Investment Symposium 2014

The following is a transcript of an interview of Gradient’s Tim Sagawa and Rodney Simms facilitated by estate planning attorney Douglas R. Irwin at the opening event:

Rodney’s Responses:

1. What are a  few important takeaways learned over your 25 year career relating accumulating wealth?

In many ways, although I may have 25 years invested in the Financial Services industry, I feel like I’m just starting.  I think if you love and have passion for what you do professionally, there is always a sense of freshness to the start of each day.  I do find your question to be interesting.  There are, in fact, a few specific things that come to mind:

First, recognize the impact that fees and taxes have on your investment portfolio. I’ve met with thousands of people during my career. In each of my initial conversations, I have a habit of asking the person with whom I am meeting “what are you paying, as a percentage of assets in your portfolio, for investment management?”. Honestly, I don’t believe a single person has been able to provide me with that information accurately. Most people fail to recognize that their mutual funds contain trading costs that go beyond the asset management fees and do not have a clue as to what the internal fees are associated with their corporate sponsored 401(k) plans. In regards to taxation of portfolio returns I see the same simple mistakes over and over. People investing in mutual funds near the end of the calendar year only to be forced to pay tax on 100% of the capital gain distribution for the entire year and short-term trading that will subject the returns generated to much higher tax brackets are two of the many mistakes that I see investors make. In the end, other than taxation and fees there are few guarantees with investing.  Both of these items, however,  are considerations in the portfolio construction process that we have complete control over.

Secondly, human nature leads us to believe that unless we are making changes we may not be making adequate progress.  Most people feel the need to completely revamp their investment strategies with every change in the economy.  These changes ultimately lead to attempts at market timing. An appropriately allocated investment portfolio rarely requires a complete overhaul. My experience suggests that fine tuning and systematic rebalancing provides a better long-term result then frequent portfolio reallocations. Simply put, don’t be afraid to stay the course.

Lastly, make sure to take advantage of opportunities when they are staring you in the face! They are actually easy to see.  The equity markets are batting One Thousand.  Believe it or not, in hindsight, every single correction over the past 100 years was an opportunity.  When people run for the exits, the smart people are there to step inside.  Many believe that these opportunities only occur during significant sell-offs within major market indices or during recessions.  In actuality, these opportunities are almost always present.  There always seems to be an asset class that is out of favor. By consistently rebalancing one’s portfolio back to the target asset allocation you will consistently reduce exposure to those assets that have increased in value significantly in the short-term (and therefor maybe overheated) and allocate funds to those assets that have likely become under valued and are priced attractively.

2. How do you view and address risk when managing your clients money?

Although in my personal life I am always intrigued and attracted to the iconoclast, the risk taker who pursues the road less traveled, when it comes to investment management,  I have an aversion to risk that takes me in the opposite direction. When mentoring university students I always encourage them to take risks as they move through their chosen careers.  In business, it’s the risk embracing entrapranuers that have the highest probability of creating wealth.  When they make that money however and need to put it away for the future, I encourage them to change that mindset 180 degrees. Although a properly allocated portfolio will have an element a risk taking, those actions must be time tested and calculated.  My nature is to pay as much attention to preservation of capital as I do to investment growth.

3. I would imagine the majority of your clients are interested in reducing their annual income tax liability.  What strategy in this regard do you find that people most often overlook?

As a group, investors have been led to believe that their more aggressive investments (being long-term in nature) should be held in their retirement accounts. Unfortunately this misconception has led to a much higher net tax burden for the majority of investors. Throughout history, in the United States, long term capital gains have been subject to lower tax rates than the rates applied to earned income.  In 2003 this bias became even greater when dividends (in addition to Capital Gains) were provided a similar preference. Unfortunately, this concession does not apply to dividends and capital gains generated by investments held in retirement accounts. Withdrawals from retirement plans are considered to be “ordinary income” for tax reporting purposes (subjecting the amount withdrawn to marginal rates up to 39.6%).  If wealth accumulators as a group would simply do the inverse of what they’ve been instructed to do by holding investments that generate dividends and capital gain income in their non retirement accounts, their net tax burden for most investors over their lifetimes could be less.

4. I recognize that your firm provides multiple services to your clients.  Is there an area within financial consulting or investment management that you enjoy the most?

