An Investment Philosophy is the overall set of principles or strategies that guide an investment manager. No one, true investment philosophy exists, and investors should select managers with different investment philosophies where possible. Some managers are bottom-up, stock pickers and consider fundamental analysis as the most important aspect of investing. Other managers believe that all of the information relevant to stock returns is contained in the price and other trade-related data. These types of managers follow technical analysis. Other investment managers follow a certain style of investing; being value or growth oriented or a contrarian investor.
Scientfic Advisors, LLC believes that the world’s economy is the best, long-term investment; offering the highest probabilty of growth. We also believe that a systematic, quantitative, data driven investment management process adds the most value to an investor’s portfolio. Below is an outline and some highlights of how we use this investment philosophy in selecting, trading and managing your assets.
Investment Objective
Investment Managers offer many different products, not all of which may be suitable for a given investor’s needs. For example, hedge fund investments and private placements are suitable for qualified or high net worth investors only. Mutual Funds and indexed ETFs are suitable for investors seeking retirement savings.
In addition, individual investors have different objectives for various investments; an IRA and 401K plan for retirement savings, an individual brokerage account from an inheritance, a college savings plan, a family trust. Each of these pools of assets may have different investment objectives that depend on the investor’s time horizon, risk tolerance, long term plans and the investor’s total financial picture including annual income, ongoing expenses and net worth.
Investment Managers sometimes offer a product that is designed to meet the investment objectives of a large group of investors; a Growth portfolio, a Balanced Fund, a Target Date Retirement Fund, an Income fund. An investor determines their own investment objective, whether through a trusted advisor like a financial planner or by using software tools that identify an individual’s risk tolerance. The investor then seeks out the most suitable and best product offered that matches their investment objective.
Scientific Advisors offers clearly defined portfolios covering Income, Conservative, Growth and Aggressive investment objectives that are comparable to a balanced fund or a target date retirement fund.
Scientific Advisors offers separately managed accounts that tailor an investor’s investment objective by asking a series of questions in our account application.
Universe of Securities
An investment manager needs to select a diverse group of investments from an appropriate universe of investments. Asset selection starts with a universe of securities from which to build a portfolio.
For example, a US Small Cap Growth manager would pick individual stocks from a group of stocks identified as US small cap growth stocks using, for example, the Russell 2000 Growth index as the universe of appropriate investments. You would not, generally, expect to find Microsoft (MSFT) or Sony (6758.JP) in a US Small Cap Growth portfolio. In this case, we say the universe of US Small Cap Growth stocks is the Russell 2000 Growth Index or that the Russell 200 Growth Index is their benchmark. Active investment managers look at the largest universe of investments that meets the investment objective and construct portfolios based on their opinions for each investment. Index managers buy all of the investments at their benchmark weight.
Our Dynamic Asset Allocation product uses a universe of investments that covers the entire world; US, International Developed and Emerging, all traditional asset classes; Equities (stocks), Fixed Income (bonds), Commodities, Real Estate and Alternatives. Each of our 20-30 investments are indexed funds or active managers with a universe of investments that numbers over 10,000.
When you invest in our Dynamic Asset Allocation product, you are getting exposure to more than 10,000 different investments, far more than many active managers offer in a single investment portfolio.
Once the universe of securities are selected, the manager then needs to determine how much of each security to purchase, how long to hold that investment, when the investment should be sold and what other investments should take its place.
Portfolio Construction
One way to construct a portfolio is to assign a weight to each available security in the universe of possible investments. Each weighting creates the potential for some reward and some risk. The simpliest weighting scheme is to equal weight each investment. Another way to construct a portfolio is to consider the benchmark using an index weighted by the market capitalization of the index constituents. Active manager’s weight their portfolios by the opinions they hold for each security as compared to a benchmark or index weight. Some equity hedge funds weight some securities negatively, or in other words they short the security and hold a negative weight, expecting the sold security to continue to decline in value.
