My investment philosophy is based on the principles of quality and value. I also advocate using well-designed index funds (a.k.a. passive/index-based strategies) for most purposes. However, deep expertise is required when selecting index products to mitigate or avoid little-known but significant issues embedded in the mechanics of many index products (see Passive Cons tab below).

Please click on the following tabs for a brief educational tour highlighting the pros and cons of various investment paradigms:

Investing 101

Every investment has underlying fundamentals. These fundamentals can grow, sustain, or contract. Moreover, they are different for each asset class (e.g., stocks and bonds) as well as each individual security. In addition to changing fundamentals, each investment's price and valuation will fluctuate through time. Investment performance will be determined precisely by a combination of fundamental performance (including dividends or interest) and changes in valuation. The two examples below describe relationship for bonds and stocks.

Managing risk and return requires one to pay attention to both the quality of the fundamentals as well as the valuation for each security purchased, held, or sold in a portfolio. Constructing portfolios with high quality securities at reasonable or attractive prices reduces both the downside risk and increases the upside potential. I find this high quality value investing strategy the best formula for preserving and growing wealth.


When one purchases a bond, they pay money now and get money later. The ability of the borrower to pay what is owed comprises the fundamentals and may fluctuate through time. The valuation of a bond is determined by prevailing interest rates and these also change. In the case of government bonds, investors are virtually certain to be repaid according to each sovereign's ability to print currency (albeit with potentially devalued money). The fundamentals for other bonds involve credit risk due to the possibility of default. I will not go into the math here, but the changes in the fundamentals (credit worthiness) and valuations (interest rates) will determine the performance of the bond investment.

It is important to note the fundamentals of bonds are limited on the upside. In some instances one can purchase a bond at a discount and realize some capital appreciation. however, after the interest is paid a lender will not receive more than the notional or par value of the bond. This is why bonds are classified as fixed income investments.

I think of the stock market as a collective of profit seeking entities that tend to succeed over time. To be sure, there are some challenging periods and some companies perform better than others. Notwithstanding, in the grand scheme of things their quest for profit keeps the lights on and this dynamic group of companies that make up the market grow at a steady pace. Warren Buffett wrote this during the depths of the recent credit crisis:

Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts; the Depression; a dozen or so recessions and financial panics; oil shocks; a flu epidemic; and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.

For the more technically-minded, I can express the value or price of a stock mathematically as P = F × P/F where P is the price and F denotes a particular fundamental quantity. Two of the most popular fundamentals used for analyzing investments are earnings and book value. The ratio of the price to the fundamentals (i.e., P/F) is the valuation (e.g., price-to-earnings and price-to-book ratios). This indicates how many dollars one pays for each fundamental unit. For example, a price-to-earnings ratio (P/E) of 10 indicates investors are paying $10 for each $1 of earnings. So the price of a stock is just the product of the fundamental and its valuation. Consequently, the return on a stock over a given time period can be decomposed into changes in the fundamentals and changes in the valuation. For example, a 10% increase in earnings and 20% increase in valuation (say from 10 to 12) produces a return of (1 + 10%) × (1 + 20%) - 1 = 32% on the stock. While this example ignored the impact of dividends, it is easy to add.

Active v. Passive

Some investors adhere to what I believe is an elegant but outdated theory: the efficient markets hypothesis. According to this theory, all publicly available information is reflected in security prices. Assessing the quality of fundamentals, considering valuations, or any other activity used to pursue stock picking or security selection is futile. In other words, Warren Buffett was just lucky. Some interpret the theory more loosely. They believe there are some opportunities but the costs (fees, transaction costs, and tax friction) of exploiting them outweigh the benefits. Both of the above camps tend to pursue passive or index-based strategies whereby portfolios are constructed as a slices of the overall market. This strategy effectively invests in all stocks and weights each stock according to its market capitalization (i.e., more money is invested in bigger companies and less in smaller companies).

