We favor low-cost, tax-efficient, diversified, liquid, and simple investments. Many investors often run into trouble when they invest in things that do not have these five characteristics. Investments with these five characteristics have been profitable over time but typically are not very exciting. There is generally no “hot story that you need to act on now!” associated with them.
The financial services industry generally does not favor these investments because they generate very little profit from them. We are in the business of helping to maximize the wealth of our clients, not the financial services industry. Keep in mind that this list of investment characteristics is not comprehensive. Other factors to look for in investments might include attractive valuation, low correlation to your other holdings, a nice dividend yield or interest income, a tilt towards market areas that have produced higher returns, such as value stocks, an appropriate risk level, etc.
Low Cost. We typically invest in low-cost index-based funds and exchange-traded funds (ETFs). The funds we invest in have an average expense ratio of only—30% per year. The typical actively traded equity mutual fund has an average expense ratio of 1% or more. With investment funds, the best predictor of future relative performance is the fund’s expense ratio; the lower, the better.
Hedge funds typically have annual expense ratios of 2% plus 20% of any profits earned. Some variable annuities and permanent life insurance “investments” can have 2% or more annual expenses. By closely monitoring our investments’ costs, we can save our clients significant amounts of money each year and help them achieve higher returns over time (all else being equal). With investment products, you don’t get better performance with a higher cost product; you typically get worse performance Team Kgs.
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Tax Efficient. Our investments (index-based funds and ETFs) are extremely tax-efficient, allowing the investor to have some control over the timing of the taxes. These funds have low turnover (trading activity), a common characteristic of tax-efficient investments. We recommend avoiding mutual funds with high turnover due to their tax inefficiency. After the recent big increase in the U.S. stock market, many active equity mutual funds have “embedded” capital gains of as much as 30%-45%.
If you buy those mutual funds now, you may pay capital gains taxes on those embedded gains even if you didn’t own the fund during the increase. ETFs typically do not generate long and short-term capital gain distributions at yearend and do not have embedded capital gains like active mutual funds. Hedge funds generally are taxed inefficiently due to their very high turnover. In addition to investing in tax-efficient products, we also do many other things to help keep our client taxes minimized, such as tax-loss harvesting, keeping our turnover/trading low, putting the right type of investments in the right kind of accounts (tax location), using losses to offset capital gains, using holdings with large capital gains for gifting, investing in tax-free municipal bonds, etc.
Diversified. We like to invest in diversified funds because they reduce your stock-specific risk and your portfolio’s overall risk. Bad news released about one stock may cause it to drop 50%, which is horrible news if that stock is 20% of your whole portfolio but will be barely noticed in a fund of 1,000 stock positions. We tend to favor funds that typically have at least a hundred holdings and often several hundred holdings or more. These diversified funds give you a broad representation of the asset class you are trying to get exposure to while eliminating the stock-specific risk. We will not likely invest in the newest Solar Energy Company Equity Fund with ten stock positions. We don’t believe in taking any chances (such as stock-specific risk) that you will not get paid for a higher expected return.
Liquid. We like investments you can sell in one minute or one day if you decide to do so and those you can sell at or very close to the prevailing market price. With liquid investments, you always (daily) know your investments’ exact cost and value. All of the investment funds we recommend meet this standard. We don’t like investments that you are locked into for years without the ability to get your money back at all or without paying large exit fees. Examples of illiquid assets include hedge funds, private equity funds, annuities, private company stock, tiny publicly traded stocks, startup company stock or debt, illiquid obscure bonds, structured products, some life insurance “investments,” personal real estate partnerships, etc. We prefer investment funds that have been around for some time, are large, and have high average daily trading volumes.
Simple. We prefer investments that are simple, transparent, and easy to understand. If you don’t understand it, don’t invest in it. Our assets are simple and transparent; we know exactly what we own. Complicated investment products are designed in the seller’s favor, not the buyer’s, and usually have high hidden fees. Examples of complex and non-transparent investments we generally avoid are hedge funds, private equity funds, structured products, life insurance “investment” products, variable annuities, private company stock, startup company stock or loans, etc. “Make everything as simple as possible, but not simpler.” -Albert Einstein.