The core of our investment philosophy revolves around one concept: low-cost dynamic asset allocation with a unique focus on risk management. We adopted three major tenets to reach this goal:
Keep investing costs and fees as low as possible
This is very important to net of fee total return and directly within our control
Diversification & Dynamic Asset Allocation
With market cycles, asset valuations, and the economic environment ever changing; Traphagen constantly monitors and allocates among all investable asset classes (stocks, bonds, cash, private, and alternative investments) to maximize returns
Communicating the risk level of the portfolio with clients before capital deployment and keeping that risk level constant through time
This gives our clients comfort in knowing that regardless of market or economic conditions, their portfolio will be managed to the risk level they are comfortable with and is consistent with their long-term plan (this risk level is our mandate)
A Dynamic Asset Allocation
In conjunction with this core approach, we also employ ‘tactical’ allocations to different sectors, industries, individual stocks, and utilize an extensive suite of private and alternative investments.
Individual Equity Selection
In order for Traphagen to invest in an individual equity we must be convinced of 3 things:
- The company is in excellent financial health (strong balance sheet, manageable debt levels, strong return of cash flow to shareholders)
- Longer term future earnings/cash flows can be estimated with an above average level of confidence (highly cyclical, leveraged, or small companies are rarely bought). Preferred companies have very steady, well defended, and predictable earnings/cash flows.
- Current stock price is below our estimate of fair value (providing a margin of error) and also represents a superior risk-adjusted return versus owning a diversified market index ETF.
Traphagen estimates a securities fair value by utilizing our custom ‘conservative discounted cash flow’ model.
- We take a conservative estimate of ‘sustainable cash flow’ (which smoothes out booms and busts in corporate earnings) and then project conservative sustainable growth into the future. We apply a 10% discount rate for most securities (which is the return that we demand for owning the stock) and this generates our fair value estimate. We then set sell and buy targets for each security and invest appropriately.
The below graph depicts what our cash flow model would have predicted as fair value for Apple stock through time beginning in 2010. Our estimated fair value for Apple is represented by the ‘hold zone’ on the graph which increases through time as the absolute value of free cash flows available to shareholders increase. At any time if the actual stock price rises above this ‘hold zone’ we would be active sellers of the stock and any time it falls below we would be active buyers. We employ this same strategy for all individual securities we purchase.
Strategic US Equity Sector Over Weights / Under Weights
One of the largest determinates of investment returns within US equities is the investors allocation among industry sectors. Traphagen actively looks to overweight sectors that we feel will outperform the general market and underweight sectors that will underperform on a continuous basis. This provides superior risk adjusted returns versus simply holding the S&P 500 index.
Traphagen monitors the below 4 metrics on all 9 major S&P 500 industry sectors throughout the year:
- Recent sector performance relative to the S&P 500 / mean-reversion performance
- Absolute valuation of sector equity basket
- Relative valuation of sector equity basket versus the S&P 500 (relative P/E comparison)
- Fundamental industry view in relation to overall business cycle and other sector variables
- Using a proprietary metric weighting model Traphagen determines a ‘sector score’ for each sector. If the score is above (below) certain levels we will overweight (underweight) the sectors(s) within our US Large Cap Equity Allocation.
- At all other times sectors will be market-weighted
S&P 500 Sectors & Examples of Recent Traphagen Over/Under Weights
- Consumer Staples (Proctor & Gamble, Kraft Foods, Wal-Mart)
- HealthCare (Medtronic, United HealthCare, Pfizer)
- Consumer Discrnty. (Nike, Starbucks, Amazon)
- Technology (Apple, Microsoft, Intel)
- Industrials (General Electric, Caterpillar, Deere)
- Utilities (Con Ed, Southern Company, PG&E Corp.)
- Financials (JP Morgan, Wells Fargo, Bank of America)
- Energy (Chevron, Exxon Mobil, Schlumberger)
- Materials (Monsanto, Newmont Mining, Alcoa)
- Financial Underweight Jan 2011 – Jan 2012: +19.1% Return Differential
- Utility Underweight Jan 2011 – Oct 2011: +14.8% Return Differential
- Healthcare Overweight Jan 2011 – May 2011: +9.7% Return Differential
- Consumer Staples Overweight Jan 2011 – Dec 2011: +12% return Differential
Dynamic Asset Allocation
Every year in depth research is completed which encompasses general capital market assumptions and asset class specific return, risk, and correlation estimates. Using this research as our foundation the investment committee establishes estimates for shorter term (1 year) and longer term (10 year) returns for each asset class. More weight is given to the 10 year return estimates as historically these have been more reliable than shorter term return forecasts.
Once we have our estimates for asset class returns, risk, and correlations we run a ‘mean variance optimization’ (MVO) model which optimizes our allocation to every asset class given a set level of risk (measured by standard deviation). This risk level is governed by your investment objective (risk ranges from a SD of 4.5% for Stable Value Fixed Income to a SD of 18% for Aggressive Growth).
Most traditional managers employ a static asset allocation and periodically rebalance. This actually decreases or increases risk and return potential as asset class valuations and correlations change over time.
As prudent managers it is our job to maximize return with a constant level of risk, and this is what ‘dynamic asset allocation’ accomplishes.
Traphagen believes keeping investment fees to an absolute minimum is essential to delivering long term superior investment returns.
This is one aspect of investment management that we have complete control over and therefore we look to take full advantage (where possible) of the lowest cost products available. Through our partnership with Fidelity and Schwab we are able to buy/sell many very low cost ETFs (Exchange Traded Funds) for no commission charge. These ETFs enable us to invest in a wide range of asset classes for very lost cost (as low as 0.07% per year vs. traditional mutual funds that could have fees as high as 1.5% or more per year).