Then there are those who believe there are security selection opportunities worth exploiting. Investors who attempt to take advantage of these opportunities using their own research are said to pursue active strategies. Active portfolio managers attempt to select individual securities to outperform their benchmark index (e.g., S&P 500). They tend to use a variety of techniques including assessing fundamentals, valuations, price charts, or other analyses.

To be sure, the active/passive debate has existed for years and is still ongoing. As I highlight in the following sections, I feel the data against active funds is condemning and makes a strong case for using passive/index-based strategies.

Active Pros

The ability to pick individual securities and deviate from a market portfolio (e.g., the S&P 500) makes it possible for active managers to outperform the market. Indeed, many attempt to take advantage of the immense wealth of data and information at their disposal. Active management would appear to be an ideal solution for investors willing to pay for the skill and work required to outperform the markets. In practice, however, the overall results are not encouraging as I discuss in Active Cons.

Notwithstanding, outperforming markets is not necessarily the only goal for active strategies. Security selection can be used to target specific fundamental attributes. For example, one might want to target companies with higher-quality fundamentals. In the context of retirement income (also for those in the accumulation phase), I like to pursue higher-quality companies that have consistently paid and raised their dividends. I touch on this in the last tab (Steady Income), but here are two articles and a video that discuss this further:

Active Cons

While there is much marketing material touting the success of various active funds and managers, I find performance data for active strategies is quite condemning. To my knowledge, no credible study has been conducted concluding the active management industry earns the higher fees it charges. I find most studies or analyses supporting active management are generally not exhaustive. They often suffer from survivorship bias or focus too narrowly on historical periods favorable to the strategy being marketed.

For investors who currently invest in or are considering actively managed investment products, I strongly suggest reading S&P's semi-annual Index Versus Active (SPIVA) scorecards. These reports illustrate the performance of actively managed funds versus their benchmark indices. While there are some periods when active management outperforms, their data clearly indicates underperformance is the norm for active strategies overall. Please feel free to contact me as I am always happy to share or discuss this data.

So why do active managers underperform overall? This is a curious and widely researched topic. I first present the simple math Nobel prize winner William Sharpe used to show how the odds are stacked against active management. I then discuss several behavioral factors that likely contribute to this underperformance as well:

Nobel prize winner William Sharpe outlined a simple and persuasive mathematical argument against active strategies in aggregate. In a nutshell, he assumes the entire market is owned by active and passive investors. The passive investors each buy and hold slices of the market. As a result, they experience the market return. The remainder of the market held by active investors in aggregate must also experience precisely the market return (otherwise the active and passive returns would not add up to the market return). However, the active investors will trade amongst themselves incurring transaction fees. Moreover, they typically charge higher management fees for their expertise. Unfortunately, all of these fees involved with active managers will erode the returns ultimately experienced by their investors. John Bogle (the founder of Vanguard) elaborated on this argument in his book. It is a quick and easy read with plenty more empirical evidence regarding the active.passive debate.
On balance, management fees for active funds are significantly higher than their passive counterparts. The Investment Company Institute (ICI) calculates average fees for active and passive equity funds each year. In 2014, average active fees were approximately 86 basis points (0.86%) versus just 11 basis points (0.11%) for passive equity funds. So the real question is whether active management is worth the extra cost.

The financial services industry has exploded in size over the last two or three decades. There is a seemingly endless list of investment managers competing against each other. Moreover, technology has made data easier to access and leveled the playing field more than ever before.

There is a relatively new field called behavioral finance. The basic idea is that human nature imposes a variety of biases that prevent us from thinking and processing data objectively. These natural tendencies become significant obstacles for executing rational investment strategies.

Conflicts of interest can dampen investment performance. Closet indexers provide one example. They claim to execute active strategies to outperform the market but really just hug their benchmark indices (i.e., their holdings deviate minimally from the benchmark) in an effort to maintain job security. Indeed, deviating significantly from their benchmark can result in short-term under-performance and this can jeopardize their job security (investors are not always patient or confident enough they will be able to recover). Another example is with hedge funds or other investments that use performance-based fees. These fee structures tempt investment managers to shoot for the moon. Heads they win (with share of the big returns). Tails investors lose. The worst case is they shut down their fund and lose their funds but resurface in a new fund or set up another one themselves.

