Equius Principles: Portfolio Structure Matters, Part 2

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Last month, I wrote about the importance of portfolio structure at the mutual fund level. We have chosen Dimensional Fund Advisors as our primary mutual fund and ETF provider because of how they structure their asset class funds to maximize return within strict risk parameters. But we also admire their ability to manage that structure in ways that further enhance returns. 

Now let’s focus on portfolio structure at your personal portfolio level and how Equius manages that structure to maximize returns within agreed-upon risk limits. Asset allocation, rebalancing discipline, costs, and tax efficiency (for taxable portfolios) are the primary inputs we should consider in this regard. 

Which asset classes add real value? 

The research we respect the most comes from University of Chicago Nobel Prize winner Eugene Fama and his research partner, Ken French at Dartmouth, and Dimensional’s internal research team. 

This research coalesces around only four risk factors that drive expected stock returns in the public securities markets: market risk (risk of stocks overall), size risk (large versus small companies), price risk (low-priced versus high-priced stocks), and firm profitability.* 

What this means in practice is that investment risk and return are directly related, and we have the science today to identify and measure the risks that are most beneficial to a long-term investment strategy. (We also know what risks are not beneficial and avoid them.) 

As I discussed last month, a fund company’s understanding and management of these risks determine which investments we use to build client portfolios. Once that decision is made, the next step is combining these investments in a total portfolio in the most optimal way based on your personal risk tolerance. 

This risk tolerance is determined at the beginning of our relationship, reviewed regularly, and adjusted as needed. Equius has developed very unique tools to allow us to understand this important step better than most other advisors. The ubiquitous “risk tolerance questionnaire” is a very poor (and lazy) substitute for the process we’ve developed. 

The result across all of our relationships is a pronounced tilt toward stocks—and small-company, low-priced, and profitable stocks specifically. This is due to the fact that all of our clients are long-term investors (investment time horizon of at least 10 years, but usually at least 30 or 40 years). 

How is the mix of asset classes managed? 

Once the overall risk of the portfolio (and thus the expected return) is established, we need to manage the portfolio to honor your risk limits and to maximize the return potential within those limits. This creates greater certainty of investment outcome, increases portfolio stability, eliminates emotion (due to recent market trends), and imposes a level of discipline on us that is crucial in an industry dominated by charlatans and conflicts of interest. 

We accomplish this through a rebalancing technique we established years ago based on the best research on the topic and confirmed through almost 30 years of experience. It is based on a degree of tolerance within established portfolio allocation bands that respects (and profits from) the fact that asset classes often go through cycles that last several years. We also know how unnecessary transaction costs and taxes negatively affect portfolio returns. 

When I first launched my firm in 1993, I had the option of aligning with other firms to handle a lot of the day-to-day management responsibilities, including portfolio rebalancing. What I found in those early days is that many firms opted to rebalance portfolios quarterly, despite evidence that it “clipped” returns from upward-trending asset classes. Essentially, they wanted to look like they were “doing more” for clients through this increased activity. In recent years, new technology has allowed these advisors to check a box or push a button and fully automate this “doing more” function. 

I never suffered from the insecurity I felt these firms were signaling, nor did I shy away from the real job of explaining why we believe our way results in higher returns compounded over time for our clients. That’s the “Equius Way” we apply to your relationship every day. 

*Evolution of Financial Research: The Profitability Premium (Dimensional Fund Advisors). 

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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