FAQs and Concepts
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Why Cedarwinds? Our investment approach and the solutions we offer are on the leading edge of the investment profession. Our business model has evolved from what we have learned over many years of hands-on, professional money management experience as well as extensive research in the academic and financial practitioner’s literature.
Our solutions have been specifically designed to address the two biggest needs we see today in the investment industry in terms of product and process. First, we wanted to take advantage of the compelling benefits of index fund investing by carefully selecting best-in-class, “structured” index funds as the basis for constructing our comprehensive set of high-performance, risk-correlated, low-cost portfolio solutions. This approach provides the most predictable and cost-effective way for investors to meet their long-term investment objectives.
Second, we wanted to ensure that our investment process is based on a formal methodology that reliably and accurately matches individual investment objectives with risk tolerance levels. In this way our clients can feel secure that their investment objectives and capacity for risk are tightly aligned with the most suitable investment solution possible.
Analogies are often the best way to help describe a story. Successful investing is a long voyage. It requires the ability to navigate through many different conditions along the way. Our goal has been to design and build a sturdy, high-quality craft and rig it with a complete set of all-weather sails to help clients reach their investment destination. The course we set will not stray from our core belief in the value of using structured index funds as the primary ballast for creating high-performance, reduced-risk, low-cost portfolios. As we make our way, we want to develop great relationships with great clients who understand and share our investment philosophy.
Index funds are mutual funds with specific and clearly defined sets of rules of ownership. When stocks are within the rules of ownership, they are purchased and held. When they no longer meet the rules, they are sold.
A pure index fund represents a “passive” investment style and accepts asset class returns of a particular sponsor’s index, such as the Standard and Poor’s S&P 500. This approach allows various commercial benchmarks (Russell, EAFE, Wilshire, etc.) to define strategy. With this style of investing, judgments about transaction costs and turnover are sacrificed in favor of methodically tracking against a defined benchmark. The index fund incurs impact costs as it must quickly react when an index sponsor changes holdings or due to the daily inflows and outflows of client investments. This means that the index fund will always underperform in comparison to its benchmark due to trading costs or other marginal costs not reflected in the pure benchmark.
In contrast to a pure index fund with its mechanical approach to fund management, a “structured” index fund, sometimes called an “enhanced” index fund, is "actively" managed, but on a limited basis. This structured approach is intended to enhance results by capturing specific dimensions of risk identified by academic research. This type of fund independently sets its own rules for buying and selling holdings within targeted asset classes. There is latitude for judgment, bundling orders for block trades, managing taxes, etc. This structured approach minimizes transaction costs and enhances returns through patient trading and portfolio engineering. Structured index funds are designed to add 100 – 200 basis points of return per year over conventional benchmarks.
What makes the Cedarwinds’ approach different from other investment managers, mutual fund companies, insurance companies or brokerage firms?
We are different in three important areas -- solutions, process and performance.
Regarding our portfolio solutions, we have teamed up with Dimensional Fund Advisors, the acknowledged global leader in the management of structured index mutual funds, to create a broad selection of high-performance portfolios. Because DFA’s line-up of structured index funds is not available to investors through normal retail distribution channels, we provide a valuable introduction and access to this premier fund manager.
In terms of process, our approach to investing emphasizes taking the time to consult with and educate our clients about different investment styles and how the markets operate. Our perspective is based on decades of experience in the industry and the knowledge we have acquired about the most effective ways to communicate and execute investment theory. Our presentation materials are rich in graphics, color and content and have been designed to easily convey concepts and promote understanding. Critical to our process is the use of a risk capacity questionnaire to assist in appropriately matching client risk tolerance with the most suitable investment solution. Our process is especially effective with investors who:
As far as performance, we can objectively demonstrate that our investment approach, using structured index funds, delivers more risk-predictable performance at lower cost than other alternative forms of actively managed investing. Unlike active managers, we do not try to chase investment returns through stock picking, market timing or drifting in and out of the most “promising” asset classes in the hope of beating the market. We do not speculate about the future. Rather, our approach is more methodical and empirical: we capitalize on known risk-return relationships available through disciplined asset class diversification and use these correlations as our principle method to achieve longer-term investment objectives. Our solutions are also characterized by unusually low operating costs. At the fund management level, the index approach offers an important advantage of reduced fees compared to the active management style. And at the advisory level, we keep our costs low so that client assets benefit from maximum market exposure in order to provide the best chance to compound in value over time.
