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Three Things

Three Things
Three Things: The belief in efficient markets has led us to the conclusion that there are only three things an investor can control when he or she is investing: Costs, Taxes, and Asset Allocation.


Investors have many decisions to make when it
comes to investment costs.

  • Individual stocks/bonds or funds?
  • Commissioned mutual fund or a no-load fund?
  • Should you buy funds with high internal expenses (expense ratio) or low internal expenses?
  • Actively managed funds (funds that actively trade to beat a benchmark) or index funds (passively track an index)?
  • Should turnover, which could lead to more taxes, be a consideration?
  • Do you transact business at a discount brokerage or a full-service brokerage?
  • How often should you trade?
  • Should you hire an advisor?
Investing is not free, but Blue Water is dedicated to keeping your costs low.
  • We use no-load, low-cost, institutional mutual funds. The funds we use typically hold hundreds to thousands of stocks. We believe this is a more cost-efficient way of investing than purchasing individual stocks. These funds are not subject to commissions and have very low expense ratios.
  • We use an “asset class” investment approach (see below) which is different than active management and indexing. It’s closer to indexing though because we use a buy-and-hold-approach and only rebalance when necessary. This minimizes transaction costs.
  • The funds we use have low turnover because they typically have an internal buy-and-hold approach as well. Low turnover protects principal because the fund is not continuously subject to bid-ask spreads (the price difference of buying versus selling) like many actively managed mutual funds. Lower turnover also has been shown to reduce taxable distributions.
  • We use a discount brokerage firm as our custodian, which helps keep our clients’ trading costs down.
  • The costs of a fully-allocated portfolio are extremely low. The expense ratios of the portfolios we construct typically range from 0.30% - 0.43% depending on the stock-to-bond ratio. Contrast that to 1.50%, which is the approximate expense ratio of the average equity mutual fund.
  • Our investment management advisory fees are very competitive. Although our fees do add to the expense of investing, we feel our expertise, discipline, institutional fund access, and ongoing management more than pay for themselves. See our Fees page to get an estimate of your total investing costs.
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Taxes are often an over-looked part of the portfolio. Their impact is real though, and they should be managed as effectively as possible. As the saying goes, it’s not what you make, it’s what you keep.

Blue Water is committed to tax efficiency.

  • Our recommended portfolios are implemented across your accounts with the goal to keep taxes at a minimum. We pay particular attention to asset location (placing tax inefficient assets in IRAs and tax-qualified accounts).
  • Our portfolio management and the funds we use are very tax efficient. Low turnover helps control taxable distributions.
  • We have access to tax-managed institutional funds. We use these and municipal bond funds, when appropriate, to reduce taxes and improve your overall after-tax return.
  • Taxes and transaction costs are considered before rebalancing any portfolio.
  • Portfolios are periodically reviewed for tax loss harvesting opportunities. Tax loss harvesting is purposely selling a position to realize a loss for tax reasons and replacing it with a similar investment.

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Asset Allocation:

One of the most important decisions to be made is how to allocate your assets. