At its core, WealthFactor’s investment approach starts with a close alignment to passive investing methodology.
Active investing involves a hands-on approach to portfolio management where managers research individual stocks and make trades in an attempt to outperform the market based on their beliefs, data, and some quantitative analysis. Many advisors actively select underlying fund managers who do the work on their behalf. We think both layers of active management are 1) unlikely to add value over time and 2) increase costs. An active approach requires substantial research costs and generally has a higher turnover which leads to increased fees and reduced tax efficiency.
By contrast, passive investing involves buying and holding a set of securities over a long time horizon, typically with the objective of matching the performance of an index. Passive investing has the clear advantages of 1) transparency, and 2) minimizing costs, such as research, transaction fees, and capital gains tax burden.
There is a significant body of research in academic finance which supports the notion that on average passive investing consistently produces superior returns net of fees over the long run.
In addition to passive investment, we believe having the right amount of risk is critical to investment success. We do not believe the mix of investment assets should be determined based on a risk preference or driven by goals or objectives. Instead, we look to quantify what the right amount of risk is for each of our clients.
We break risk up into two categories - 1) behavioral risk and 2) structural risk.
Behavioral risk measures an individual’s tendency to make investing mistakes due to their behavior.
Structural risk measures an individual’s ability to absorb financial losses without putting their financial goals in jeopardy.
To start, we work with clients to establish behavioral and structural risk scores on 1 to 100 scales. The lower of these two scores becomes the investor’s MaxRisk score. This represents a limit on the amount of risk recommended for long term investment.
A MaxRisk score of 100 represents a 100% growth-focused investment strategy, whereas a
MaxRisk score of 1 is consistent with 100% cash holdings. In practice, we find that 90% of clients have a MaxRisk score between 20 and 80.
We also consider an individual’s risk preference and their access to help from an investment expert. If, for instance, you prefer a lower level of risk than what your MaxRisk score indicates, that's acceptable! Also, if your behavioral score is lower than your structural score, having a MaxRisk score somewhere in the middle is also acceptable, but only with access to expert help to mitigate behavioral mistakes.
Adding these additional factors of investment expertise and risk preference together with the investor’s MaxRisk score allows us to finally determine the RiskSmart target for their portfolio. Once a client’s RiskSmart target for long term investment is established, we determine how to allocate their investable assets based on what we call buckets.
In WealthFactor’s investment approach there are two primary buckets, 1) the Growth bucket, which is primarily composed of publicly traded equities and 2) the Stability bucket, which is primarily composed of investment grade fixed income.
We have 3 secondary buckets which are used to achieve risk targets not possible with the primary buckets or to help enhance portfolio income.
1) The Growth+ is primarily composed of publicly traded equities, but differs from the Growth bucket with increased allocations to smaller companies and emerging markets and may also include options writing as a means to increase returns.
2) The Stability+ bucket has the potential to include non-investment grade fixed income and also tactically use option writing in an attempt to increase the portfolio's income.
3) The Cash+ bucket is used to achieve risk targets lower than the Stability bucket and is generally composed of short-term treasury securities and options writing strategies.
The following table depicts the average target risk scores for each bucket.
Exchange Traded Funds (ETFs) are the default investment instruments we use for allocating capital to the various buckets. ETFs are preferred for their low cost, diversification, and liquidity properties. However, for clients who allocate more than a certain threshold dollar amount to U.S securities in the Growth and Growth+ buckets, we offer additional options for Personalized Indexing investments. Personalized indexing provides a well-diversified investment solution that fits seamlessly into an investor’s overall asset allocation strategy. See the next section for details.
Personalized Indexing Methodology
WealthFactor’s Personalized Indexing methodology seeks to deliver returns through buying and holding a diversified portfolio of publicly traded equities. Plus, we increase fee efficiency by removing the fund layer, manage concentrations to optimize risk, and individually address client’s tax management.
In the pursuit of providing personalization, we start with a universe of stocks, an index or multiple indices2. For example, if a broad exposure to large-cap U.S. stocks is desired, then we may start with the Russell 1000 Index. Or, a personalized index of small-cap U.S. stocks may start with the Russell 2000 Index.
Then, we reduce this universe through filtering which may include the following:
1) Factor: remove securities that do not screen for the value, profitability, or momentum factors.
2) Size: screen out companies that are under a market cap of at least $2 billion to $5 billion.
3) Dividends: screen out companies that do not pay a dividend of a certain percentage, if generating income is important..
4) Sector exclusion: For those that have large percentages of their wealth or income tied to specific industries it may be valuable to avoid adding to that concentration.
5) Environment, social, and governance: remove securities that do not meet certain criteria for responsible environmental, social, or corporate governance actions.
After the universe is narrowed through filtering and structural limitations are added to minimize risk both at sector and position level, each of these positions are purchased on behalf of the client.
When it comes to ongoing management of the portfolio, unlike direct indexing, a rules-based process is used to prioritize client specific considerations. Generally, our rules-based systems look more like a rebalancing, as the exposures and weightings of our portfolio move.
This can be a healthy phenomenon for a portfolio. Individual securities and sectors have historically exhibited periods of momentum; rather than try to predict this momentum, we instead utilize a multi-part rebalancing approach. On a more frequent basis we employ a “soft-rebalance”. In this rebalance we allow for increases in position and allocation size, allowing participation in the momentum. On a less frequent basis we employ a “hard-rebalance” returning all of the positions and sector weightings back to equal.
There are a few main advantages to utilizing personalized indexing.
1) Remove a layer of management, which may reduce costs.
2) Tailor a portfolio specifically to an investor’s income targets or tax situation.
3) Tax management strategies, such as deferring gains and loss harvesting, are far more effective than with funds.
1 For example, Jensen (1968), Malkiel (1995), and Fama and French (2008) demonstrate that U.S. equity funds with active investment management significantly underperform passive investment strategies, net of fees.
2 We recommend personalized indexing for clients allocating more than $200,000 to stocks in large U.S. companies and/or more than $500,000 to small U.S. companies.
3 For more detail, see WealthFactor’s “Factor-based: an alternative to market cap weights,” https://www.wealthfactor.co/insights/single-post/direct.
4 WealthFactor’s “Introduction to Direct Indexing,” https://www.wealthfactor.co/insights/single-post/direct.
At WealthFactor, we believe personalized and direct indexing will be a disruptive force in investing for years to come.
Our services are built around proprietary technology that allows us to:
1) eliminate the advisor layer of management,
2) efficiently implement our direct investing strategies, and
3) pass these operational and trading efficiencies onto our clients in the form of lower fees for investment services.
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