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Does Your Advisor's Investment Philosophy Point True North?

Dimensional Fund Advisors co-founder David Booth famously said, “just like a personal philosophy can act as a moral compass, an investment philosophy guides your decisions on how to invest.” Having spent over 25 years in the investment business I would add this caveat – does your investment philosophy remain consistent or does it come and go with the latest fads? I was reminded of this recently while perusing another wealth management firm’s web site.

The firm in question outlines their investment approach as “evidence-based” – an investment strategy which we endorse. Evidence-based investing (EBI) is rooted in the fundamental belief that markets work, prices are fair, and that efforts to outguess the market are neither persistent nor consistent. The last two decades have witnessed vast independent academic research that makes a compelling case for the wisdom of EBI – which we use with our clients through funds from Dimensional Fund Advisors and Vanguard.

It wasn’t the other firm’s eloquent case for EBI that caught my attention however. It was the fact that in the very next paragraph the firm touts an investment strategy 180 degrees different from EBI,  “... we also offer alternative investments, which provide low correlations with traditional asset returns and add diversification benefits such as higher potential returns and lower volatility.”

To the average person this all sounds very appealing, even “sophisticated.” The investment strategies that fall within the accepted definition of “alternative investments” includes a wide variety of things, including hedge fund strategies like long /short funds, distressed debt, arbitrage and event-driven. However, just as there is overwhelming academic research supporting evidence-based investing, the academic research supporting alternative investments is flimsy at best. And not only is there little or no academic evidence supporting such strategies, these investments typically cost 4-5 times more than an EBI portfolio. 

But don’t take my admittedly biased word for it, look instead at what some of the leading investment minds in the world have to say about alternative investments. When asked about the wisdom of investing in hedge funds, Nobel laurate Eugene Fama (whose academic work on security pricing serves as the foundation for Dimensional Fund Advisors) said, “I can’t figure out why anyone invests in active management, so asking me about hedge funds is just an extreme version of the same question…so you can forget about hedge funds.” Warren Buffett, perhaps the world’s most renowned investor, has been exceptionally blunt calling investing in alternatives “a fool’s game.” 

Perhaps drawing parallels with physical health will bring perspective to fiscal health. Espousing an evidence-based investment approach in one breath while proffering alternative investments in the next is akin to a doctor prescribing a patient a healthy diet and exercise while offering them a cigarette. Such an unwieldy juxtaposition makes one question if this wealth management firm’s compass is pointing south, not north.