I get great pleasure working in the space were philanthropy and wealth management intersect (the idea of using planned giving and philanthropy to actually enhance ones financial position while providing assistance to a non profit organization).  Most of us support our favorite charities throughout our life times through systematic cash contributions.  We save the big gifts, however, until after our expiration dates (through bequests upon death).  In my career,  I believe some of my best work has been completed by working with my clients and their favorite charities to develop strategies that allow my clients to achieve their personal financial goals (reduce taxes, increase income, get to retirement sooner) while providing benefits to the non profit organization at the same time.  One specific case comes to mind that took place early on in my career.  I was referred to a women in her late 80’s who lived in an oceanfront home here in San Diego. She and her husband (who had recently passed away) purchased the home 50 years earlier.  During our initial meeting I asked her what concerned her, if anything about her financial situation. She explained to me that she had almost depleted all of her investment assets and that in a short period of time her only source of income would be her Social Secuity benefits (which totaled less than One Thousand dollars per month).  She indicated that she would be listing her home shortly and would need help investing the sales proceeds.  As our conversation progressed, she explained to me that (in addition to her husband) her only child had passed away after battling cancer a few years earlier.  Upon his death, she began caring for his two rather large dogs that he had left behind. In her spare time, she enjoyed painting the coastline in front of her residence.  After her son’s demise she started donating her paintings to a large non profit organization dedicated to cancer research.  Her paintings, along with other items, had been auctioned off at the charities annual gala. She indicated that, although she took comfort in knowing that she would have the resources required to move into a retirement home, she had not yet located a facility in the area that was willing to accept two large dogs.  At that point I asked her “if financial considerations were not an issue, what would yo do?”. She responded right away and said “of course, I would stay in the home my husband and I raised our son in, surrounded by my two wonderful dogs.”  In the end, my client got her wish.  With collaboration from her accountant, attorney and representatives from her favorite charity we structured a Gift Annuity for Remainder Interest in Residence arrangement. With this transaction, an agreement was reached with her charity that upon her passing they would receive the home (which would then be sold providing a large sum of money towards research efforts). She retained the right to live in the home for the rest of her life and in return for the gift would receive (through the purchase of an immediate annuity) monthly income in excess of $5000 for the remainder of her life. She lived an additional 12 years after we structured the program. The last year of her life she was able to use the income to pay for in-home care givers.

5. We are always told that our investment portfolios should be diversified.  Although this may be a basic simplistic tenant, research would indicate that when polling retail investors, opinions vary dramatically as to what constitutes success in achieving this objective. What insights might you have in this regard?

First off, I would agree with that basic principle. I would point out, however, that in many situations individuals have gone too far and in fact have over diversified their investment holdings.  As an example, it is not uncommon for an individual investor to hold 10 or 15 different mutual funds (typically with a bias towards domestic equities). Assuming that the average fund has exposure to 100 individual securities, there is a good chance that, in this situation, the investor has figuratively bought the entire market. Given the higher expense ratios associated with actively managed mutual funds (as compared to index based investments), more times than not, the investor would have been better off allocating all of the money to one broadly diversified index like the Wilshire 5000 (which can maintain an annual expense ratio 75% below that of many actively managed funds).  Although portfolio diversification has been a core component of an appropriate investment plan, it’s application has changed dramatically over the years. In my investment practice as an example, the utilization of individual stocks (as opposed to broadly diversified exchange traded and index funds) has decreased significantly. This has occurred for two reasons. First, through competition and ongoing new offerings available, investors have access to hundreds of exchange traded funds that allow one to diversify and target a specific asset allocation with precision all with very low internal operating expenses. Secondly, market volatility associated with a large group of individual stocks, has increased over the past three decades. Although there are debates as to what has caused this change, I believe that modifications overtime as to how senior executives are compensated have played a significant roll.  Like we have experienced recently, three decades ago there was a large revolt against the size and scale of the average CEO’s pay package.  Unlike today, at that time the majority of compensation for corporate leaders came in the form of large salaries. Through pressure from activist shareholders, these mega salaries were replaced by stock-based compensation (Option grants, Restricted Stock Units etc).  The government even got involved by enacting tax law changes that enabled corporations from deducting salaries paid to corporate leaders that exceeded one million dollars.  Although, at the time, these modifications may have done a better job of aligning the interests of shareholders and corporate executives, I believe a larger problem was created.  Given that the majority of CEO compensation is now stock-based, corporate leaders may be incentivized to pursue more aggressive business plans.  Assuming that the average CEO maintains their position at the helm for a period of five years, with a stock based compensation plan it is logical to assume that their motivation would be to elevate the companies share price as much as possible during their tenure.  In my opinion this changes how a large number of companies are being run today.  If traditionally companies worked off of a long term business plan, there would now be an incentive to compress that plan with a strong emphasis placed on short term results.  In my opinion, this leads CEO’s to support the implementation of much more aggressive strategies (the use of significant leverage, buyouts of their competition etc). Although these techniques have allowed some corporate leaders to hit home runs (with record breaking short term stock gains) they have led other companies (some with inception dates going back over 100 years) to their knees.  Just 30 years ago “Blue Chip” stocks were considered to be “lifetime holds,” securities to be past down from generation to generation.  Within the past decade many of the individual companies that make up this group have seen their stocks decline by more than 75% at one time or another (Bank of America, Ford, General Electric are just a few that come to mind) with some even going into actual bankruptcy. Although I see more volatility with individual stocks today (for the reasons referenced), I believe that, collectively, these securities will continue to generate similar returns to what we saw over the past 100 years.  To obtain those returns with as little risk as possible, however, I believe that the average investor is best served when using diversified Exchanged Traded Funds rather than a concentration of individual securities.