Another questionable behavior often witnessed with active managers is window dressing. That is, they purchase securities that have already appreciated significantly before the end of a reporting period so they can claim to have cleverly owned those winners. Unfortunately, many studies have been conducted indicating this phenomenon is common practice in the investment industry.

On balance, the logic and empirical evidence above provide a strong case for passive and index-based investments relative to active investing. However, that is not to say one cannot improve upon the existing index-based strategies as I discuss in the Intelligent Passive section.

Passive Pros

Passive strategies solve many of the problems associated with active strategies. By relying on a set of pre-defined rules to manage a portfolio, human emotions and biases are avoided in day-to-day portfolio management. Moreover, passive strategies typically charge significantly lower fees (on average just 11 basis points or 0.11% versus an average of 86 basis points or 0.86% for active according to ICI).

While Markowitz defined passive strategies as those that carved off slices of the market portfolio, the rules behind indices and passive strategies can be customized while maintaining most of the above benefits. For example, they may be designed to systematically exploit opportunities in security selection by imposing constraints for valuations (i.e., value indices). However, as I point out in the next section, it is very important to understand index rules and mechanics as they will naturally impact performance.

Passive Cons

While I am a strong advocate of passive investing, one must exercise caution when utilizing index-based products. My research indicates many indices embed subtle costs that far outweigh the low fee they advertise (you get what you pay for or worse in many cases). Marketing seemingly trumps quality with many investment products as the industry caters more to the marketing needs of advisors than the performance of the end investors. I highlight some of these issues below but please feel free to contact me for my more detailed research on these issues.

  • Market capitalization weighting (MCW): Market capitalization indicates the total cost to purchase a company (i.e., the number of shares outstanding multiplied by the stock price). The weights for stocks in most passive indices are proportional to their market capitalization. This imposes a systematic bias whereby over-priced stocks receive higher weights and under-priced stocks receive lower weights. This is precisely the opposite of what investors should want. My research corroborates the findings of others indicating this results in approximately 2% or more per year of underperformance over the long term.
  • Index front-running: Another common issue with many popular indices is index arbitrage. Many investment banks, hedge funds, and other professional traders exploit the transparency of indices by front-running their trades. Indeed, they research the rules of index products so they can identify what and when index managers will be buying and selling. This front-running activity pushes up (down) the prices of stocks going into (out of) the indices so that by the time the index managers go to buy and sell those securities, they are buying at higher prices and selling at lower prices. My research indicates the results of this index arbitrage activity can dampens index investor returns significantly. For broad market indices with the lowest turnover like the S&P 500 index, I estimate index arbitrage extracts at least 25 basis points (0.25%) per year by effectively picking the pockets of index investors. For other indices with higher turnover, smaller and less liquid securities, the impact can exceed 1-2% per  year.
  • Poorly designed index rules: Based on the immense growth and success of index-based investment products, index providers (i.e., those who design and create indices) have flooded the market with vast array of index products. Unfortunately, I find many of these products were designed for the purposes of marketing rather than performance. For example, the U.S. value index for one of the largest and most respected index product companies in the world invests in "stocks of large U.S. companies in market sectors that tend to grow at a slower pace than the broad market". They define value as not growth. They and others have fallen hook, line, and sinker for the marketing pitch assuming value and growth are mutually exclusive categories. I agree with Buffett's comment on this topic: "Market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. In this and other instances of poorly defined indices, we suspect the motivating factor is marketability; product vendors create the appearance of more choices so investors are more likely to find products they think will suit them better or help them diversify. Unfortunately, these more marketable index definitions and rules typically imposes costs to investors when it comes to performance.

