A cornerstone concept of modern economics is that a free and competitive market system is the most efficient way to allocate resources. Securities markets throughout the world have a history of rewarding investors for the capital they supply. Companies compete for investment capital, and millions of investors compete with each other to find the most attractive returns. This competition quickly drives prices to fair value, ensuring that no investor can expect greater returns without taking greater risk.

We have reached the following conclusions with respect to the public capital markets:

• Current market prices incorporate all available information and expectations about the future, and are therefore the best approximation of intrinsic value
• Price changes are generally due to unforeseen events and cannot be predicted with any consistency
• Pricing errors occur, but they do not do so in predictable patterns and it is difficult to recognize them in real time

Financial market movements may not always appear rational and prices may not always be "correct," but market forces are so competitive that we believe it has yet to be demonstrated that any investor, or group of investors, can consistently profit at the expense of others, or outperform the market as a whole. The idea that markets work is widely acknowledged by financial professionals and academic researchers alike. The implications of market efficiency are profound and affect a wide variety of financial and investment decisions.

We use institutional mutual funds that incorporate the following concepts in our asset class investing approach:

Capture Market Rates of Return

• Attempt to capture market rates of return by investing in large numbers of securities in selected asset classes, resulting in portfolios that offer exposure to thousands of securities (through mutual funds).
  
  

Exclude Certain Securities

• Exclude Initial Public Offerings, financially distressed and bankrupt companies, and illiquid securities.
  
  

Minimize Trading Costs

• Own a broad representation of securities in an asset classes and hold onto them, rather than frequently buying and selling unnecessarily.
• Do not attempt to track indexes as this can result in significant trading costs.
• Allow portfolio managers flexibility on when to add or remove individual securities from asset classes to account for momentum effects, trading costs, etc.
  
  

We believe that investment returns are determined principally by risk, and that a diversified portfolio's expected return is a result of its exposure to certain risk market-based factors. Since a portfolio's asset allocation determines its risk factor exposure, how to allocate one's assets is one of the most important decisions an investor can make. We spend significant time with our clients helping them analyze and create appropriate asset allocation policies, which is largely about selecting an appropriate risk factor exposure.

Our research has identified five risk factors that we believe determine the expected rates of return of a diversified portfolio. The first three are stock market risk factors and the last two are fixed income risk factors:

Market Risk

• Stocks in general have higher expected returns than fixed income securities.

Size Risk

• Small company stocks have higher expected returns than large company stocks.

Valuation Risk

• Lower-priced "value" stocks have higher expected returns than higher-priced "growth" stocks.

Maturity Risk

• Longer-term instruments are riskier than shorter-term instruments.

Default Risk

• Instruments of lower credit quality are riskier than instruments of higher credit quality.

Academic studies show that the degree to which a portfolio is exposed to these five risk factors determines nearly all of its risk and expected return. An advantage of asset class investing is ease with which one can manage risk by investing in precise asset classes.

You can visualize the equity risk components with the illustration below. The extent to which you "tilt" your portfolio toward small and value stocks your increase your risk and expected return.

Cross Section of Expected Stock Returns, Eugene F. Fama and Kenneth R. French, Journal of Finance 47 (1992)

Successful investing means not only capturing risks that generate expected return but also reducing risks that do not. Avoidable risks include holding too few securities, betting on individual countries, industries, or sectors, following market predictions, and speculating on buy or sell recommendations from securities analysts.

Diversification is the antidote to all of these potentially damaging mistakes. Diversification helps to minimize the random outcomes of individual stocks, and positions your portfolio to capture the returns of broad economic forces.

Diversification is much more than the idea of not putting all your eggs in one basket. We know that stocks that share similar risk factors tend to move together. This can dramatically reduce the benefit of owning multiple stocks in a portfolio. In a simplistic example, if a portfolio of stocks move in perfect correlation, there is little reason to own more than one. Combining stocks in a portfolio that move in tandem is what we call "ineffective diversification" because risk is not reduced.

Alternatively, "effective diversification" does help to reduce risk. An effectively diversified portfolio is constructed of securities, or preferably entire asset classes, that do not share common risk factors and therefore tend not to move in concert with each other. These portfolios have components that “zig” while others “zag,” creating a more consistent, less volatile net return series. Effective diversification should not only help you sleep better at night, but also your money may compound at a greater rate compared to a more volatile portfolio with the same average return.

Here is how asset class investing takes advantage of effective diversification:

Combine Multiple Asset Classes

• Seek to combine multiple asset classes that have historically experienced dissimilar return patterns across various financial and economic environments.
  