Tim’s Responses:

1. What is your investment process and why is that important?

Good question.  I would argue that an investment manager’s investment process is the most important determinant in long term performance.  The investment process and philosophy will drive all investment decisions being made for the portfolio.

That being said, we believe it is of the utmost importance to first learn and understand a client’s goals, risk tolerance, time horizon, tax situation, previous market experience and unique circumstances.  With this information, we can come up with a customized portfolio, based on asset allocation analysis, that seeks to maximize after tax returns for the given risk level.  After determining an appropriate asset allocation for a client, we then implement a portfolio utilizing a “core/satellite” approach, monitor the portfolio over time and rebalance the portfolio to ensure we remain within our stated risk parameters.

2. You mentioned using asset allocation analysis when generating a portfolio.  What is Asset allocation?

Asset allocation, also known as Modern Portfolio Theory, seeks to maximize investment returns for a given level of risk.  The theory, as developed by Nobel Laureate, Harold Markowitz, states that how one allocates investments between various asset classes is the greatest determinant of portfolio returns, as opposed to market timing, stock picking, etc.  By diversifying one’s portfolio amongst investments which maintain low correlations (i.e. move it different directions at different times), one can achieve a higher rate of return for a given risk level.  As an example, a portfolio of all long term government bonds may seem like a very conservative portfolio.  However, said portfolio is subject to a significant amount of interest rate risk (when interest rates rise, bonds lose money in the short term).  As a result, during periods of rising interest rates, this long term bond portfolio would be subject to significant principal loss.  Conversely, if we were to take a small position, say 10%-15% from bonds and allocate that towards large cap equities (a more risky asset class on a stand-alone basis), historical analysis demonstrates that the portfolio would actually have a lower standard deviation, or risk level, given the diversifying benefits of combining the two asset classes with little to negative correlation, while providing a greater long term expected return.  Historically, when bonds do poorly, equities do well and vice versa.

3. I’ve heard you mention asset location before.  What does that mean?

Asset location is a very important but often overlooked part of managing an investment portfolio.  As I stated previously, our goal is to maximize after tax investment returns.  This is where asset location comes into play.  Asset location is the process whereby we determine which type of account to place specific investments, based on their tax classification.  For example, by holding more tax efficient/favored investments (such as Equity based Exchange Traded Funds which produce tax preferred qualified dividends and capital gains) in non-qualified (taxable) accounts, while holding more tax inefficient investments (such as bonds, which pay regular income in the form of interest, which is taxed at marginal rates) in qualified (tax deferred) accounts, you can maximize the after tax rate of return on the portfolio, even if they hold the exact same investments.

4. Another question I hear come up a lot is about “active” vs “passive” investing.  Can you describe the difference between “active” and “passive” investment strategies, and which do you prefer?

