Our selection of commingled fund products are U.S-listed open-end mutual funds (includes both active and passive funds), ETFs, and CEFs.
In selecting the funds with the most promising prospects for each asset class, we initially conduct a thorough screening of the investment universe, taking into account dozens of numerical measures of fund performance. Our analytical skills and quantitative tools allow us to dig deeper into the meaning of various measures, uncover hidden trends in performance data, statistics that may have predictive value for future performance. Still, fund selection combines elements of art and science. Thus, generally once a fund satisfies a ‘2nd quintile’ threshold on the most relevant quantitative factors, we turn to the more important analysis of qualitative factors to complete our process. We employ a skeptical eye and are very selective, choosing only the funds we have the highest confidence will outperform going forward.
Active vs. Passive.
Active vs. Passive. We are specific when it comes to choosing investment vehicles, whether they be mutual funds, index funds, ETF’s, or derivatives. We simply choose the investment strategy we believe has the highest likelihood to outperform its peers, factoring in risk and other externalities (taxes, liquidity). As markets become more efficient over time, cheap passive products become more favorable. In the highly efficient U.S. large cap equity space, for example, an overwhelming majority of active funds underperform their benchmark.
Moreover, research shows while poor-performing managers tend to continue to underperform, short-term top managers’ subsequent performance is essentially random. Superior future performance is largely unpredictable. Our experience has shown that to be generally true. Yet, superior fund managers do exist. They are a rare minority who we seek to identify.
[[The arguments for passive management (index funds, ETF’s) are typically predicated on the theory that while a small subset of active managers can outperform the passive alternative, identifying these managers ex-ante is a very difficult, if not impossible, task. Indeed, noted financial experts such as John Bogle and David Swensen essentially deem it an exercise in futility. Proponents of passive management further proffer the statistical argument that given a large sample, a small random number of active managers would always be expected to outperform (the bell curve effect). In addition, Nobel laureate William Sharpe observed that since all the participants in a market comprise the market, after fees (not to mention taxes), the median must underperform the mean. Hence, a passive investment that mimics the market, which can be achieved with minimal costs, is the best strategy.
We agree with expert opinion and the mounting financial literature against active management for the average investor. How can a typical investor, with a full-time job and family obligations, be expected to have the skills, tools, information, time, or interest to compete against full-time investment professionals? Yet, even professional investors often fail to outperform a passive benchmark. Therefore, in our judgment, If an investment advisor is unable to identify the top 5% (perhaps as little as 2% in more efficient asset classes) of the top managers in a given asset class, the prudent approach is the indexing approach. Our experience, computerized tools and information sources, dedication to studying investments and conducting research, and structured process, allows Valedictory the edge to outperform. In short, we love the markets- that’s all we do. We read a lot– from everywhere, and crunch a lot of numbers. We’re also pretty savvy. That’s how we’re good.
While more efficient asset classes lend themselves more to a passive management approach– we will select the best passive vehicles in those asset classes– in general we select active managers for the majority of our asset classes. Most passive funds have flaws that good active managers can beat. The funds we place on our Fund List have demonstrated a time-tested ability to outperform its peers and passive investment alternatives, and have the characteristics we believe will sustain that outperformance. Inevitably some of our funds will perform as we expect, some will not. By choosing the best funds, those we believe will achieve first-quintile performance in the medium term (3 – 5 years), we believe that most will significantly outperform their peers, some will moderately outperform, and a few may moderately underperform. If we can achieve this level of success and constantly maintain a fresh list of top managers, which we feel is reasonable and have a high degree of confidence in, the overall performance of the portfolio should be quite satisfactory.]]
Past performance does not guarantee future results. Simply looking at past returns is ineffective and often counter-effective. Investments move in cycles. At a broad level, markets segments (sectors, industries, regions) do not continue to outperform over the long-term. Research shows that over the medium-term (2 to 5 years), investments exhibit reversionary trends. At Valedictory, while we look for superior past performance, we focus on understanding how the performance was achieved. We look for sustainable investment fundamentals and advantages: time-tested strategies, proven portfolio managers, low costs, shareholder-oriented managements, and performance behavior that we can understand.