For every $200,000 invested approximate fee savings of $1,000 per year is realized when comparing our portfolios with a 100% traditional mutual fund portfolio (assuming 0.425% average fee for our portfolio vs. 0.925% with an all mutual fund portfolio). It should be noted this savings is realized year in and year out regardless of market returns.
There are certain asset classes and investment strategies where no ETFs are available and therefore some traditional mutual funds remain an important part of our client portfolios.
Tax Loss/Gain Harvesting
We constantly monitor client portfolios for the opportunity to ‘harvest’ tax losses or gains for federal and state income tax purposes. This is the process by which we will actively sell one position to recognize a loss or gain (depending on what exactly we are trying to accomplish) and then immediately replace the original position with an near identical position. This captures the loss or gain (which defers or eliminates income taxes) while not affecting your overall investment exposure.
Again this is something we have control over, so Traphagen invests a lot of time and effort monitoring portfolios for possible harvesting opportunities.
Traphagen pays special attention to Asset Location between accounts to maximize tax efficiency. We ‘overweight’ tax efficient assets in taxable accounts, while using tax deferred accounts to house tax inefficient assets. This results in greater ‘after-tax’ returns as a result of deferring or avoiding taxable income/gains.
As the above graphic depicts we use IRAs to house high yielding assets. This includes most bonds and real estate. We can use these accounts to shield these cash flows from immediate taxation. In some cases we can permanently eliminate taxation on the income generated from these assets if allocated to a Roth IRA. Most equities, commodities, and all municipal bonds are held in taxable accounts. Most equities and commodities produce relatively low cash flow (and if they do it is normally qualified income) while municipal bonds produce no federal taxable income.
If executed correctly this ‘asset location’ strategy can add between 0.2% and 0.4% per year to after tax returns regardless of market returns.
Alternative & Private Investment Selections
Since early last decade, our firm has built long-term partnerships with several private equity, private real estate, and alternative investment managers in the country. We see these investments as imperative to a portfolio in generating income and reasonable total returns while yields on bond and cash are historically low.
Traphagen believes allocations to these investments provide significant value to most investors. Large institutions such as pension plans, endowments, and foundations have been utilizing these investments for decades because of their unique advantages. Traphagen was one of the first RIA firms in the country to begin offering these securities to the retail investors and continues to be an industry leader in the space. Below are the major advantages of incorporating these investments within most client portfolios:
•Opportunity to earn higher total returns in assets such as private equity, private real estate credit, private real estate equity, and real assets/infrastructure
• Little correlation to most traditional financial markets, which provides strategic portfolio rebalancing opportunities
• Lower volatility than most publicly traded securities
• Higher cash flow yields than most publicly traded securities
• Ability to replace lower returning bond allocations with a suite of alternative and private investments. This can increase cash flow and prospective total returns, while keeping volatility in check
Please contact Traphagen for more information on the specific alternative/private investments we offer...
Strategic U.S. Equity Sector Allocation
Our strategic sector selection seeks to achieve superior risk adjusted returns by overweighting different sectors within the U.S. stock market. As part of our portfolio management process, Traphagen utilizes a proprietary model to overweight certain stock sectors over others:
1. Recent sector performance vs. the S&P 500
2. Absolute valuation of each sector
3. Historical relative sector valuation vs. the S&P 500 and itself
4. Fundamental sector view vs. S&P 500
Cost & Fee Minimization
Fees can be a very large component of investment returns. It is also one of the few investment variables directly within in our control. Traphagen is committed to implementing the lowest cost investment options throughout traditional asset classes. We accomplish this by utilizing primarily commission free exchange traded funds (ETFs). Many of the ETFs we allocate funds to have no transaction cost to buy or sell and carry annual expenses of 0.04% - 0.20% vs. traditional active mutual funds that could have fees as high as 1.50% or more.
In addition, when used in taxable accounts, ETFs are much more tax-efficient than traditional mutual funds. Whereas mutual funds usually distribute any capital gains annually (which are taxed at the time of distribution), ETFs can retain capital gains within their fund structure with no tax impact. The capital gain is only realized when we choose to sell the ETF, allowing much more flexibility in terms of when to incur the gains.
There are certain asset classes and investment strategies where no ETFs are offered. In these cases, we utilize other investment structures.
Exchange Traded Funds (ETFs): These are baskets of bonds, stocks, or other securities (like mutual funds), but are more tax efficient, usually have much lower fees, and can be bought/sold throughout the day.
Tax Loss & Gain Harvesting
Our firm consistently monitors client portfolios for the opportunity to harvest tax losses or gains for federal and state tax minimization purposes. This is the process of actively selling securities with an unrealized gain or loss to recognize a ‘realized’ gain or loss, depending on what we want to accomplish. At the same time, we immediately replace the original security with a similar (but not identical) position. This captures the loss or gain which can defer, accelerate, eliminate, or reduce income taxes while not affecting the overall investment allocation.
Traphagen considers ‘security location’ among different types of accounts to maximize tax efficiency as part of the investment strategy. We overweight tax efficient assets in taxable accounts, while using tax deferred or tax-free accounts to overweight tax inefficient assets. This results in greater after-tax returns by deferring or avoiding taxable income or gains using different types of accounts to our advantage.
We can eliminate or defer taxation on the tax inefficient income generating assets if allocated to a Roth or Traditional IRA.
Discover how we can help.