Each weighting scheme has advantages and disadvantages. Equal weighting a portfolio means that, for example, Microsoft (MSFT) is given the same weight in your portfolio as the smallest company in your universe. This creates a small cap bias, a higher weighting to small cap stocks than what would be expected from the companies relative contribution to GDP. A small cap bias can be a good thing, when small cap stocks outperform. A small cap bias can be a bad thing, when small cap stocks underperform. In either case, a small cap bias will result in higher volatility for a portfolio.
Scientific Advisors constructs Dynamic Asset Allocation portfolios by using a multi-tiered weighting. A core weight for each major asset class exposure is determined. For example, a growth investor may have 60% equities and 40% bonds. The core weight is tilted towards stocks, bonds or into cash depending on the over-all market conditions.
Then each of our 70 distinct asset groupings are weighted according to our opinion on each one. The portfolio is constructed by tilting away from the core weight towards asset groups that are expected to outperform over the next 1-2 years.
Setting your investment objective, selecting appropriate assets and constructing the optimal portfolio is three quarters of our investment management process. Now it is time to implement the portfolio.
Trading
The most important implementation task is trading the portfolio. Since returns compound over time, the initial investment should be done with care and understanding about how much a trade should cost. As well, the number of trades, the frequency with which investments are added and liquidated from the portfolio and the ease with which trades can be made are all factors that must be taken into consideration when implementing an investment portfolio.
Trade costs are a drag on performance. Typically, the commission charged by a broker for a trade is just one, but the most visible, trade cost. In addition to commission costs, trading results in what are termed slippage costs, how much does the price change when I trade. When you decide to trade also incurs opportunity costs, should I trade today or tomorrow, will the price be higher or lower if I wait.
Commissions
Commission costs generally are $8-$12 per trade for ETFs and equities at many online brokers. If you construct a portfolio of 20 investments, buying these investments could result in about $200 of commission costs. On an initial investment of $20,000, this is 1% of the value of the portfolio. For an initial investment of $4,000, commission costs alone can be 5%. Mutual Fund investments can cost $5-$75 per buy or sell transaction resulting in even higher direct costs. Individual bonds can be even more expensive, with Municipal bonds charged a 1% markup by the dealer and another 1% markup by the broker; costing the individual investor 2%. Some high yield and illiquid, long-maturity dated bonds can be even more expensive to trade.
Bid-Ask Spread
When an investor or broker trades a stock or bond the micro-structure of the market determines the slippage cost. Slippage costs are modeled on three or more components; the market impact, the bid-ask spread and the opportunity costs. The bid-ask spread is the cost of having market markers available for orderly markets. Generally, markets in investments consist of buyers and sellers, with buyers bidding to buy investments and sellers asking a price to sell their holdings. Robust markets in securities have active buyers and sellers with a spread between the bid (price at which buyers will purchase) and the ask (the price at which sellers will sell). When these prices are the same, a trade is executed and the buyer and seller clear the marketplace, making room for the next buyer and seller.
Slippage
Typically, the bid/ask spread in individual US large cap stocks is 0.05% or 5 basis points. However, spreads ten times as large or even 1% are not uncommon when buying or selling Exchange Traded Funds, especially during volatile market conditions. In addition, the spreads change in a dynamic and non-linear way depending on the size of the trade.
For example, trading 100 shares of IBM common stock results in very little slippage and usually IBM trades at a spread of one penny. At $100 per share, this is a 1 basis point spread. However, a million share order to buy or sell IBM common stock would require many sellers (or buyers) to enter into the market and the price would move significantly until all buyers or sellers, at that moment, where satisfied and the entire one million shares were placed.
Institutional Trading
Institutional managers generally pay much smaller commissions that are based on a per share traded basis, generally .5 cents per share. So on a trade of 100 shares, an institution pays fifty cents in direct commission charges. By paying a per share commission, an institutional money manager can reduce their slippage costs and minimize their timing or opportunity costs by trading throughout the day. A 10,000 share order may move the price of a stock by a large fraction, whereas ten 1000 share orders may move the price less. A fixed, per trade commission works against the individual investor.