal. Diversification does not eliminate risk, including the risk of market or systemic loss.

Please consider the investment objectives, risks, and charges and expenses of any mutual fund and read the prospectus carefully before investing. Indexes are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

© 2023 Equius Partners, Inc.

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