CLIENT CENTER REP / ADVISOR CENTER

What Is A Fiduciary?

AFA

A fiduciary is one who owes to another the highest duty of care, good faith, trust, confidence and candor based on their relationship. We act as fiduciaries in our relationships with our clients. When making a decision, a recommendation, or providing advice, the needs of the client must always take precedence above those of the firm and of the investment advisor representative.

An Introduction

Since 1989, American Financial Advisors has worked with successful individuals, businesses and institutions to address their full range of investing and planning needs. AFA is headquartered in Orlando, Florida with additional offices in Albany, New York.

Our Fiduciary Duties

As a registered investment advisor, we act as a fiduciary in our relationship with our clients. This means we have certain designated, ethical and legal responsibilities, including:

  • Acting in each client’s best interests with the skill, care and diligence of a prudent expert
  • Providing qualifications and compensation in writing
  • Disclosing conflicts of interest

As part of our fiduciary responsibilities, AFA has had to perform extensive due diligence to make key decisions concerning investment philosophy, money managers and custodians.

Our Investment Strategy Decision: Passive vs. Active Money Managers

According to the American Law Journal: “The greater the trustee’s departure from one of the valid passive strategies, the greater is likely to be the burden of justification and also of continuous monitoring.”[1]

  • Active money managers have difficulty beating the market. Over the last five years, 72% of large-cap managers underperformed the S&P 500 Index, 88% of small-cap managers underperformed the S&P SmallCap 600 Index, 84% of international managers underperformed the S&P 700 Index, and 90% of intermediate fixed income managers underperformed the Barclays Intermediate Government/Credit Index.[2]
  • Asset class selection has more impact (96%) on portfolio performance than does individual security selection or market timing. Only 4% of portfolio return can be attributed to stock picking and market timing.[3]

CONCLUSION: We believe that PASSIVE investing is PRUDENT.

Money Manager Selection

  1. There are three major alternatives in the passive money management universe:
    • Vanguard Funds
    • ETFs (Exchange Traded Funds)
    • Dimensional Fund Advisors
  2. Of these, only Dimensional Fund Advisors (DFA) specializes in “asset class” funds. These seek to capture an entire market segment like large cap, for example, and provide wide diversification with no overlap of securities between funds and no possibility of style drift. A fully-diversified portfolio of DFA funds will hold literally thousands of securities, both equity and fixed, domestic and international.[4]
    • Cost: Dimensional Fund Advisors funds’ internal expenses average 32 basis points while those of Vanguard average 22 basis points. However, studies of Dimensional vs. Vanguard indicate that Dimensional funds, overall, deliver a higher expected premium over market rates of return, especially in the small cap arena.[5] Index funds also offer a number of challenges, including inefficiencies, lack of true asset class exposure and the reconstitution effect.
      • Size: >$400 billion assets under management
      • History: Founded 1981

CONCLUSION: Dimensional Fund Advisors money management style is consistent with our commitment to passive investing through the use of a diversified portfolio of asset class funds. Cost, track record, duration of management style and team, as well as expectation of future profitability, were all considered.

Custodian Selection: Pershing vs. Schwab

  1. Our firm has had experience with the following custodians:
    • Herzog, Heine, and Geduld, Inc.
    • Rothschild
    • National Financial
    • PrimeVest
    • Pershing
    • Schwab
  2. Choice: Charles Schwab and Co.
    • Size ($1.2 trillion in client assets and $4.6 billion in equity capital)[6]
    • Cost: trading costs are comparable across all these companies
    • Regulatory compliance: Charles Schwab, as a registered broker/dealer, is subject to the rules and regulations of the Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board and all other exchanges of which Schwab is a member.
    • SIPC Coverage: Accounts of Charles Schwab & Co. Inc. (including those held by clients of investment advisors with Schwab Institutional) are insured by SIPC for securities and cash in the event of broker/dealer failure. SIPC provides up to $500,000 of protection for accounts that clients of advisors hold in each separate capacity (e.g. joint tenant or sole owner), with a limit of $100,000 for claims of uninvested cash balances. More information about SIPC coverage may be obtained at www.sipc.org.
    • Additional brokerage insurance is provided to Charles Schwab & Co., Inc. accounts through underwriters at Lloyd’s of London. Schwab’s coverage with Lloyd’s provides protection of securities and cash up to an aggregate of $600 million and is limited to a combined return to any customer from a Trustee, SIPC and Lloyd’s of $150 million, including cash of $1 million. This additional protection becomes available when SIPC is exhausted.[7]

CONCLUSION: We selected Charles Schwab as the custodian for our clients’ investment accounts.

