Passive (Index/ETF) Investing


This may sound antithetical coming from a money manager, but it’s basically impossible to regularly beat the stock, bond, real estate, commodity, currency, or any other type of capital market today. We’ve resigned ourselves, and so should you, to the concept of “meeting the market,” rather than beating the market. The latter just takes too much time (and, often, money) to bother with. It has become generally futile–with the advent of program trading, instantaneous data flow, hyper-quick assimilation of material information points, and the like–to expect to outperform, so we track the market with passive indices, and sell covered calls (a derivative to the underlying security) to attempt to mitigate risk and provide out sized performance. It’s not stock picking, it’s innovation, which will potentially win out today.

The stock/bond/real estate markets take care of themselves–they are going to carry on just as if you didn’t exist, and there’s not much you can do about it to try to predict or outsmart the market. It’s an inconvenient truth, but it is the truth. The market is too efficient to allow for exploitable anomalies Wall Street money managers claim exist. They don’t. At least not any longer; there could be an argument made for such opportunity existing in past decades, but today such advantages do not exist.

Money managers are too busy trying to make money for themselves to try to focus on what should be their number one core responsibility: Making money for their clients. Another inconvenient truth, but one that the client needs to come to grips with.

We meet the market – through Index investing in low cost Exchange-Traded Funds (with expenses which are one tenth the cost of the typical mutual fund). “ETFs,” as they are called, which save you time and money–enabling you to sleep well at night knowing you’re not getting fleeced by the latest Wall Street venture capital or private equity deal–and mirror the overall index, meeting the market, are our specialty.

You can index to match the performance of any market today: stock market, real estate market, commodities markets, bond markets, currency market, etc.

We at Caritas are believers in the Efficient Market Hypothesis (EMH) which states that all information and market moving data is efficiently disseminated and digested by decision makers or investors in the market immediately.  Thus, it’s relatively impossible to beat the market through individual stock picking. The statistics bear this out, whether you look at Morningstar, Ned Davis, S&P, Princeton/Harvard studies, or any independent firm analysis on the subject.

From Wikipedia, the definition of EMH:

In financial economics, the efficient-market hypothesis (EMH) states that asset prices fully reflect all available information. A direct implication is that it is impossible to “beat the market” consistently on a risk-adjusted basis since market prices should only react to new information or changes in discount rates (the latter may be predictable or unpredictable).

The EMH was developed by Professor Eugene Fama who argued that stocks always trade at their fair value, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by chance or by purchasing riskier investments.[1] His 2012 study with Kenneth French confirmed this view, showing that the distribution of abnormal returns of US mutual funds is very similar to what would be expected if no fund managers had any skill—a necessary condition for the EMH to hold.[2]

Further, for the business person with little time to evaluate and continue to monitor portfolio holdings, the sure conclusion to simply own the market–rather than pick stocks within that market, putting their assets on a diversified “auto-pilot” path–makes complete sense. We at Caritas are proponents of this low-fee, autonomous approach, and with our proprietary covered-call options strategies we argue that we can not only reduce fees, match market performance, but also in many cases consistently beat the market benchmark.

The inconvenient truth about your personal investment advisor is that unless they are indexing, using the proprietary low-fee Exchange-Traded Funds (i.e., listed baskets of stocks, bonds, commodities, real estate assets, etc.) that Caritas has vetted and has determined to be the highest performing vis a vis liquidity, internal expense ratios, and sector/country exposure–many identified by Schwab Institutional, where Caritas resides–they simply don’t have the ability or time to keep watch over your entire portfolio of assets. We admit, we wouldn’t have the time either.

And setting artificial stop/loss buys or sells on individual holdings in an account has proven to be a flawed and ineffective way to properly manage money. It rarely works, and often you get horrible execution during wide market swings. Lastly, when an advisor does realize a company is having trouble or, in the opposite case, realizes the company has just crushed their quarterly earnings release, the ship has already sailed. It’s a losing battle. So, we profess a philosophy that says, “we’ll meet the market, and not beat the market.”

Again, meet the market; don’t try to beat the market. And let us employ our proprietary call-option overlay strategy to limit risk, and generate an additional 2% – 3% of income every quarter, on top of the dividends paid by the index baskets themselves.

In short, we believe it wiser to own the market index–a fixed income, equity, commodity, or real estate basket of stocks, for example–and gain broad market, sector, and country exposure, in a fully diversified manner, than it is to try to pick and choose the individual stocks which will outperform other stocks in that particular segment.

We ask our clients regularly, “When you bought your house, did you buy it on the premise that it was going to appreciate faster than all the other houses in the neighborhood?” And their answer is inevitably, “No, of course not, I just liked the location, it was what I could afford, and I know it will rise or fall with the overall real estate environment.”

The same is true with how we feel people ought to examine and look at their stock, bond, commodity, currency, or other asset classes of investments. Pick your asset class, and the allocation therein, but ignore the individual securities in that asset class; you’re not going to beat the market, and you’re going to spend your life wasting time trying to do so if you don’t listen to that recommendation.

So, leave the decision making to the market, it will take care of itself. Your time on this planet is limited enough, and you shouldn’t have to worry about such futile endeavors when it’s virtually impossible to pick the individual ones that will outperform the others.