We feel there is only one risk exposure question that needs to be posed: “What mix of indexes provides the highest expected return at each level of risk?” Getting to that answer involves many concepts discovered by academics who have methodically applied the scientific method to this problem. The basic Cedarwinds approach is a step process that can be summarized as follows:
How reliable and predictable is your investment approach? There are two primary reasons why we determined that the Cedarwinds’ business model and the needs of our clients would be best served by partnering with Dimensional Fund Advisors (DFA), a Santa Monica, CA based index mutual fund investment company with approximately $150 billion under management. First, DFA has earned the reputation of being the best index fund manager in the industry according to independent surveys of investment professionals. Many large, sophisticated institutional clients rely on the expertise of DFA for investment management. This reputation was confirmed after extensive due diligence meetings with the firm’s principals, management, clients and other objective reference sources. Second, DFA is uniquely committed to partnering on a selective basis only with those financial advisors who share their view regarding the superior long-term performance, cost efficiency and predictability of returns using a carefully constructed mix of index funds as the most effective way to meet client investment objectives.
With your structured index fund approach, how do the fund managers decide which stocks to buy or sell?
DFA creates an eligible universe of all traded stocks of real operating companies. It then applies filters to exclude certain stocks that do not fit the asset class of the fund or that have specific pricing or trading concerns. The remaining stocks are eligible for purchase and are subject to rough market-capitalization target weights. DFA regularly monitors trading in the marketplace with real-time checks for current news that may impact prices, such as a looming takeover. Other than that, DFA is generally indifferent among the stocks comprising the eligible fund universe. This allows it to trade opportunistically and take advantage of liquidity premiums that benefit client returns. More explanation is available in the "LIbrary" section of this web site, DFA Fund's prospectus and statement of additional information. In a relationship with Cedarwinds, who is actually managing my money and what kind of statement reporting do I receive?
In general, Cedarwinds, as a registered investment advisor, will oversee and direct how client assets are invested based on the specific investment objectives set forth in each client’s Investment Policy Statement as reflected in the Investment Advisory Agreement. For clients investing in one of our model portfolios consisting of a mix of underlying index mutual funds managed by Dimensional Fund Advisors (DFA), our role is to direct how the assets will be allocated and rebalanced, if necessary. Investment positions are executed and funds are held by our custodians, Fidelity Investment Services or Charles Schwab & Co. (unless directed otherwise by the client). In this way, Cedarwinds never takes direct control of client funds.
For statement reporting purposes, our custodian provides an investment summary of portfolio positions on a monthly basis to each client. Transaction confirmations are sent directly to the client by the custodian whenever position changes occur. Additionally, Cedarwinds provides an investment summary review to each client on a quarterly basis.
No. Our model portfolios have been created based upon our ability to access structured index mutual funds managed by Dimensional Fund Advisors. Our approach is unique in that we customize the mix of underlying funds in our portfolios to achieve certain risk-return relationships based on a rigorous analysis of various performance attributes and historical data series.
No. However, there may be transaction costs and advisory fee considerations that need to be reviewed and understood before a decision is made to open an account for amounts less than $50,000.
Yes, we have four structured index fund solutions specifically designed for taxable account portfolios. The investment strategies employed by these funds include tax lot accounting, avoiding capital gains, monitoring dividends, and harvesting losses. These techniques typically add 80-120 basis points of annual after-tax value at the underlying fund level for taxable investors.
There are three elements that reflect our overall investment philosophy.
First, we believe it is important to distinguish between short-term “speculation” and long-term “investing.” In the short term, market trends are inherently unpredictable and volatile. Trying to make thoughtful investment decisions in this context represents a form of gambling. It is impossible to predict with confidence the direction of short-term market movements, other than that the market will go up and down. However, over longer periods of time, results clearly demonstrate that the market tends to rise and that there is a measurable relationship between risk and return. We believe the benefits of longer-term investing in portfolios consisting of diversified asset classes begin to become statistically demonstrable after five years of market exposure based upon historical return patterns.
Second, we believe that investing can be conceptually explained as an integrated system consisting of six variables including: investment objectives; the risk-return relationship; investment costs; the time factor; market behavior; and inflation. These elements are related to one another, individually and in combination. However, as far as the individual investor is concerned, two of these variables are uncontrollable, those being the uncertainty of market behavior and the degree to which inflation erodes performance.
Third, we believe the essential challenge for every investor in our simplified system is how to effectively manage the remaining controllable parts to achieve maximum advantage in the context of the uncertain and uncontrollable elements. Obviously, the real world is a far more complicated place than our simple investment system might suggest. However, we feel it is critically important for investors to remain grounded to these basic variables and focus on the controllable elements. The successful investor will concentrate on understanding and managing the relationship between investment objectives, risk-return correlation, investment costs and the time dimension.
