Shearwater Capital was founded by Eric Malden and me in 1999, while we were classmates in the Executive MBA program at Washington University. We started the company due to a long-standing interest in finance, and a lack of attractive investment management options for physicians and their families. Rather than benefitting their clients, most of the financial advisory firms we encountered were designed to enrich themselves by selling high cost insurance products and actively managed investment vehicles with excessive fees.
Our own approach to investing was, and continues to be, informed by one simple question: How can we add the most value for our clients? We were initially guided in this quest by one of our professors, the eminent financial economist, Dr. Phil Dybvig. Phil helped us develop our investment philosophy by assigning influential articles from the academic finance literature for us to review, and then meeting with us periodically to discuss and debate the merits of each article. Based on these discussions, we reached the following conclusions about how best to add value for our clients:
Avoid active management. It is more expensive and less tax efficient than passive management and there is no convincing evidence that it adds value.
Asset allocation is critical, and should be tailored to the client’s risk tolerance and time horizon. Broad diversification across global markets offers the best risk/reward trade-off for most clients.
Keep expenses as low as possible. It is important to minimize not only the obvious expenses, such as mutual fund fees, but also hidden expenses such as the bid-ask spread on purchases and sales of financial securities.
Minimize investment related taxes. The only returns that matter are your after-tax returns.
The article that had the greatest influence on our investment approach was The Cross-Section of Expected Stock Returns, by Eugene Fama and Ken French.(1) This article showed that portfolio returns can be almost entirely explained by three simple factors: 1) relative exposure to stocks vs. bonds; 2) relative exposure to value vs. growth stocks; and 3) relative exposure to small cap vs. large cap stocks. Portfolios with heavier weightings in stocks (vs. bonds), value stocks, and small cap stocks have historically outperformed portfolios with less emphasis on these factors. This observation has held true in markets throughout the world over multiple historical time periods.
We use DFA funds as the primary building blocks of our client portfolios because they incorporate all of the above features of our investment philosophy: they are not actively managed, at least in regard to stock selection and market timing; the DFA core equity funds provide the broadest possible diversification, including a wide range of international asset classes; their fees are among the lowest in the mutual fund industry; and the DFA tax-managed funds help to minimize investment related taxes within taxable accounts. We also use these funds to overweight small cap and value stocks in our client portfolios in order to capture the higher returns that have been associated with these asset classes.
Eric and I initially used Shearwater Capital just to manage our own financial assets. Our first clients were a few close friends and family members, and we have grown gradually since then, mostly through referrals from existing clients. We now have over 100 clients and about $75 million in assets under management.
We have tried to base our investment approach on the best ideas from the world of academic finance.
While data has helped to reaffirm our investment approach, we realize that there is more to providing outstanding investment management services than achieving good returns. It is equally important for us to understand our clients’ investment needs, provide sound advice and exceptional service. If there is anything we can do to improve our performance in these areas, please let me know. We appreciate your business and the opportunity to help with your investments.
Jeffrey J. Brown, MD CFA Principal, Shearwater Capital
(1) Fama EF, French KR. The Cross Section of Expected Stock Returns. Journal of Finance 1992; 47:427-465