And, if your Advisor tells you he or she can beat the market, ask him or her to show you actual past performance from an unbiased, objective, independent performance reporting agency. We can bet you’re going to see mediocre performance.

But with Caritas‘s proprietary covered-call, passive indexed Exchage-Traded Fund strategies, you will not only take on less market risk (by definition, a fact), but we believe you will possibly inadvertently beat the market, as well. We aren’t espousing that you won’t under-perform the market, but we are promising that you will take on less risk than you would without the call option strategy, with potentially a muted upside return (in a fast rising market, covered-call writing will reduce the total possible upside capital gain, but you still get to keep the added income from the sale of the call option).

And we are offering this at a lower fee than literally any large Wall Street firm (e.g., Goldman Sachs, JPMorgan, UBS, Wells Fargo, Bank of America, Citigroup, Credit Suisse, Morgan Stanley, Deutsche Bank, etc.) can offer it.

And we offer you the choice of participation in a customer loyalty program whereby we return 10%, 20%, 30% or 40% of our fee revenue to community organizations of your choice. If you remain a client for four years, you get a 40% management fee discount, or that money goes to the charities of your choice. It’s all about showing caritas, or charity (in Latin), and we put our money where your mouth is, to spin a new angle on an old adage.

Think about the potential. Change is good, and Caritas is here to help you navigate to an all-index, covered-call (safety net) hedged portfolio which will allow you to meet the market (and possibly beat the market) and, potentially, beat the market while paying ultra-low fees, making a difference in the community. 

Investopedia on The Importance of Asset Class Allocation (cf., “Determinants of Portfolio Performance,” (c) Brinson, Beebower, et al., Institute of Financial Planning, CFA Financial Analyst Journal on Investing):

Most investors, including investment professionals and industry leaders, do not beat the index of the asset class in which they invest, according to two studies by Brinson, Beebower et al entitled “Determinants of Portfolio Performance” (1986) and “Determinants of Portfolio Performance II: An Update” (1991). This conclusion is also backed up in a third study by Ibbotson and Kaplan entitled “Does Asset Allocation Policy Explain 40%, 90% or 100% of Performance?” (2000). Which begs the question, if a U.S. equities growth fund does not consistently equal or beat the Russell 3000 Growth Index, what value has the investment management added to justify their fees? Perhaps simply buying the index would be more beneficial. (To learn more about active management that gives passive returns, check out Beware The Index Hugger.)

Furthermore, the studies show a high correlation between the returns investors achieve and the underlying asset class performance; for example, a U.S. bond fund or portfolio will generally perform much like the Lehman Aggregate Bond Index, increasing and decreasing in tandem. This shows that, as returns can be expected to mimic their asset class, asset class selection is far more important than both market timing and individual asset selection. Brinson and Beebower concluded that market timing and individual asset selection accounted for only 6% of the variation in returns, with strategy or asset class making up the balance.

Figure 1: A breakdown of factors that account for variation in portfolio returns

Broad Diversification Across Multiple Asset Classes

Many investors do not truly understand effective diversification, often believing they are fully diversified after spreading their investment across large caps, mid or small caps, energy, financial, healthcare or technology stocks, or even investing in emerging markets. In reality, however, they have merely invested in multiple sectors of the equities asset class and are prone to rise and fall with that market.

If we were to look at the Morningstar style indexes or their sector indexes, we would see that despite slightly varying returns, they generally track together. However, when one compares the indexes as a group or individually to the commodities indexes, we do not tend to see this simultaneous directional movement. Therefore, only when positions are held across multiple uncorrelated asset classes is a portfolio genuinely diversified and better able to handle market volatility as the high-performing asset classes can balance out the under performing classes.

Hidden Correlation

An effectively diversified investor remains alert and watchful, because correlation between classes can change over time. International markets have long been the staple for diversification; however, there has been a marked increase in correlation between the global equity markets. This is most easily seen among the European markets after the formation of the European Union. In addition, emerging markets are also becoming more closely correlated with U.S. and U.K. markets. Perhaps even more troubling is the increase in what was originally unseen correlation between the fixed income and equities markets, traditionally the mainstay of asset class diversification.

It is possible that the increasing relationship between investment banking and structured financing may be the cause for this, but on a broader level, the growth of the hedge fund industry could also be a direct cause of the increased correlation between fixed income and equities as well as other smaller asset classes. For example, when a large, global multi-strategy hedge fund incurs losses in one asset class, margin calls may force it to sell assets across the board, universally affecting all the other classes in which it had invested. (For related reading, check out Hedge Fund Failures Illuminate Leverage Pitfalls and Are Structured Retail Products Too Good To Be True?)

Class Realignment
Ideal asset allocation is not static. As the various markets develop, their varying performance leads to an asset class imbalance, so monitoring and realignment is imperative. Investors may find it easier to divest underperforming assets, moving the investment to asset classes generating better returns, but they should keep an eye out for the risks of overweighting in any one asset class, which can often be compounded by the effects of style drift. (To learn more about drift, see Don’t Panic If Your Mutual Fund Is Drifting.)

An extended bull market can lead to overweighting in an asset class that may be due for a correction. Investors should realign their asset allocation at both ends of the performance scale.

Read more: Diversification: It’s All About (Asset) Class
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