Index investing is inexpensive as a method of investing and using ETFs can be extremely tax efficient depending on the method of portfolio management. However, let’s take a step back and acknowledge what indices are: man-made lists of investments chosen to be representative of something. “Something” could be many things. In the most general way, it could be representative of a country’s economy, like the S&P 500. More specific could be a sector or industry of the economy like technology (sector) or semiconductors (industry). Some indices have criteria that must be met to be considered for addition to the index. S&P 500 requires at least four quarters of positive earnings and in theory only allow 500 constituents (it’s a few more, actually). Removal is more like college in that you must be a dumpster fire for removal, and they have to have a replacement lined up. As one can see, an index is managed somewhat because there is some thought going into what they add and the removal is usually pretty apparent why. One might ask, is there a smarter way to index? Just because an index is regarded as a benchmark, does not mean it is the best solution for you, your needs, your goals.
A whole group of ETF’s are in the category of “smarter way”. Low volatility, Smart Beta, Cash Cows, Dividend Growers, Businesses with Moats, High Yielding Dividends, Equal weight…companies that end in a “y”. There is no shortage of ways to “skin the cat”. And some offer a better way than a general index. Some are riskier. Some are too specific. Also, because it is not the general index there are times it will do better and times it will do worse when comparing it to an index (AKA, benchmarking). In the end, that is ok as long as it helps you achieve your goals, which are the ultimate benchmarks.
The actual topic, custom indexing and custom portfolio construction, is the actual focus of this post. Imagine buying an ETF being like buying a bag of apples or onions or potatoes. If you have ever shopped for these produce, you likely have a process for looking over the bag to make sure you aren’t buying bad produce. Even with Strawberries, blueberries and raspberries in those clamshells, you likely give it a good look over before placing it in your cart. Regardless of the effort, when one gets home and starts using the produce, there are always some stinkers in the bag or box. That is what general indexes are like- a bag of potatoes. Surely there is a better approach. The way to assure the quality of each piece of produce you buy is to pick each yourself. Whether at a farmer’s market, a U-Pick, or some other place (your own garden), the general opinion is you’ve gotten something better, higher quality, and better cost for yield.
The same is true in stock selection. If one is looking for certain qualities, I can create a way to find that group of stocks. But is it good? Once qualities have been used to find a group of stocks, we can look at past performance (no guarantee of future results), see what the make-up is (sector exposure, etc), and what other risk metrics look like. We can also do a Monte Carlo simulation of how it could grow in the future based on the traits it has now. (Again, no guarantee of future results, but probabilities of outcomes based on 10,000-20,000 tests). From there, we can start to make decisions as to whether this is a good grouping of stocks or not.
An example of search results from research software used to perform Boolean logic searches of the database.
What are some of the benefits of this approach? It can remove emotion bias. It is a process that is repeatable. It can find investments that were never on our radar. It can reduce risk by NOT being like the general indices everyone else is chasing. And, ideally, it can help steer clear of the rotten apple, the potato with eyes, the rotting onion, and the unripe or mashed strawberry. What it does not steer you clear of is systemic risk. Systemic risk is like the whole field of potatoes being attacked by some insect infestation or a major frost destroying most the blooms in the apple orchard. It is important to know there are risks that can be controlled for, risks that can be minimized, and risks there is no hiding from if you remain in the asset class. This is where working with an advisor can be useful and provide proper guidance for the situation.
RASP Wealth Solutions builds every stock portfolio using the process described above. We can then mix stock portfolios of different traits to create a stock allocation providing diversity and a goal of aiming at Size (Large, Med, Small) and Style (Growth, Value). If the Models we have designed and built are not suited to you, we can work with you to craft a custom approach to meet you goals and needs.
RASP Wealth Solutions, LLC is an SEC registered investment adviser. SEC registration does not constitute an endorsement of RASP Wealth Solutions, LLC by the SEC nor does it indicate that RASP Wealth Solutions, LLC has attained a particular level of skill or ability. This material prepared by RASP Wealth Solutions, LLC is for informational purposes only and is accurate as of the date it was prepared. It is not intended to serve as a substitute for personalized investment advice or as a recommendation or solicitation of any particular security, strategy or investment product. Economies and markets fluctuate. Actual economic or market events may turn out differently than anticipated. No investor should assume that future performance will be profitable, or equal either the previous reflected performance or that of the referenced benchmarks. The historical performance results of the comparative benchmarks do not reflect the deduction of transaction and custodial charges, or the deduction of an investment management fee, the incurrence of which would decrease indicated historical performance. The S&P 500 index includes 500 leading companies in the US and is widely regarded as the best single gauge of large-cap US equities. The holdings and performance of RASP Wealth Solutions, LLC’s client accounts may vary widely from those of the presented indices.
Advisory services are only offered to clients or prospective clients where RASP Wealth Solutions, LLC and its representatives are properly licensed or exempt from licensure. No advice may be rendered by RASP Wealth Solutions, LLC unless a client service agreement is in place. This material is not intended to serve as personalized tax and/or investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. RASP Wealth Solutions, LLC is not an accounting firm. Please consult with your tax professional regarding your specific tax situation when determining if any of the mentioned strategies are right for you.