Our Disciplined: Academically-Based Approach to Prudent Investing

Step One: Write an Investment Policy Statement. This Statement should provide specific instructions to the investment advisor and cover such topics as target rates of return, risk tolerance, anticipated withdrawals/contributions, regulatory issues, desired holding periods of asset classes, communications, and short-term and long-term investment goals.

Step Two: Select an investment advisor. Our firm utilizes money managers who use asset class and/or index strategies because we consider market timing and individual stock selection to be unreliable management techniques. We choose to follow asset class investing, which offers an academically sound approach to investing.

Step Three: Determine the appropriate time period to carry out the plan’s investment policy. Use at least a five-year time horizon for investing.

Step Four: Determine the clients’ level of risk, particularly on the downside. For example, a three percent loss might be sustainable while an eight percent drop in a single year may be too aggressive.

Step Five: Set target rates of return for the client’s overall investment portfolio to achieve the stated objectives. Our firm uses a detailed questionnaire and in-depth personal interview to help determine what asset allocation model is suitable and appropriate.

Step Six: Our firm is paid a fee for assets under management. AFA does not receive commissions. Advisors who manage clients’ assets for commissions may be more likely to recommend excessive transactions in the client’s portfolio or recommend securities products that have more favorable payouts to the advisor. As a fiduciary, we must be vigilant regarding cost containment for the benefit of our clients. This is one reason Dimensional Fund Advisors funds are used. They are no load funds and have lower than average internal expenses.

Step Seven: Monitor the investment performance. Our clients receive monthly statements from our custodian, Charles Schwab & Co., as well as all trade confirmations. Our firm provides our clients with a quarterly performance summary through Portfolio Center (which is a direct download from Charles Schwab) as well as reporting on any other securities the client may hold under our management. Using the goal parameters set in Step Five, a client can determine whether the performance of the portfolio is consistent with the objectives established in the written Investment Policy Statement.

Step Eight: Rebalance the portfolio. If an asset differs by more than five percent from its original target allocation, we consider buying more or selling some of the asset to bring it back to its target percentage. This serves to prevent overweighting in any one asset class.

Building a Diversified Portfolio

Background Theory[8]

  1. Eugene F. Fama and Kenneth R. French, University of Chicago, in their “Market Asset Pricing Model” in 1992 stated: (1) Stocks have higher expected returns and risk than fixed income, (2) small company stocks have higher expected returns and risk than higher-priced “growth” stocks, (3) lower-priced “value” stocks have higher expected returns and risk than higher-priced “growth” stocks.
  2. The implications of Fama and French’s research are that there are three investment risks worth taking :
    • Invest in stocks
    • Invest in small companies
    • Invest in value companies

Implementation

Step One:  Bonds vs. Stock Allocation

The first decision is the division between stocks and bonds. This is based on the answers to the client questionnaire and is a function of time frame, risk tolerance and income requirements. A “traditional” pension plan allocation is 60/40 equities/bonds, for example.

Step Two:  Bond Maturity

Research[9] indicates that risk as measured by standard deviation increases dramatically once maturities exceed five years. Our selection of fixed income securities limits maturities to five years because the purpose of fixed income in these portfolios is to reduce volatility, not increase risk as measured by standard deviation.

Step Three:  Large vs. Small[10]

Average expected return (minus t-bills) – average excess return + sensitivity to market (market returns – t-bills) + sensitivity to size (small stocks minus large stocks) + sensitivity to BtM (value stocks minus growth stocks) + random error e(t). Sensitivity to market, size, and BtM comprise “priced risk” (positive expected return, systematic, economic, long-term investing). Random error (e(t)) = noise, error.

Step Four:  Domestic vs. International[11]

U.S. markets and international markets perform differently. Rolling 12 month variances ranged from 0% to >60% from January 1972 – December 2007. Since price variances are not predictable, we hold both domestic and international equities in our portfolios.

