Our Beliefs
Both index-based approaches to investing and traditional active approaches have their merits and their drawbacks. Gerstein Fisher’s investment process seeks to optimally blend the two, taking the Efficient Market Theory-based approach, focus on diversification, and lack of emotional bias that characterize indexing and marrying them to the flexibility and insight of an active process.
Our investment philosophy is based on several core beliefs:
- Markets are efficient, but investors are human
- Risk and return are related
- Diversification matters
- Structure drives performance
- Control what you can
1. Markets are efficient, but investors are human
The Efficient Market Hypothesis states that a company's stock price incorporates all available information about the company and is the best approximation of its fair value. And while this theory grants that stock prices may periodically drift away from intrinsic value, it also maintains that investors cannot systematically exploit these periodic dislocations to their advantage.
Our belief in the efficiency of the market means we spend most of our time on careful portfolio engineering, or structure—ensuring adequate diversification and the appropriate mix of stocks, bonds, real estate and cash—not on strategies that have not proven consistently reliable or replicable, like guessing at which sector of the US equity market is poised to be the next winner, or seeking out specific stocks we think are mispriced and headed for appreciation. Indeed, much of the academic research indicates that seeking consistent active manager outperformance is a "wealth hazard" for most investors.
We also recognize that investors are susceptible to emotions that can affect their decision making and behavior, at times creating disparities between the fair value of financial assets and their actual prices. We incorporate behavioral insights into our process both qualitatively and quantitatively, recognizing that they are a very real factor in determining financial outcomes for both individuals and the market as a whole.
2. Risk & return are related
In the early 1990s, award-winning financial economists Eugene Fama and Kenneth French analyzed the returns of all US equities over different independent time periods and identified three systematic sources of risk that explain over 90% of portfolio performance:
- Market (Premium for being in equities vs. fixed income)
- Size (Premium for investing in small cap vs. large cap stocks)
- Price (Premium for being in value vs. growth stocks)
Other academic research (Jegadeesh and Titman [1993]1, Carhart [1997]2) also identified a premium for positive momentum stocks, or stocks that have outperformed the rest of the market in the recent past. Stated simply, momentum is the tendency of past winners to keep winning and past losers to keep losing, relative to their peers. Some of this “momentum premium” might be explained by investor behavioral biases such as investors’ underreaction to bad news. A risk-based explanation would see this premium as investors’ compensation for bearing the exposure to downside risk inherent in positive-momentum stocks.
By focusing on risk/return relationships that are underpinned by sound economic reasoning, we can increase the likelihood that our portfolios will consistently add value and help our clients achieve their financial goals.
3. Diversification matters
In a 1992 article in the Financial Analysts Journal entitled “Diversification and Asset Contributions,” David Booth and Eugene Fama explored the effects on portfolio return and risk of combining assets with disparate characteristics—the so-called “diversification effect.” Indeed, portfolios containing a broad mix of asset classes have historically proven to deliver higher compound returns with less risk than those more concentrated in only a few asset classes or market segments.
A diversified portfolio also offers a greater opportunity set when it comes to selecting investments. That's why our client portfolios typically include (subject to client guidelines) allocations to commodities and real estate in addition to the traditional mix of domestic stocks, bonds, and cash. International investing—both in equities and fixed income—adds a further dimension to an investment portfolio by incorporating currency positions. By building well-diversified portfolios, we provide investors with a whole that is often much greater than the sum of its parts.
In thinking about diversification, it’s also important to remember that correlations don’t always tell the whole story. Even during distressed periods in which correlations rise across asset classes, it is often the case that, when looked at on a month-by-month basis, the return streams of different asset classes diverge enough to still deliver the benefits of volatility reduction and, in some cases, rebalancing opportunities.
4. Structure drives performance
Academic research indicates that portfolio structure is the key determinant of long-term performance. In 1991, a study by Brinson, Singer and Beebower3 found that strategic asset allocation explained a full 91.5% of variation in portfolio returns.
The critical decision of how much to allocate to stocks, bonds, real estate, cash and alternative assets forms the foundation of every client portfolio that Gerstein Fisher designs, and we continue to monitor this mix over time through systematic reviews that sometimes lead to portfolio rebalancing and realignment.
Recognizing the dynamic nature of markets, we use statistical techniques such as backtesting, Monte Carlo Simulation, and sensitivity analysis to test out proposed portfolio structures through thousands of scenarios that combine different values for variables ranging from interest rates to equity and bond returns. This exercise gives us greater confidence that the proposed structure is appropriate for our clients’ objectives not just today, but in the face of a wide range of possible market environments.
When it comes to implementing portfolio structure, we employ a multi-factor approach based on Arbitrage Pricing Theory (APT), which was pioneered by MIT finance professor Steven Ross in 1976 and states that several systematic factors significantly influence the long-term returns of financial assets. Using an approach based on this theory, we are able to construct portfolios with far fewer stocks than a traditional index fund. Instead of mimicking the exact holdings of a benchmark index, we design a portfolio with similar exposures to factors such as value, small cap, momentum, and also economic factors such as US dollar exposure, credit structure, and interest rate exposure.
Focusing on these factors enables us to tune out some of the “noise” that we believe can serve as a distraction within active management approaches. It also gives us the flexibility to customize portfolio holdings based on our clients’ specific requirements and, where applicable, to harvest tax losses in order to minimize their future tax liabilities—all the while maintaining market-like exposure.
5. Control what you can
If it's true that "It's not what you earn that's important; it's what you keep," then you want to work with an investment advisor who pays careful attention to such things as trading costs, fees, and taxes.
Research has shown an increase in price for securities that will be added to an index between the announcement of the addition and its effective date. The performance of index managers (or active managers closely tracking a particular index) who all trade at or near that one point in time when the index reconstitution takes place is often affected by this phenomenon. Gerstein Fisher has the flexibility to trade selectively in order to keep these costs in line.
Further cost efficiencies come from our use of technology and our scale, for instance when we batch trades for rebalancings across multiple portfolios. In negotiated markets like fixed income, our use of multiple pricing platforms and an extensive dealer network means we can put dealers in a competitive situation that can ultimately result in better pricing – which helps save our clients money and translates into better investment results. At the enterprise level, we negotiate tirelessly with our vendors on our clients’ behalf, recognizing that what we can save them by way of fees and costs is “real money” that, particularly over the long term, can make a real difference to investors’ returns.
If not carefully managed, taxes also can have highly adverse effects on portfolio performance for taxable investors. At Gerstein Fisher, we employ tax loss harvesting strategies to reduce clients' overall capital gains and always consider the tax implications of purchases, sales, and rebalancings. Our focus on portfolio engineering versus individual sectors, industries or securities makes it even easier for us to apply the necessary discipline to "do the right thing" from a tax management perspective, even if it means selling a position that has performed well.
1Jegadeesh, Narsimhan, and Sheridan Titman. “Returns to buying winners and selling losers: Implications for stockmarket efficiency.” Journal of Finance, 1993: 65-91.
2Mark Carhart, 1997, On Persistence in Mutual Fund Performance, Journal of Finance 52 (1): 57–81.
3Brinson, Gary P., L. Randolph Hood & Gilbert L. Beebower, “Determinants of Portfolio Performance”. The Financial Analysts Journal, July/August 1986.