INSIGHTS

Expert knowledge combining financial science with real world applications.

Confessions of an Investment Advisor

May 14, 2018

We at Versatile continue to observe common behavioral flaws across most investors and many potential clients.  These revolve around the actions and inactions of individual investors and speak to the pitfalls of long-term investment success.  They can be grouped as follows:

  1. What is one’s investment strategy and approach?
  2. How do fees and taxes affect returns over time?
  3. How do investors think about time horizons?
  4. Is ignorance bliss in investing?
  5. What does history tell us?

Investment Strategy and Approach
Investment Strategy and ApproachMost investors do not spend the time necessary to think about their investment strategy and implementation, despite its importance, and in many cases can’t define their investment approach.  Correcting this is so necessary yet lacking across many investors.  Articulating strategy and its implementation is the first step to a better investment management approach and the first step in applying discipline to the investment process.

Fees and Taxes
If you asked the typical investor their all-in fees and taxes on their investment accounts over the last year, they could not tell you.  Many investors pay wrap fees of approximately 1% on top of relatively higher fund fees for actively managed strategies and are subject to taxes that are avoidable with the more tax-efficient products available today.  Yet the accrual of an additional 1-2% per annum can add significantly to wealth creation over time.

Time Horizons
Many investors look at recent investment performance as indicative of future results.  “How have you done lately?” is a typical question of prospective clients.  This implies return chasing, which can be extremely costly and detrimental to sticking with a long-term plan.  Short-term performance is typically noise.  Longer-term performance, and how that compares with the broader markets, is what matters.

Ignorance Is Not Bliss
Many people do not want to talk about their money and investments.  Reasons for this include embarrassment or ignorance about past performance, laziness when it comes to investments, hubris with performance to date, lack of knowledge and awareness of what drives returns, or some combination of all these.  The important thing to note is that they all get in the way of people achieving the best results possible with their investments.  The reality is that few people spend or even have the time necessary or apply the discipline required to be good investors.

History Lessons
The S&P 500 Index has been a top quartile money manager over the past 3, 5 and 10 years.  Few investors consistently earn the return of the S&P 500 on their domestic equity portfolio, and yet there are many ways to improve on the performance of the S&P 500.  The S&P 500 Equal Weighted Index, going back to 1995, is up nine-fold compared to a six-fold increase for the S&P 500.  That equates to a 1.5%+ excess return per annum over that period.1 

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This compelling performance differential makes the case for avoiding the standard S&P 500 Index.  Top companies rotate out of the Index every decade resulting in a significant drag on returns.  For example, IBM, the #1 market cap company in the Index in 1985, with twice the market cap of # 2 Exxon and 3 times that of #3 GE, is now #30.  Over-weighting the largest companies has been detrimental to long-term investment performance. 

It also typically pays to avoid actively managed strategies.  Not only are the fees higher than fully passive index funds or factor-based ETFs, but also very few active managers can provide sustained performance above their market capitalization-weighted benchmarks.  Add the higher tax costs with actively managed funds over ETFs and it makes it that much more difficult to argue for an actively managed approach.

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Furthermore, investors should be pairing equal weighted exposures with other ”factors” emphasizing value over growth, lower volatility, positive price momentum, and smaller market capitalization - all with international diversification.  What results is a portfolio that is highly likely to produce significantly greater returns over long time periods with similar or lower risk than a market capitalization-weighted portfolio.

The table below shows the long-term historical benefits of these indices domestically.  With the S&P 500 as a benchmark, Versatile uses ETFs to invest in these indices given their higher expected returns.2 

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Conclusion
Thanks to the extensive and robust academic and market research available there is a better approach to address the issues and biases highlighted above.  Investors can benefit by electing for intelligent diversification3 and discipline at a low cost.  A portfolio of rules-based, non-capitalization weighted indices that increases the odds of higher returns, along with better tax efficiency through use of ETFs, is possible.  Surprisingly, this approach is still not widely dispersed or practiced by most investors.  Versatile Capital offers this simple solution that so many investors resist implementing yet should lead to higher expected returns over time without taking more risk


Versatile Capital Management is a registered investment advisor with the State of Illinois. The firm will only transact business in states where it is properly registered and in compliance with the applicable laws and securities regulations. Versatile Capital Management is a registered investment advisor with the State of Illinois. The firm will only transact business in states where it is properly registered and in compliance with the applicable laws and securities regulations.

Investing entails some degree of risk. Investors should inform themselves of the risks involved before engaging in any investment.

Before commencing an investment program, we recommend you seek independent professional legal, tax and investment advice as to whether it is suitable for your particular needs and circumstances. Failure to seek detailed professional personally tailored advice prior to acting could lead to you acting contrary to your own best interests and could lead to losses of capital.

Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.

Neither this presentation nor any accompanying materials constitute an offer to sell, nor a solicitation of an offer to buy, securities, nor may this presentation nor accompanying materials be relied upon in reviewing future offerings to be made.


1,2 Past performance does not guarantee future results. Index returns are not inclusive of any associated fees; The S&P data is provided by Standard and Poor’s index Services group. The FTSE RAFFI data is provided by a joint effort of FTSE and Research Affiliates. The MSCI USA Minimum Vol Index is provided by MSCI. 

3 Neither Asset Allocation nor diversification guarantee a profit or protect against a loss in a declining market. They are methods used to help manage investment risk.

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