In summary, the foundation of our business model is based on the belief that the best way to manage these elements over the longer term is through the use of globally diversified portfolios consisting of low-cost index funds designed to achieve predictable rates of return against calculated levels of risk.
There are many high-quality, well-trained and knowledgeable investment professionals working very hard every day to serve their clients. It has been our privilege to have worked directly with many of them and to be acquainted with many more. Some of these individuals do a terrific job in terms of delivering investment performance over short periods of time using a specific management style or asset class approach compared to an appropriately identified benchmark. The problem, however, is that over the longer term their results become inconsistent and volatile in comparison to the broader market. This is due to the fact that their narrow management style is not diversified enough to reflect the inevitable style rotation that occurs in a diversified market as their particular style gets out of favor. This creates performance uncertainty for their clients as the market simply rotates away from their particular expertise. The result is that investors get stuck in one or more poor performing style boxes, sometimes for very long periods of time.
There are also other problems common to active money managers. Firms and their clients can face unknowns and loss of investment discipline with portfolio manager changes and/or analytical staff turnover. There is a tendency to create a “star” system in many firms where managers are financially motivated to outperform their benchmarks, making bets by taking risks well beyond what may be in the best interests of clients. Also, internal investment rules -- what to buy and sell, and when to do it -- will typically drift around if their particular investment style is out of favor for extended periods of time. In some cases, as with new management or ownership, investment philosophies may change entirely. In other caes, styles may be diluted by adding more styles or products so that firms can remain more relevant to their clients. In many cases, this is an economic necessity as clients tend to migrate away in search of better performing options.
The bottom line is this: The active management approach essentially represents a game of chasing market performance – it is an ineffective, unpredictable and expensive way to invest. Regardless of individual firm dynamics or how good a manager has been, the fact remains that over time, active managers simply cannot outperform their assigned benchmarks without exposing clients to higher relative levels of risk and volatility. In certain cases this may be an appropriate strategy as, for example, with institutional clients seeking specific exposure to a narrow asset class or management style. In our view, however, this is not an acceptable long-term approach for the majority of individual or institutional investors.
The simple fact is that most investors are far better off with a disciplined exposure to a full range of asset classes by taking advantage of the higher performance and lower cost features available with index funds. Once this conclusion is accepted, the only remaining question is how to effectively manage a portfolio of index funds. And this is where we feel the Cedarwinds’ structured and risk-correlated approach represents an excellent choice.
Long-term investors should not be distracted by short-term events or influences. The key is to keep your investment dollars working in the market according to an asset-allocation strategy that best suits your risk tolerance. Otherwise you are a market timer and this is a speculative investment strategy.
I would like to invest the contributions I am making in my retirement plan with your firm but my employer limits me to a specific list of choices. What should I do?
You may open up a self-directed brokerage account if your plan allows this option and then we will direct your plan investments as part of an investment advisory relationship established with you. Otherwise, if your plan does not currently allow for a self-directed option for employees, you can approach your employer and request that the plan be amended to allow for a participant self-directed option.
The fund-of-funds investment approach is variously referred to as “life cycle,” “target maturity” or “strategic allocation” funds. This approach generally involves mixing together a number of actively managed mutual funds which adds layers of expense at the holding fund level as well as at the underlying investment fund level. This double expense really punishes investment returns. It is not unusual to see annual fees ranging from 2.5% – 3.5%, or higher, in these arrangements--including broker ‘wrap’ fees--before even considering annual transactions costs. If a sales load is charged, investors experience even more “leakage” in their annual returns. There is also the probability that this blended approach will create style overlap and compromise diversification objectives. These are very costly investments which typically underperform compared to their weighted benchmarks. In most cases it is difficult to determine risk correlations of underlying investments or obtain objective performance data compared to a blended benchmark. In contrast, our model portfolios are far more cost-effective, tax-efficient and transparent in terms of managing risk-correlated returns and providing objective performance and pricing information.
There are over 900 index funds currently available representing a full spectrum of investment class and style options. And while these passive indices may offer some of the same cost advantages as our approach, they do not provide the performance enhancement potential of DFA’s “structured” funds. Further, this piecemeal investment approach does not support total portfolio solutions that are rigorously back-tested and risk-correlated like the comprehensive analysis that supports the Cedarwinds program. The net result is that investors are left with a hodge-podge of funds, often guessing about how they fit together. In effect, this represents a "pick and pray" option. That is why we strongly believe a disciplined, total portfolio investment process is necessary to ensure that client risk tolerance matches effectively with anticipated portfolio performance.
