In reviewing and creating investment portfolios, InvestSense uses the acronym PACE as a fundamental guideline. PACE stands for proactive portfolio management, absolute returns, correlation of returns and expense control. By focusing on these four areas, we not only provide useful information for both individual and institutional clients, but we also address the major fiduciary requirements set out in ERISA.
The Chinese philosopher Lao Tzu once noted that the best way to control anything is to take advantage of its nature. The market is dynamic and cyclical. Therefore, an effective portfolio management system should also by dynamic to take advantage of the cyclical nature of the market.
Buy-and-hold ignores the nature of the market and exposes investors to unnecessary risk of financial losses. Market timing, trying to catch every move of the market, is equally impractical. However, monitoring the market and using defensive strategies to avoid unnecessary losses is sound investment management, not market timing. Studies have consistently shown that avoiding losses has a significantly greater impact on an investment portfolio than missing a potential gain.
Financial service companies often tout that they are number one over a certain period of time or have led in a particular investment category. The problem with such ads is that they can paint a misleading picture. A fund or adviser with poor performance, even negative returns, can still make such representations as long as they outperformed their peers.
Investors should focus on the ability of an investment or an adviser to achieve consistent, positive returns. Consistent, positive returns allow an investor to reap the benefits of compound returns, which allows their portfolio to grow even faster.
Correlation of returns among potential investments is an important factor in creating and managing an investment portfolio. One of the biggest problems in the investment industry today is what I refer to as “pseudo” diversification. Pseudo diversification involves evaluating diversification based on the quantity and different types of investments in a portfolio.
The problem with evaluating diversification on quantity and types of investments is that is that it does not factor in the extent to which the investments react similarly in different market conditions. A portfolio consisting primarily of highly correlated investments simply does not provide an investor with the benefit of downside protection during downturns in the market. Expense control is an an area often overlooked by investors. One study estimated that over a twenty year period, an investor’s overall return is reduced by 16% for each 1% increment of expenses. Other posts and white papers on our blog have discussed a measure known as the “active expense ratio,” a measurement that calculates the effective cost of actively managed funds against a similar index fund. Generally speaking, the effective cost of active management results in an effective overall management fees signficantly higher that the fund’s publicly stated fee, often three to four times higher.
While we use PACE in constructing and advising portfolios for individuals, PACE is also appropriate for institutional investors. The four components of PACE address a fiduciary’s duty of prudence under ERISA.
The acronym PACE was also chosen based on the fact that it distinguishes the difference between true investing and speculation. As Ben Graham, recognized by many as the greatest investors of all time, once noted, the true secret to successful investment management is the management of investment risk, not investment returns. The four components of PACE allow an investor the best of both worlds by focusing on risk management, while at the same time creating a portfolio that provides both upside potential and downside risk protection.