It is our opinion that working with a Registered Investment Advisor who has a clearly defined investment philosophy, based on sound academic research, provides the best opportunity to fulfill the trustees’ and participants’ goals of consistency, clarity and financial peace of mind.
The typical Wall Street approach essentially amounts to what has been described as a “black box”. This leaves the investors in the dark as to just how their money is being managed and invested. It also allows the firm to avoid the discipline and the accountability that result from a clear and open investment policy. Premier Financial Group goes to great lengths to assure that our clients fully understand the investment policies that we follow.
Starting in the early 1990’s Premier began re-evaluating its entire investment approach, carefully looking at the fundamentals of Modern Portfolio Theory, seminal work out of the University of Chicago, that ultimately resulted in a Nobel Prize in Economics. The basics of Modern Portfolio Theory can be summed up as follows:
Markets Are Efficient — Markets work and, for investment purposes, assets are fairly priced.
Risk and Return Are Related — Priced risk factors determine expected return – the greater the return expectation, the higher the risk; lowering risk will lower expected relations.
Diversification is Key — Diversification is the antidote to uncertainty. Concentrated investments add risk with no additional expected return.
Structure Explains Performance — Asset allocation primarily determines results in a broadly diversified portfolio. The type of asset class funds and the percentage allocated to each one will have a major impact on risk and return
Based on that evaluation, and our ongoing analyses, Premier exclusively uses and recommends the use of passively managed structured asset class portfolios. We rely heavily on the research produced by Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College, two leading financial economists. Their analysis of the sources of investment returns has reshaped portfolio theory and greatly improved the understanding of the factors that drive equity performance. They have determined that there are three factors that influence returns, which include:
Equity Market — (complete value-weighted capitalization) Stocks have higher expected returns than fixed income.
Company Size — (measured by market capitalization) Small company stocks have higher expected returns than large company stocks.
Value — (measured by ratio of company book value to market equity) Value stocks have higher expected returned that growth stocks.
The notion that equities behave differently from fixed income is widely accepted. Within equities, Fama and French find that differences in stock returns are best explained by company size and value characteristics. Taken together, the three factors on average explain more than 90% of the performance of diversified stock portfolios.
Research indicates that financially distressed “value” companies have higher costs of capital than financially healthy companies because they carry more economic risk. When they borrow from a bank, they pay higher interest rates; when they issue stock, they receive lower prices. A firm’s cost of capital is the investor’s expected return. Because they are riskier, small distressed companies have higher expected returns than large healthy companies. Long-term increases in expected return can only be achieved by accepting greater size and/or value risk.
The three-factor model has become the modern research standard. Size and value characteristics, along with broad stock market exposure, provide the richest explanation of equity returns.
In fixed income, low-grade obligations have higher expected returns than high-grade obligations and long-term bonds have higher expected returns than short-term bonds. However, historical rates of return indicate that these premiums are not large enough to reward the additional risk.
The primary roles of fixed income are diversification and to dampen portfolio volatility. By keeping maturities short and credit quality high, portfolio risk from fixed income is minimized so investors can focus on the much higher returns of stock factors.
Premier is in continual communication with the industry’s most respected financial economists. This is where the feedback loop begins. Financial economists lead the way in understanding risk and return in securities. In working with these economists, Premier is able to bring this leading edge research to our clients.
The next section on Premier’s investment strategy is really “where the rubber meets the road” and we put into effect investment portfolios aligned with our investment philosophy.
Next Chapter: Investment Strategy