Structured and Disciplined Process. Our fund selection process begins with a quantitatively-oriented screening of the investment universe for a given asset class. We include all readily available pooled investment vehicles: both open-end and closed-end mutual funds (including index funds), and ETF’s. The screening typically whittles the list to 10-25% of the original, which we then conduct our intensive qualitatively-oriented research. The qualitative research typically yields 5-15 of our favorite funds from the original universe. Selecting funds is both art and science. Our experience of managing money through a bear market and running consistent top-quartile asset allocation funds, combined with thorough qualitative assessments and rigorous quantitative appraisals of each fund, gives us confidence that the funds we ultimately select have the attributes that should lead them to outperform.
Generally, for active products, we favor relatively low expenses, usually below average in its category, from a highly-regarded, investor-focused active asset management firm, with an experienced, long-tenured manager with a time-tested strategy and ideally high manager co-investment. Most of these products are Morningstar 4- or 5-star rated or ‘Medalist’ funds.
For passive index-based products, we favor a very low expense ratio, typically the lowest in its category, from a premier passive parent sponsor, such as Vanguard or Blackrock (iShares). We also favor index strategies with plain market capitalization (cheapest) or well-established factor exposures (e.g. value, momentum).
Our comprehensive investment product (or manager) selection process is a combination of quantitative and qualitative analyses based on our framework of the “6P’s”:
- People: the portfolio management and organization personnel
- Portfolio Manager: what is the background of the key investment personnel? How stable, experienced, and sensible are they?
- Passion/ Purpose: how well is the portfolio personnel incentivized, personally and financially? How dedicated are they to integrity and excellence? How open and detailed is their communication?
- Partnering: how much are the portfolio managers and executives invested personally in their own product? How investor-focused is the firm?
- Parent: how reputable and reliable is this organization? How well-governed and financially stable is the firm? How investor-centric?
- Process: the proprietary investment strategy in building the portfolio
- Philosophy & Principles: what and how sound are the beliefs and values underlying the investment approach? What is the competitive advantage versus peers (e.g. edge)?
- Perspective: what guides the portfolio managers’ thinking and investment style and action-taking? How thoughtful and sound is it, and how much is it aligned with our our thinking?
- Policies/ Procedures: how well defined, robust, and consistently implemented is the strategy? How are investment decisions made? How is the portfolio built, from research to trading?
- Portfolio: the way the portfolio is structured and the securities held
- Number of holdings; sector/ geographical/ capitalization concentrations
- Levels and types of risk taken, instruments used, security characteristics (e.g. P/E, credit quality), leverage utilized, appropriate benchmark; changes through time
- Price: fees and other frictional costs
- Expense ratio, management fees, access fees
- Turnover, trading costs, tax efficiency
- Product:how is the strategy packaged as an investment vehicle?
- Share classes, investment minimums, and brokerage availability
- Strategy’s capacity and how committed is the firm to manage asset bloat?
- OEF, CEF, ETF, limited partnership
- Performance: the historical return and risk profile, and prospect of that continuing
- Long-term returns and risk relative to peers, on a trailing and rolling basis, and performance consistency to expectations
- Correlation with other asset classes/ strategies; attribution
With almost 7,000 unique funds available in the public funds universe (nearly 23,000 individual share classes), combing through the vast list of funds and mountainous fund data is a laborious task.The amount of information we gather and review may appear overwhelming. Yet, research has shown that larger amounts of information do not necessarily lead to better decisions. Too much information can actually cloud the decision-making process. We recognize that. The key is to know what to look for; the right questions to ask, to be able to decipher often subtle clues. Our experience, gained through many years of fund selection, allows us to be good at holistically assessing the strengths and weaknesses of funds.