Adding Value to Your Investments (Without Active Management)

We have repeatedly discussed on this blog our belief that active management of investments–i.e. trying to beat the market by trading in and out of individual stocks or in and out of equities versus cash or bonds–is an expensive, counterproductive, and generally ineffective way of trying to maximize investment returns. However, there are alternative ways to add value to your investment experience, even while following a passive investment strategy.

At PFS, we believe that holding a diversified portfolio with equity funds that remain fully invested at all times, managed with regular rebalancing, is the best strategy for a successful investment experience  over the long term. With Dimensional Fund Advisors (DFA) mutual funds, we expect “asset class returns”–i.e. that the investment performance for each fund (e.g. US Large Cap, US Small Value) will mirror the aggregate performance of all of the stocks in that asset class. While this might not sound significant, academic research has shown that most mutual fund managers do not perform as well as the respective asset class that they are investing in and that investors can significantly underperform as they chase performance from one fund to the next.  Using DFA funds as our tools, we try to add value over the long term by investing in asset classes that have been proven to behave differently (and, on average, deliver higher returns) than what most people think of as “the market,” e.g. the S&P 500, which is comprised primarily of U.S. large growth stocks. Several asset classes tend to be more volatile than the S&P 500 and have provided a premium, or additional investment returns, over the long run. For example, small company stocks tend to outperform large company stocks over time, value companies tend to outperform growth companies, etc.

The graphic to the right, designed by DFA, outlines the average annual premium gained by each asset class over its counterpart since 1928.  The first bar demonstrates the premium gained by investing in equities as compared with bonds, the second in small stocks over large, and the third in value stocks over growth.  We structure client portfolios to take advantage of these trends, believing that over the long-run, they will be rewarded for the additional risk that these asset classes entail.

Over the past two years, U.S. large growth stocks have been one of the best performing asset classes, so some clients have wondered why their portfolios have underperformed compared with “the market,” generally referring to the S&P 500 or a similar index. Each year, a different asset class tends to be the top performer in any given year, and it just so happened that U.S. large growth companies were at or near the top of the list in the past two years.  To be clear, while these premiums have been present over the long term in the past, there is no guarantee that they will continue and they do not occur every year.  However, as you can see from the chart above, this is not what we would expect to occur over the long term in the future. We are not active managers, but by tilting client portfolios toward asset classes including small and value stocks, we do plan to add investment value over the long term.