Is it possible to outperform the market?
Plenty of active managers compete for your investment business, so clearly, there are enough people in the world who believe they can.
We cannot speak for those active managers, but we can share the following that we hold to be universal truths:
- No one has a crystal ball, and as a result, no one can predict what will happen tomorrow or certainly in the next year.
- Markets are efficient, with all known information available to investors and professionals alike.
- According to Morningstar, It was basically a coin flip whether an actively managed mutual fund or ETF outperformed its average passive peer from July 2023 through June 2024.
- The US large-cap market has been particularly challenging for active managers. Just 20% of them survived and beat their average passive rival over the decade through June 2024.
- At M3 Family Office, we believe that returns are driven by asset allocation and time in the market riding the long-term growth of the economy. However, it is planning, cash flow and tax minimization strategy that we call planning alpha that can be the key differentiator in the successful outcomes for our clients.
In this article, we’ll explore these points to illustrate our approach to developing a sound financial plan.
The Myth of Beating the Market
The thought of consistently beating the market is seductive, but it does not hold water in practice.
There’s one simple reason for this: markets are efficient.
Thanks to the Internet, you have an unlimited supply of information readily available. So do investment professionals and PhDs. With so much information for everyone, it is extremely rare to gain a competitive edge.
To paraphrase Burton Malkiel’s joke about the efficient market professor whose student saw a $100 bill on the sidewalk, don’t bother reaching for it—if there were $100 lying on the ground, someone would have found it by now.
In inefficient markets like private equity, you may be able to access information others do not yet have. But in an efficient market like the US economy, there is no room for arbitrage. Rather than try to get lucky or time the market (which requires knowing exactly when to leave and when to rejoin), it’s far better to focus on time in the market and ride the long-term growth of the economy.
Don’t Beat the Market, Join it and Take a Bucket Approach to Your Wealth
As Warren Buffett said, the market is a voting machine in the short run and a weighing machine in the long run.
As time in the market marches on, the odds tip in your favor away from a game of chance. This focus on growing with the market rather than outsmarting it also frees you up to focus on more critical aspects of your financial plan. Things like setting up an asset allocation to match your financial plan and reaping tax benefits along the way. Warren Buffet also said, Don’t put your money into the stock market unless you are prepared for it to decline 50%. Equity markets are like a fine wine or scotch that needs time to mature. Although you can catch lightning in a bottle like Nividia the past two years, we encourage clients to be investors instead of traders and allow a diversified portfolio to provide long term positive returns. Bears markets and multiple compressions happen, and a correction of 20% or more can pull a portfolio of quality companies down. In these valleys of anxiety, it is essential to have the perspective of duration and understand that the allocation to stocks is long term, 5 years or longer, and this too will pass.
With planning and duration in mind, we take a three-bucket approach to achieve this for our clients:
- Money you need now
- Money you need in the near term
- Money you need in the long term
Money You Need Now
Firstly, it’s important to set aside safe money you think you will need in the short term, either to cover immediate expenses, cash flow, capital calls or to reserve a balance for emergency savings. Whether you follow the 3, 6, or 12-month savings rule, we recommend keeping this money in the highest-yielding money market account that we can provide.
Money You Need in the Near Term
The money you may need in the near term should also be shielded from equity risk, whether for, capital calls, tax payments, tuition, or future expenses, should be in a safe but higher-interest yet easily accessible investment.
We recommend a ladder approach to US Treasuries. There’s a lot to love about US Treasuries:
- They are relatively safe and backed by the US government.
- They earn more than most savings accounts and some CDs.
- They are exempt from state and local taxes.
- A ladder approach allows you to lock in current maximum rates for the duration that matches your cash flow.
Money You Need in the Long Term
Longer-term funds allow you to build wealth over time and ride out the inevitable short-term dips along the way.
Riskier investments like stocks are a great option here. Rather than trying to find a needle in a haystack and select individual companies, we recommend buying the whole haystack in low-cost, tax-efficient broad index funds or model portfolios from some of our leading providers (Vanguard, State Street Global Advisors, Fidelity, Goldman, Zacks Advisors or JP Morgan) to ride the wave and invest in the long-term growth of the US and global economy. Through diversification, tax-loss harvesting, strategic giving, and rebalancing, you can grow your wealth over time while minimizing your tax burden (or offsetting income). These options are designed to participate in the market without moving out on the risk curve to attempt to outperform it.
Direct Indexing and Tax Alpha
Rather than try to outperform the market, we recommend seeking tax alpha.
You can select a market index to replicate, such as the S&P 500, NASDAQ 100, or DJIA. In any given year that has market growth, such as 2024, the S&P 500 is up over 24%. However, a good portion of the performance may be driven by top-performing stocks in the index, such as the Magnificent Seven.
There may be many holdings in the index that have losses for the year. In an ETF, if the S&P 500 is up 24%, there is no way to earn any tax alpha. However, in a direct indexing strategy, you can own all the holdings in a particular index in a SMA (separately managed account), to earn a market return for your benchmark. The added benefit here is that direct ownership expands your opportunities for tax-loss harvesting those positions with a loss. This capital loss will offset other investment capital gains. This gives you greater flexibility to influence your tax bill come April and enhance your overall return.
Beyond market benchmark returns, many clients have an interest in our Market Tilt portfolios. This allows you to set aside funds you are willing to gamble on thematic portfolios, M3 provides options such as:
- M3 Alpha Tilts
- AI, Chips, and Big Data
- Dividend Blue Chip Stocks
- Earning Stable & Wide Moats
- FinTech
- Gig Economy
- Crypto and Blockchain
- Energy
- Cybersecurity
Why call this gambling? Because as we illustrated earlier, you cannot time the market and may be subject to outsized gains when you’re right (or lucky), and outsized losses when you’re wrong.
Grow With the Market, Reap Tax Benefits – That’s the M3 Difference
If you take a room full of Warren Buffetts, give them every advantage, give them the very best data, and have them pour over the financial metrics day in and day out, then chances are good that they could add value to your portfolio.
But in the long run, that same collection of sage investment managers would only outperform their passive counterparts by a mere 1%, and that’s before charging a hefty fee for their services.
Compare that to an approach that tracks you with the market’s long-term performance while adjusting your plan based on the needs and demands of your life and reaps every possible tax benefit along the way.
That’s how we think about investing.
At M3 Family Office, we focus on establishing a wealth plan to meet your needs at any stage. This includes asset allocation, cash flow management, income and estate tax minimization, insurance planning, and private equity services. With M3 Family Office, you’re not paying for advice that may or may not work in any given year, we’re providing you with a blueprint and operating system to grow your wealth and pass it on to the next generation.