That’s another good question.  There has been an ongoing, sometimes heated, debate in the investment world between whether one should use a “passive” or “active” investment strategy for decades.  Simply put, a passive strategy seeks to own the entire “market” (such as owning and S&P 500 Index Fund), thereby achieving market returns, while minimizing costs.  An active strategy, by contrasts, attempts to “beat the market” by investing in a portfolio of securities which deviates from the market (either through different securities or different allocations to the securities).  While it seems intuitive to want to beat the market, history has shown that it is very difficult to do this on a consistent basis, after accounting for the additional fees and transaction costs required to implement the managers “active” bets.  In fact, various studies have shown that the majority of actively managed mutual funds underperform their benchmark (i.e. the market) over time.  That being said, there are managers who have successfully achieved their objective of providing excess returns over various market cycles.  The difficulty is determining who those managers are moving forward.  We always hear the disclosure “past performance is no guarantee of future results”.  At our firm, we actually believe there are benefits to pairing the two strategies.  Specifically, we utilize a “core/satellite” investment philosophy, whereby we utilize extremely low cost index funds and ETFs to serve as the “core” of the portfolio, while allocating the remainder of the portfolio to actively managed strategies, which serve as “satellites” to the core, providing the opportunity to provide excess returns.   When choosing managers for the actively managed strategies, we seek to find managers who have a proven process that has been successful in the past and is repeatable in the future.  Also, we seek to use actively managed strategies in markets that have shown to be less efficient, meaning that theoretically, a manager with good information should be able to better exploit those inefficiencies.  For example, in theory, when investing in international small cap stocks or emerging market stocks, it is likely that the market will be less efficient than when investing in U.S. Large Cap stocks.  In practice, this has also born true with a greater percentage of actively managed funds beating their benchmark in these spaces.

5. How do you go about picking the active managers you utilize in portfolios?

Haha…this is the difficult part.  With the amount of information now available (Morningstar, Lipper, etc), it is easy to find managers that have “beat the market” in the past, but the question is, how do we find the managers who will succeed moving forward?

We believe that it is important that active investment managers have a proven investment process, which has succeeded in the past and is repeatable, allowing them to succeed in the future.  Also, we strive to find managers that are actually running an active strategy, whereby they have the ability to generate significant alpha, or excess returns.  Often times a so called “active” strategy, looks strangely familiar to the index it is tracking but with much higher fees.

This is done through both quantitative and qualitative measures.  As a starting point, we look to past performance over various market cycles and environments.  Often times, the “Five Star” funds, as defined by Morningstar, go on to significantly underperform their benchmarks and peergroups in the future.  We seek to weed these managers out by looking at attribution analysis of what were the drivers of their outperformance (i.e. sector bets, stock picking, tactical positioning, etc).  For example, in the late 1990s, there were a large number of managers who had great performance numbers, but looking a little deeper, they were simply allocating a huge portion of the portfolio (sometimes in excess of 50%) in technology companies.  Once the technology bubble burst, these funds significantly underperformed.

Once we have narrowed the universe of managers to those that have shown the ability to outperform the market in the past, we conduct additional due diligence on the “best” managers by interviewing the portfolio managers and/or analysts on their teams.  Through this process we seek to better understand their investment process and philosophy.  At this point, we have identified the manager as having shown the ability to add value in the past, and this is where we seek to determine whether or not we believe their process is repeatable and can provide value in the future.

6. You also mentioned monitoring and rebalancing portfolios.  I’ve recently read some arguments against rebalancing.  Can you explain why you believe in rebalancing?

My opinion is that rebalancing is the correct strategy. Although in a prolonged bull market (which one never knows until after its over), with stocks moving only higher, rebalancing does hinder returns (slightly); however, when markets are volatile rebalancing increases returns. The more important point though, I believe, is the risk management aspects of this process. The idea behind the strategy is to maximize long term investment returns for a given risk level. If one were start with a moderate risk tolerance and a portfolio of 50% stocks and 50% bonds, over time, assuming a positive stock market, said portfolio would become increasingly risky (hypothetically to a moderate aggressive portfolio of 65% stocks and 35% bonds) as the equity weighting increased through market appreciation. When the market ultimately corrects (once again, we never know when this will happen), the portfolio would be subject to significantly more losses, given the higher equity weighting. Alternatively, a portfolio which was rebalanced would experience a lesser drawdown. In addition, that portfolio would be in a place to take advantage of the sell-off to buy in at the lower levels. My opinion is that if someone is comfortable with a higher risk level (which inherently comes if rebalancing does not take place), they are better to initially position their portfolio with a higher equity weighting and rebalance back to that level over time.