Step Five:  Value vs. Growth[12]

“Value” (high book to market) stocks have higher expected returns and risk than “Growth” stocks.

Since variances in performance between “Value” and “Growth” stocks cannot be predicted. We hold both in our portfolios.

SUMMARY:

This summarizes our structured, disciplined approach to investing. We embrace the following principles:[13]

  • Diversification reduces risk.
  • Assets should be evaluated not by individual characteristics but by their effect on a portfolio.
  • An optimal portfolio can be constructed to maximize return for a given risk level.

Structured Investing[14]:

  • Combine Multiple Asset Classes: Seek to combine asset classes that have historically experienced dissimilar return patterns across various financial and economic environments. Diversification does not guarantee a profit or protect against a loss.
  • Diversify Globally: More than 50 percent of the world stock market value is non-U.S., and international markets, as a whole, have historically experienced dissimilar returns patterns to the U.S.
  • Invest in thousands of securities: Compared to a portfolio concentrated in a small number of securities, investing in thousands of securities globally can limit portfolio losses during a severe market decline by reducing company-specific risk.
  • Invest in high quality, short-term fixed income: Fixed income’s role in our portfolios is to reduce volatility. Shorter maturities have historically had low correlations with stocks and high quality instruments are used to lower default risk.

[1] The American Law Institute Restatement of the Law Third, Trusts Prudent Investor Rule (St. Paul, Minnesota: American Law Institute Publishers, 1992) paragraph 227, comment h.
[2] Source: Standard and Poor’s Index vs. Active Group, March 2009 (for the period 1/03-12/08).
[3] Ibbotson and Kaplan, “Does Asset Allocation Policy Explain 40%, 90% or 100% of Performance,” Financial Analysts Journal, April 1999.
[4] For additional information, please visit www.DFAUS.com
[5] Dimensional vs. Russell, June 30, 2009.
[6] Consolidated Balance Sheet, The Charles Schwab Corporation Quarterly Report on Form 10-Q for the Quarter Ended June 30, 2009, page 2.
[7] Note: SIPC and excess SIPC protection do not cover fluctuations in the market value of securities, and are not extended to accounts held by banks or broker/dealers maintained for their own account.
[8] Cross-Section of Expected Stock Returns, Eugene F. Fama and Kenneth R. French, Journal of Finance 47 (1992).
[9] Source: One month U.S. Treasury Bills, Five-Year U.S. Treasury Notes, and Twenty-Year (long term) U.S. Government Bonds provided by Ibbotson Associates. Six-Month U.S. Treasury Bills provided by CRSP (1964-1977) and Merrill Lynch (1978-present).
[10] Dimensional Fund Advisors study (2002) of 44 institutional equity pension plans with $452 billion total assets. Factor analysis run over various time periods, averaging nine years. Total assets based on total plan dollar amounts as of year-end 2001. Average explanatory power (R2) is for the Fama/French equity benchmark universe.
[11] Past performance is not indicative of future results. All investments involve risk. Foreign securities involve additional risks including foreign currency changes, taxes, and different and financial reporting methods. International markets are represented by the MSCI EAFE Index (Morgan Stanley Capital International Europe, Australasia, Far East Index). EAFE represents non-U.S. large stocks. U.S. Market performance represented by the Standard and Poor’s 500 index.
[12] Based on comparison of the growth of a dollar from January 1, 1927 – December 31, 2007 in the Fama/French U.S. Large Growth Index, Fama/French Total U.S. Market Index, and Fama/French U.S. Large Value Index. Indexes are unmanaged baskets of securities that investors cannot directly invest in. Past performance is no guarantee of future results. Hypothetical value of $1 invested at the beginning of 1927 and kept invested through December 31, 2007. Assumes reinvestment of income and no transaction costs or taxes. For illustrative purposes only and not indicative of any investment. An investment cannot be made directly in an index. Total return is represented in U.S. dollars. Value is represented by companies with a book-market ratio in the top 30% of all companies. Growth is represented by companies with a book-to-market ratio in the bottom 30% of all companies.
[13] Diversification and Portfolio Risk – 1952, Harry Markowitz, University of Chicago, 1990 Nobel Prize in Economics.
[14] Past performance is no guarantee of future results.

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