Intelligent Passive

Piggybacking on the success and popularity of index investing, a new generation of index products has evolved under the banner of smart beta products. Beta is just market jargon for investing in the overall market. The crux of these new products is to make smart changes to the rules for selecting or weighting securities in an index. Many of these products sound eminently sensible and the marketing material contains historical charts indicating significant performance benefits. Unfortunately, many of these products are based on unsound theories and data mining. However, there are some innovations that I believe truly add value for investors. Just as with the more common index products, deep expertise is required to distinguish the substance from the snake oil.

I give my clients two options when they choose me to manage an index-based portfolio for them. The first option is to leverage my expertise to select from existing index products to find those best-suited for their goals. Given how subtle index issues can be and how few advisors are aware of them, my deep expertise is important and can provide clients with significant performance benefits.

I also give my clients the option of having me construct their own Personal Index Portfolios. That is, I design the rules for a custom index and then manage that index portfolio directly within your account. This allows me to avoid the pitfalls above and pursue superior performance via more robust metrics and index models while also achieving a higher degree of customization.

One advantage my Personalized Index Portfolios provide is the ability to integrate multiple factors to improve performance and reduce risk. While most common index products focus on individual factors, I believe the best recipe for minimizing risk and maximizing performance requires integrating at least two factors: quality and value.

As I explained in Investing 101, investment returns are derived from a combination of fundamental performance and valuation changes. My quality models attempt to minimize risk to the businesses underlying each portfolio by identifying resilient and growing fundamentals. My value models facilitate the purchase and ownership of securities only at reasonable or attractive valuations. On the risk side, the quality+value approach mitigates the risk of investing in stagnant or failing businesses while reducing the risk from adverse valuation changes. On the performance side, it allows me to target superior performance by targeting robust and growing fundamentals while increasing the potential benefits from improving valuations.

While the ability to benefit from a synergy of multiple metrics is significant, the devil is also in the detail. In particular, it is important to recognize the importance of the metrics used for these quality and valuation controls. For example, many investors utilize P/E (price-to-earnings) ratio for valuation purposes. I find this metric useful but inadequate.

The P/E ratio only compares one year's earnings to the market price; it does not indicate whether the company is sitting on a mountain of cash or slipping into a black hole of debt. The P/E ratio only reflects how much money they made over the last year. More generally, it does not account for the capital structure of the company. Some firms are said to be leveraged; they fund their assets and operations with varying degrees of debt (e.g., Autozone Inc.). Other firms use little or no debt (e.g., Monster Beverage Corp). The P/E ratio does not distinguish this difference.

I calculate a more robust metric for valuation that calculates the cost of purchasing the entire firm free and clear (i.e., purchase both the equity and debt). I then compare this figure to earnings before interest and taxes (EBIT). This allows me to make better valuation comparisons between companies with different capital structures.

I also employ a more robust quality model. I identify businesses with persistent competitive advantages and profitability. Moreover, while reported figures typically describe the performance of the core operating business(es), management can have a significant impact on the performance shareholders experience (hence Buffett's focus on management). To this end, I use my proprietary and patent-pending Fundamental Reporting model to monitor fundamental performance and ensure management ultimately creates and retains value for shareholders.

Steady Income

One natural extension of my quality and value approach is the construction of portfolios targeting steady and increasing income. Despite a seemingly insatiable demand for stable income, I find the existing market of funds and other investment products falls short in delivering on this demand. Indeed, many funds (even those whose mandate indicates dividends and income) typically generate very unstable income streams.

Our research highlights this income instability issue and explains why it exists. For example, I find the top priority for portfolio managers is the pursuit of total return - the metric by which virtually every investor, investment database, analysis, and regulator ultimately judges them. Unfortunately, focusing on total return compromises the income stream investors ultimately experience as income becomes an ancillary factor or is completely ignored when securities are purchased and sold.

Given the lack of stable income generated by existing investment products, it is no surprise many investors are susceptible to the marketing of annuities and other income-focused products. While these products are not all bad, they often work out better for the broker selling them than the investor. It is always important to work out the math and figure out what returns and fees are embedded in these products.

Please read this article or contact me to learn how I structure steady and increasing income streams while preserving and growing your wealth. This could be the most important and refreshing 15 minutes you ever spend on investing.