Exchange Traded Funds (ETFs) are baskets of stocks that track a specific index, like the S&P or Dow Jones Industrial Average. They are listed on U.S. stock exchanges and can be traded throughout the day just like a stock. ETFs provide two primary advantages: the flexibility, ease and liquidity of stock trading and the diversification benefits of traditional mutual funds. They offer a non-derivative alternative to trading futures, baskets of stocks and even mutual funds.
Exchange Traded Funds (ETFs) were first introduced in January 1993. ETFs are considered to be the leading financial innovation of the last decade. As of January 2010, over 900 ETFs are listed in the U.S., representing $800 billion in assets. ETFs are used to track a wide variety of asset classes and market sectors.
In important ways the industry is in a crisis mode and has needed attention for many years. The speculative bubble of the late ‘90s masked much of the problem due to extraordinary investment returns that helped create unrealistic expectations and a large, if temporary, wealth effect for many investors. The darker reality, however, is that the interests of longer-term investors are not currently well-served and haven’t been for quite some time. There are a number of reasons for this.
First, there have been problems with historically low investment returns and volatile performance over the last several years. Part of this is due to perpetuation of the belief that active management can deliver better returns than the market can. This rationale is contrary to many academic studies and the weight of statistical evidence. It is an indisputable fact that an active management style, over time, delivers inferior portfolio returns on a risk-adjusted basis in comparison to a passive index fund investment approach. The evidence is so compelling it is simply not worth debating the issue. The bottom line is that the longer investors ignore this reality, or fail to act on it, the greater the level of investment wealth that is permanently sacrificed.
Second, the operating costs of active management absolutely punish investment returns in terms of the total cost structure borne by investors. These costs reflect a smorgasbord of loads and sales commissions, investment management fees, idle cash, advisory fees, marketing expenses, portfolio trading costs, unrealistic compensation packages, and, more recently, the fines and legal expenses absorbed by investors as a result of well-publicized mutual fund abuses. Collectively, these expenses are enormous and act to create a tremendous drag on performance. And it is not just the direct costs that hurt performance; it is also the fact that these expenses reduce the ability for assets to otherwise grow so that there is a real “opportunity cost” that compounds over time. For taxable accounts, the costs are even higher when considering mutual fund investment returns calculated on an after-tax basis. Most regrettable is the fact that it is difficult for investors to easily identify what these costs really amount to because of the lack of transparency with investment financial reporting. And remember that the added “cost” of inflation and its impact on absolute returns is not considered in any industry reporting format. The bottom line is that investors struggling to accumulate assets for retirement or other long-term needs have tremendous odds stacked against them.
There are other problems as well. In addition to poor relative investment performance and high costs, many long-term investors are also victimized by the daily hype from the so-called experts to buy the “most promising” stocks, the “best” mutual funds or annuities, the latest “sure thing” hedge fund, the current “hot sector” play, or “can’t lose” market timing technique. This flavor-of-the-day mentality creates a confusing array of expensive, poor performing investments and conflicting approaches that undermine industry integrity and the interests of long-term investors. This daily siren song only leads to poor investment decisions as innocent investors are seduced into thinking that they must behave like short-term gamblers in order to be successful. Exacerbating the problem is that these products or approaches are typically marketed (i.e., “pushed”) by commissioned salespeople who are measured on the basis of their “monthly production.” This inherent conflict between what is in the best long-term interests of the investor versus the short-term incentives of salespeople to move product in order to generate commission income is painfully apparent. It clearly undermines the needs of individuals seeking a low-cost, disciplined investment approach aimed at accumulating and preserving long-term financial assets.
Unfortunately, there is a lot of industry inertia and institutional self-interest associated with protecting this “old model.” Fortunately, there are some new approaches being developed by firms like Cedarwinds that are working hard to provide solutions that promote the long-term best interests of clients.
The Efficient Market Hypothesis says that market prices are fair: they fully reflect all available information. First, information about stocks is widely and inexpensively available to all investors. Second, all known and available information is already reflected in current stock prices. Third, the price of a stock agreed on by a buyer and a seller is the best estimate of the true value of that stock. Finally, stock prices change almost instantaneously as new, unpredictable information appears in the market. This does not mean that prices are perfect; some prices may be too high and some too low, but there is no reliable way to tell. In an efficient market, investors cannot expect to earn above-average profits without assuming above-average risks. Market efficiency does not suggest that investors can’t “win.” Over any period of time, some investors will beat the market, but the number of investors who do so will be no greater than expected by chance. All of these factors make it nearly impossible to capture returns in excess of a market return without taking greater than market levels of risk. The only issue of concern is the relationship between risk, return, time and correlation.
