Selecting Passive Investments

Some of the largest hedge funds on the planet have been pouring investor funds into gold-related assets over the past year or so. The managers running these funds, including John Paulson, Eric Mindich, George Soros and David Einhorn, are among the shrewdest actors in the global marketplace.

If you are an astute investor, you might naturally consider whether you should place some portion of your portfolio in gold. Unfortunately, the hype surrounding gold is so overwhelming it is very difficult to separate fact from fiction. Nonetheless, it is worthwhile to wade into the sea of information about investing in gold to determine whether it belongs in a portfolio.

I sit on a small investment policy committee with two other advisors who also run their own firms. We get together quarterly to review our existing model portfolios, evaluate the individual asset classes currently held in these portfolios and consider new investments for inclusion in these portfolios.

We do not often make changes to the composition of our portfolios. While there are new investments entering the market daily (literally), we consider most of these to be introduced by the marketing and sales departments of large financial institutions. We’re pretty well convinced that Wall Street has the game set up to entice individual investors through glossy marketing brochures, fancy power point presentations and seductive conference calls to buy expensive products that are destined to underperform the market.

We are interested in those investment opportunities that satisfy criteria we believe are consistent with the fundamentals of low-cost, passive investment management. Many bright, highly-educated professionals are constantly researching and studying the elements that drive investment performance. So, we are certainly not alone in this process. But we do take a rather narrow approach to this process, because of our belief that markets are generally efficient and it is not possible to earn excess returns over long periods of time.

Here are 10 questions we ask about every investment we consider:

1. Does the investment represent an opportunity to invest in a new asset class? An asset class is a group of investments that share basic characteristics, perform similarly in the market and are subject to the same laws and regulations. The application of this definition can be somewhat subjective. Is frontier investing a new asset class? Yes, we think it is. Is “clean tech” a new asset class? So far, I am not convinced. We currently track some 15+ asset classes.
2. What does this investment bring to our portfolios? Does it provide income? Does it provide growth? Is it an inflation hedge?
3. How do we invest in this investment? If we cannot access the investment through a no load mutual fund or an exchange traded fund, we’re probably not interested. These vehicles provide diversification, professional management, and low cost of entry.
4. What is the return history of this investment? Naturally, we’re interested in investments that provide a healthy return for our clients.
5. How much risk must investors accept to receive the returns this investment provides? Investors accept risk in order to earn returns. We’re keenly interested in the risk-adjusted returns an investment offers.
6. What is the correlation of this investment with other investments in our model portfolios? Correlation refers to the relationship between assets. We like investments that do not act the same way. We can achieve diversification and reduce the risk of portfolio declines. Investments that are closely correlated with each other are less attractive, because they all tend to move in the same direction. When the stock market crashed in 2009-2009, we saw that most asset classes went down in tandem.
7. What does it cost to invest in this investment? What are the trading costs (commissions bid-ask spreads)? What are the internal costs inside the vehicle? We like investments that have very low trading costs. We prefer investments that have internal costs that are less than 0.25%.
8. How liquid is this investment? If we are to use a fund to invest in this investment, are there a large number of shares actively traded at all times? If we need to sell, can we get out quickly?
9. What are the tax characteristics of this investment? Does it generate income (i.e. dividends) that receives favorable tax treatment? Does the asset instead grow over time and avoid taxation until it is sold? Would we put this investment in a taxable portfolio or in a tax-qualified portfolio?
10. Finally, can we invest in this investment in a passive manner? Is there an index that tracks this investment? Are there passively managed funds that offer access to this investment? If only active funds invest in this idea, we’ll pass.