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Evidence-Based Fund Selection vs. the Stock-Picking Circus

Investment Management

In a recent Cogent Commentary, “Peering Past the Market’s Peaks and Valleys,” we emphasized how important it is to embrace an evidence-based strategy as a prudent way to pursue your personal financial goals. The alternative can seem more like a three-ring circus than a practical way to proceed.

So how do we choose the funds we typically use, to convert our advice into action? Evidence-based investing isn’t just for spectators. You, your fund managers and your advisor each have distinct roles to play in a three-step process of elimination, implementation and ongoing coordination:

Step One: Separating Speculative from Evidence-Based Selections

Our initial process is more like a process of elimination than the usual stock-picking high-wire act associated with conventional investing. We still consider the entire mutual fund universe and its thousands of possible contenders. But it’s relatively easy to eliminate the vast majority of them in the early rounds, with only the strongest surviving as viable candidates.

In this first round, we want to eliminate speculative fund managers who are not even in the arena for what we have in mind.

Speculative: Speculative strategists try to forecast the upcoming performance of securities, sectors or markets and trade accordingly. Individuals may do this by gazing at funds’ “star” ratings or acting on seemingly hot tips from any number of sources. Fund managers may hire well-heeled analysts to probe the universe for secrets about to unfold, and issue buy, sell or hold recommendations accordingly. Either way, these are not exercises that are expected to beat the market, especially after the costs involved in trying.

Evidence-Based: Instead, you and your fund manager can simply hold the universe and be part of its expected expansion. Speculative fund managers may be working very hard at what they’re doing, but it’s an exercise that is more likely to detract from than benefit your goals of building and preserving durable wealth in volatile markets.

By disregarding those who are engaging in speculative tactics, we can readily eliminate a wide swath of would-be fund selections in this initial step.

Step Two: Separating Passive from Evidence-Based Strategy

Once we disqualify speculative fund managers, that still leaves a relatively large (and growing) collection of fund managers who seek to efficiently capture various dimensions of the market’s expected long-term growth without engaging in seemingly fruitless and costly forecasting.

In this category, you’ll find two broad types of funds:

  1. Index Funds: Index funds track popular benchmarks such as the S&P 500 or the Barclay’s Global Aggregate, which in turn track particular market asset classes such as U.S. large-cap value stocks or global bonds.
  2. Evidence-Based Funds: Evidence-based funds seek to wring the highest expected returns with the least expected risk out of similar market asset classes in a more flexible, but still rigorously disciplined manner.

The goals of each are similar, mind you, making it harder to choose among these second-round contestants. Each emphasizes the importance of minimizing wasted efforts and maximizing the factors we can expect to control.

Still, all else being equal we typically favor evidence-based funds for the core of our clients’ portfolios. We feel they are structured to do an even better job at participating in relatively efficient markets over time.

By being freed from slavishly following a popular index benchmark and similar restrictive parameters, your fund managers can focus directly on the factors that matter the most according to what the evidence has to say on the matter. This includes most effectively capturing markets’ expected returns, while aggressively managing for market risks, minimizing trading costs and dampening some of the noisy volatility along the way.

A Side Note About “Smart Beta”: Similar But Different

Most recently, we’re also seeing the proliferation of investments that concentrate on harnessing multiple market factors that appear to provide an additional source of return. You may see these referred to as “factor based” or “smart beta” funds.

It gets tricky here, because the overt strategy is similar to our own, but many of these newest offerings are not yet grounded in sufficient evidence. It’s deceptively easy to mistake random anomalies as reliable patterns, so we must first filter out promising but flawed theory before investing in it. To do so, we turn to those factors that have survived rigorous academic inquiry by being published in professional, peer-reviewed journals, and that have been replicated across multiple markets and extensive periods of time.

Step Three: Synchronizing You and Your Evidence-Based Investments

Even if you’ve decided to engage an advisor to help you build and manage your investment portfolio, YOU also play a critical role in your investment experience.

Personalized for You. First, once we’ve narrowed down our fund choices to a manageable group, the final step is to match the best funds with you and your individual goals. In fact, this “human factor” may be the most important factor of all. That’s why we want you to have a personalized plan in place, preferably in the form of a written Investment Policy Statement.

For example, investing heavily in even the best emerging market fund may be a poor choice for you if your greatest goal is to preserve the wealth you already have accumulated. Conversely, an excellent bond fund may be best used in moderation if you are seeking aggressive growth (and are willing and able to take on some market risk to do so).

Embraced by You. Second, once your portfolio has been structured to reflect your unique goals and risk tolerances, you must be personally prepared to stick with it as built – not just for a year or two, but over the long haul that separates you from your end goals. An advisor can and should assist with that, but in the end, it’s your often-challenging role to remain true to your goals.

A Solid Fund Selection Strategy

Evidence-based investment selection is a significant break from traditional investing, where those with a perceived talent for picking star performers end up in the center ring.

True, their glittery victories and agonizing defeats may be interesting to read about. They may seem important when they are splashed across the headline news. But by eliminating speculative stock pickers, favoring fund managers that apply the science of investing, and helping you stay the course with your carefully structured, evidence-based portfolio, we hope to shine the spotlight right where it belongs: on you and your financial goals.