What Happens When Good People Have Bad Ideas?

After realizing the effects of the recent market turmoil, many people have taken inappropriate actions at an inopportune time, and in hindsight wished they had planned accordingly for the global economic downturn we are now faced with. Many people are quick to say they have a “trusted advisor” whom they rely on to give them sound financial advice, yet still found their portfolios decimated at the end of 2008. What is worse, your advisor may have been smart enough to see the turmoil coming, but unfortunately was constrained as to what he could do to try to protect your assets.

In the early ‘90’s, Morningstar introduced a nine square grid that classifies securities by size, (large, mid, or small), along the vertical axis and by characteristics (value, core, and growth) along the horizontal axis, and thus style box diversification was born. Within this framework, Investment Advisors hire “best in class” managers, through mutual funds, third party managers, or exchange traded funds, to represent a particular box. Mangers are expected to invest only in stocks with characteristics fitting that box. In theory, the style box helps the investor construct a diversified portfolio that reduces overall volatility and, hopefully, increases return.

Unfortunately 2008 demonstrated that the style box approach has flaws and failed to shield investors from harm. If the manager/fund the Investment Advisor hires does not beat the index of the specific box he is hired to manage, they will fire him and replace him with another manager/fund. We believe that this approach is flawed in both its underlying assumption, that having money in all of the boxes is the best way to beat the market, and its implementation, that Investment Advisors are going to be able to identify the managers most likely to beat their assigned indexes.

Keeping managers constrained to a specific style box in our opinion actually limits investment performance, erodes purchasing power, and further results in a costly and inefficient portfolio. If investors employ nine traditional style box managers/funds, plus one that specializes in foreign stocks, and each manager/fund owns 50 securities, investors possibly own more than 500 stocks. Take into account the turnover between managers and trading costs, and at the end of the day with more than 500 positions, investors in effect would own a very expensive index fund, where the winners may be too small to have a significant impact on the portfolio.

In seeking to achieve superior returns, we feel that Investment Advisors should be free to roam the entire stock universe in search of opportunities and should not be constrained to one box. Proponents of style box diversification will tell you that from year to year there’s no telling which asset class will be the best performer, therefore portfolio diversification reduces risk by allocating assets across the various boxes. While it may be true that it’s very difficult to select the exact asset class that will perform best during any given year, for anyone willing to dig even slightly below the surface, it’s been very clear as to those that should be avoided. For example, the direction of the U.S. economy has been very clear, yet many fund managers are restricted from actively taking precautions against loses, such as raising cash or limiting exposure to a certain asset class, such as financials.

Warren Buffet, widely considered one of the worlds greatest investors built his wealth by concentrating his exposure, not through diversification. At times, he has held a mere five positions in his entire Berkshire Hathaway equity portfolio. He does not diversify, because with his level of expertise, he feels there is no need to do so. Further, he defines risk as “not knowing what you are doing,” and suggests if you are unsure of yourself, that diversification is the best strategy for you. In our view Investment Advisors that are truly on top of their game should concentrate their positions, as sustainable rewards can be reaped only by those that have the foresight and ability to invest in certain stocks and asset classes well ahead of the curve.

In an effort to achieve superior returns given today’s volatile market conditions, we believe that an Investment Advisor must be free of portfolio restraints or limitations. If economic conditions suggest a move to all cash, an advisor needs to be able to quickly act on that decision. If your advisor wants to hold a concentrated position in a certain sector or stock, we think he should have the ability to do so. The old rules of style box diversification are dead. If your portfolio is over diversified and achieving index type of returns, what are you paying your advisor for?





Past performance is no guarantee of future results. The information contained herein is based on internal research derived from various sources and does not purport to be statements of all material facts relating to the securities, markets or issues mentioned. The information contained herein, while not guaranteed as to accuracy or completeness, has been obtained from sources we believe to be reliable. Opinions expressed herein are subject to change without notice