Adding Value

At Shearwater Capital, we apply ideas from leading thinkers in academic finance to the practical world of investment management. Our approach is based on the belief that markets are efficient and that intelligent asset allocation holds the key to higher risk-adjusted returns.

Efficient Markets

The efficient market hypothesis states that at any given time, stock prices fully reflect all available information. This occurs because there are millions of participants in the market actively competing to buy undervalued and sell overvalued stocks. The net effect is that a stock's price is usually a good estimate of its intrinsic value. Of course, stock prices are not perfect, but even the best professional money managers have a hard time identifying mispriced stocks.

In a typical year, about 75% of actively managed mutual funds lag behind their relevant benchmark indexes. Many investors are aware of this, but stick with active management in hopes of selecting funds in that elusive upper quartile. Unfortunately, this strategy fails because there is no way to predict which funds will beat the market averages going forward. Most people rely on past performance, which has almost no predictive value for future returns. A better alternative is to invest in index funds, which not only outperform most actively managed funds, but also have lower fees and are more tax-efficient.

But can you do better than traditional index funds? We strive to capture higher returns for our clients based on the Fama-French Three Factor Model and DFA discount trading strategies.

The Three Factor Model

Eugene Fama of the University of Chicago and Ken French of Dartmouth have identified three factors that collectively determine more than 96% of a diversified stock portfolio's performance. The first is the "market" factor, which for practical purposes, means that stocks have higher expected returns than bonds. The second and third factors are company "size" and "value," respectively. Empirical research has shown that, over the long run, small cap stocks outperform large cap stocks and value stocks outperform growth stocks.

We rely primarily on funds from Dimension Fund Advisors (DFA) to build our client portfolios. DFA funds are designed to capture stronger exposure to the size and value factors that drive returns. For example, a DFA value fund reflects deeper value (measured by price-to-book value ratio) than other so-called value funds. Historically, this has resulted in higher returns.

Discounted Block Trades

DFA also adds value by functioning as a market maker for small and micro-cap stocks. Rather than replicate an index in a mechanical fashion, DFA funds can have slight variations in their underlying portfolios. This allows them to extract significant discounts from sellers seeking rapid execution on large blocks of stock. Historically, DFA's average block purchase price is 3% below the next day's closing price. This translates into higher returns.

Diversification

The Nobel Prize-winning economist, Harry Markowitz, revolutionized the field of academic finance when he discovered that by owning a diversified portfolio you can reduce risk without sacrificing expected returns. A balanced portfolio should include all the major asset classes, including foreign and domestic stocks and bonds. Diversification within asset classes is also important. For example, a domestic stock portfolio should not be too focused on any particular sector or industry group, but should reflect the overall composition of the U.S. stock market. We therefore recommend fully diversified portfolios for most clients, with some overweighting of small cap and value stocks, as noted above.

Summary

Hopefully, this discussion has helped illuminate our approach to investment management. Our goal is to deliver added value to our clients based on the best practices of leading financial economists and institutional money managers.

April 2004

Disclaimer: Investing in stocks is risky and may result in loss of principal. Past performance is not indicative of future results.

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