  

Diversify Globally

• More than half of the market value of global equities is located outside the United States. International stock markets as a whole have historically exhibited dissimilar return patterns to the U.S. markets.
  
  

Invest in Thousands of Securities

• Compared to a portfolio concentrated in a small number of securities, investing in thousands of securities around the world can limit portfolio losses during a severe market decline by reducing company-specific risk.
  
  Invest in High-Quality, Short-Term Fixed Income

• We believe the role of fixed income in a diversified portfolio is to reduce volatility. We seek to accomplish this by using funds that purchase short-maturity, high-quality securities that have a low correlation with stocks and strong credit quality.
  
  
  

Nobody likes to pay taxes, especially on investment portfolios aimed for long-term growth. It obviously follows that to the extent tax liability is reduced, after-tax returns are increased. Tax management does not imply avoiding tax completely but seeks to maximize after-tax returns while maintaining a client's desired asset class exposure.

We use a comprehensive tax management approach in managing portfolios to help minimize tax exposure for our investors. We are committed to our objective of bringing tax benefits to our clients with minimal or no reduction in pre-tax portfolio returns. Here are the elements of our tax-management strategy:

Asset Location

• The tax status of accounts is considered when choosing where to hold securities. A higher proportion of income-generating securities can be held in tax-deferred accounts (such as IRAs or pension accounts), while a greater percentage of asset classes that generate larger capital gains may be located in taxable accounts.
  
  

Tax-Efficient Rebalancing

• Combining accounts of differing tax status in one portfolio can result in more tax-efficient rebalancing than if the accounts are managed as stand-alone portfolios. For example, if an IRA account and revocable living trust account are aggregated together in one portfolio, we could buy and sell securities inside the IRA to rebalance the portfolio, resulting in no capital gain recognition for the investor.
  
  

Tax-Managed Mutual Funds

• In certain asset classes, we can use tax-managed mutual funds to help reduce dividend and capital gain distributions that are paid to fund shareholders through the mutual funds. These funds use tax-management strategies performed by the fund manager. Dimensional Fund Advisors, for example, uses proprietary strategies designed by their team of academic researchers to try and minimize or eliminate short-term gains, harvest capital losses when possible, and minimize dividend yield when appropriate.
  
  

Cost Basis Evaluation and Reporting

• We track the cost basis of managed assets in taxable accounts and consider capital gains implications when trading and managing taxable portfolios.
• We provide clients with a year-end tax report showing the cost basis of securities sold during the year. We use the "highest cost" method of determining cost to help defer capital gains to future years.
  
  

Tax-Loss Harvesting

• We seek opportunities to generate tax losses for clients who would benefit from them. One way to add value to a portfolio in a market decline is to harvest losses while maintaining the portfolio's proper asset class exposure. This requires careful trading and planning to make sure that tax rules are followed correctly.
  
  

A portfolio can drift from its initial asset allocation over time due to market fluctuations, changing the portfolio's risk and return characteristics. By rebalancing the portfolio on a regular basis, the original risk profile can be more closely maintained. There is also evidence in academic research that a systematic rebalancing program may increase returns by taking advantage of market fluctuations over the long-term.

We review all portfolios regularly for rebalancing, unless there is a specific reason not to rebalance (due to certain tax or cash flow considerations, for example) or if a client has requested that we not rebalance their portfolio.

The following guidelines summarize our rebalancing philosophy:

Rebalancing trades should only occur when the expected benefits from rebalancing exceed expected costs.

• The frequency of rebalancing opportunities fluctuates. This is because their occurrence depends on the unpredictable movements of relative asset values.
• When a portfolio's component assets experience quick and repeated divergent returns, rebalancing opportunities may occur more frequently. Alternatively, when assets move together over prolonged periods rebalancing opportunities may occur less frequently.

Focus on reducing the tax and transaction costs of rebalancing.

• Place rebalancing trades inside tax-deferred accounts to reduce capital gains exposure.
• Strategically use newly deposited funds to rebalance an account to reduce taxes and trading costs.
• Rebalance taxable accounts only part way back to target allocations when a taxable gain will be recognized on the sale of assets.

Review portfolios frequently for possible rebalancing opportunities.

• The rebalancing process should not be automated on a time-based schedule, such as quarterly or annually. Rather, portfolios should be reviewed more frequently for possible rebalancing opportunities.

An asset class must be sufficiently away from its target allocation to be considered for rebalancing.

• Place a "non-trading" region, or volatility band, around each asset that prevents overly frequent rebalancing.
• This band should be larger for more volatile asset classes and smaller for less volatile ones.
• Rebalancing should only be considered when at least one asset class in a portfolio is beyond its volatility threshold.