Model Portfolio Theory deals with the principles underlying analysis and evaluation of rational portfolio choices based on risk-return trade-offs and efficient diversification. It is based on the concept that an investor’s desire is not simply to maximize the return of a portfolio; rather, it is to maximize the portfolio return while simultaneously minimizing the portfolio’s risk. Risk management, rather than risk avoidance, has become the standard.
Today’s investment strategy is not about the avoidance of risk but for the prudent management of risk. Risk management takes account of all hazards that may follow from inflation, volatility of price and yield, lack of liquidity, and so forth. The concept is to blend investments together in a manner that lowers overall volatility of the total portfolio. Even though individual investments within a portfolio might be considered to be “risky” or volatile, it is found that if you blend together two investments, even so-called “risky” investments, the overall risk of the portfolio or the overall volatility may be significantly reduced.
This theory has evolved into the concept of an “Efficient Portfolio” which relies on blending together baskets of different investments specifically for the purpose of controlling the volatility risk of the entire portfolio. The method focuses on combining assets whose expected returns are not highly correlated. The overall returns that the whole portfolio earns can, therefore, be enhanced or preserved through the combination of assets with known correlations, thereby adding value to the portfolio itself.
For our purposes, risk is simply defined as the possibility that there is more than one outcome to an event. It is measured using a calculation known as “standard deviation.” In mathematical terms, standard deviation is calculated as the square root of the variance. In our work, this is a measure that quantifies the difference between portfolio performance and expected return. It measures the total risk of a portfolio. In comparing two portfolios, the portfolio with a higher standard deviation has more risk. The following example helps illustrate this measurement:
Portfolio A Portfolio B
Year 1: 25% 16%
Year 2 5% 14%
Average 15% 15%
When an investment manager is actively managing a client portfolio or a mutual fund, it means the manager is attempting to beat the market through security selection, industry or sector betting, and market timing. This approach may undermine the purity of asset class exposure as the manager tries to guess where the market is going next to keep up with the most “promising” securities or market trends. This investment approach generates higher fees, trading costs, and taxes due to increased turnover.
The expected return of a portfolio of assets is the weighted average of the expected return of the portfolio’s component assets. With our model portfolios consisting of structured index funds, the expected return of each portfolio is the weighted average of the expected returns of each index mutual fund used in the construction of that portfolio.
Mean reversion is a tendency for certain random variables to remain at, or return over time, to a long-run average level. Individual stock prices, mutual fund manager performances and short-term market performance tend not to be mean reverting. Large diversified portfolios of stocks tend to be mean reverting over time.
Persistence refers to the condition where those managers who have done well continue to do well relative to the other managers or an index. Lack of persistence refers to the condition where managers who have done well in one period deliver average performance in the next period. Persistence may indicate the presence of skill, though does not guarantee it, as other conditions such as asset class performance and expense advantages can play a role. Some studies analyze market variables within their research. In contrast, the lack of persistence would fairly indicate that there is no evidence of manager skill to consistently outperform the market. If it turns out that performance does persist, then an investor may be able to pick active mutual funds which have beaten the market in the recent past and expect to beat the index fund or other mutual funds with a positive degree of statistical certainty. On the other hand, if no performance persistence exists, then the index fund would be the better choice, as lower expense ratios must do better if skill cannot add value to owning stocks.
Survivorship bias refers to the phenomenon that the worst performing funds often disappear from fund lists because the fund companies do not want to market poor performing funds. Many of these funds get merged into other funds, thus hiding their poor performance of the last several years. Several other studies confirm that survivorship bias can create the false appearance of superior performance and persistence by upward biasing the average fund returns; average figures range from 1-3% annually, depending on asset class. Survivorship bias, and other artifacts of incomplete databases, is part of the reason there is some variation of results from different studies.
“Cedarwinds” essentially represents a state-of-mind, a spirit and an attitude rather than a specific place or thing. It connotes tenacity, resiliency, courage and strength of conviction. As far as our logo is concerned, our little version of a “swift boat” was stylized from a photograph of a 12-meter yacht racing off the coast of New Zealand. To be competitive, these magnificent racing machines not only must be designed to sail efficiently in all types of seas and weather conditions, they also require cutting-edge technology, intelligent course strategy, disciplined preparation, effective teamwork, and the ability to sail well. It is a fitting metaphor for our business model.
Click on the “Library” button of our web site for more general information. Click on the "Newsletter" button of our web site for more specific information about our program.
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