We often discuss with clients how to create a proper retirement income strategy. Given so many retirement assumptions are different in today's environment, its probably a good idea that many investors revisit their approach, especially since we have found that the key to creating sustainable lifetime income is mostly attributed to smart financial planning and investor behavior. However, one topic that often gets lost in the noise is the impact one's investment strategy has on their future.


I said I would not engage in the debate nor write about it anymore, but given how much discussion has taken place recently (along with so many questions we've received on this topic), I felt it was necessary to take a few minutes to revisit and further educate investors. As most of you know, I have spent over half of my career educating both individual and institutional investors on active vs. passive investing. Lately, most of our discussion has related to which strategy will be best for financial and retirement planning purposes. But today, we discuss a little investing 101.

Market pundits have spent a great deal of time the past three decades endlessly debating the merits of “active” vs. “passive” investing. At its core, the argument can be distilled down to this:

Is it better for investors to employ elaborate strategies to try and outperform market benchmarks? Or is it better to abandon such costly strategies and simply track the market benchmarks using low-cost, index-type investments?

On this score, the passive investment approach has been shown time and again to be the hands-down winner against active strategies. In fact, the poor performance of active strategies is almost hard to believe – yet it’s true. This graph from the Wall Street Journal sums it up:

The bottom line, clearly, is that the active vs. passive debate isn’t much of a debate. Based on historical performance, if you go the active route you have a greater than 85% chance of underperforming the market when you pay up for a fund whose job it is, ironically, to outperform the market. There is a simple, logical explanation for this disconnect: Active management strategies can’t overcome their high costs (i.e., fund manager fees, trading costs, taxes, etc.). In a market that has become highly efficient in recent decades, active managers simply can’t deliver enough excess return over their cost of operation to justify their existence.

So, when given the binary choice of using active funds that have an extraordinarily high likelihood of underperforming their market benchmark or passive funds that are assured of tracking their market benchmark less their comparatively low fees, the logical choice is to use passive funds.

The problem with pure passive funds (like index funds), though, is that there is little or no management of the securities in the portfolio. Stocks are automatically bought when they are included in the specific benchmark the fund tracks, and sold when they are no longer included in that benchmark – regardless of whether it is an opportune time to buy or sell those stocks. Nor is any thought given to how those funds might work in the context of a larger portfolio strategy; the index fund simply tracks the index because it exists, whether it is a desirable asset class or not.

As it turns out, it isn’t a binary choice between active and passive. In our opinion, there is a third, better way to invest – and it’s one we’ve employed at CAM Investor Solutions through Evidence Based Investing. In short, this philosophy brings rigorous academic science and research to the investment process which can provide investors with a higher probability of having a successful investment experience.

Our evidence based investment philosophy has identified strategies which offer this to our clients. Some of our primary investment strategies, that are rooted in academia, are through the funds of Dimensional Fund Advisors (DFA). DFA was founded by some of the most accomplished thinkers in the field of efficient market research, including Nobel Prize winner Gene Fama and Dartmouth professor Kenneth French. DFA uses the term “evidence based investing” to describe their approach, and while that may sound a bit jingo-ish, the proof of its success is in the numbers.

Over the past 15 years, only 14% of actively managed funds (across all categories) and 1% of passively managed funds have outperformed their benchmarks. (We would expect this of passive funds as they are designed to track their index less their management fees.)

In contrast, 73% of DFA funds have outperformed their benchmark over the past 15 years.

Suffice it to say that is a remarkable track record, especially when compared to the futile efforts of actively managed funds to beat the market.

How does DFA (and other evidence based investment managers) accomplish this? By incorporating many of the best aspects of passively managed funds – low management fees, low turnover, style purity – with their own uniquely academic approach to portfolio construction and management. In their own words:

Rather than relying on futile forecasting or trying to outguess others, we draw information about expected returns from the market itself—letting the collective knowledge of its millions of buyers and sellers set security prices.

Letting markets do what they do best—drive information into prices—frees us to spend time where we believe we have an advantage, namely in how we interpret the research, how we design and manage portfolios, and how we service our clients. It means we take a less subjective, more systematic approach to investing—an approach we can implement consistently and investors can understand and stick with, even in challenging market environments.

DFA avoids subjective forecasting about where the market is headed and which stocks may or may not be in favor in the future – strategies that continually cause active funds to underperform. Instead, DFA focuses on identifying desirable risk and return characteristics that are specific to certain asset classes (such as small value stocks), and then creating funds to capture those risk and return characteristics as efficiently and inexpensively as possible. This type of approach is consistent across our entire philosophy.

That’s why we utilize investment managers (like DFA) who believe in an evidence based investment philosophy. As wealth advisors, it is vital that we use investment vehicles that provide accurate exposure to the most efficient asset classes at the lowest cost. With our philosophy, that’s what we get.

As fee-only advisors, we receive no compensation from DFA, or any other investment vehicle we use in our portfolio strategies. If another alternative comes along that allows us to give our clients better asset class exposure at a lower cost than our current fund strategies, we will use it. For the past two decades, however, this evidence based approach has consistently, and uniquely, shown us that given its commitment to low cost, diversification and tax efficiency, this approach is the best investment option to help our clients meet their retirement income needs.

We appreciate our relationship with you and we are here to help.


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Source:  Dimensional Fund Advisors' Mutual Fund Landscape Report; Wall Street Journal; Bloomberg. M & A Consulting Group, LLC, doing business as CAM Investor Solutions is an SEC registered investment adviser. We provide financial planning and investment information that we believe to be useful and accurate. However, there cannot be any guarantees. There are many different interpretations of investment statistics and many different ideas about how to best use them. Nothing in this presentation should be interpreted to state or imply that past results are an indication of future performance. Tax planning and investment illustrations are provided for educational purposes and should not be considered tax advice or recommendations. Investors should seek additional advice from their financial advisor or tax professional.

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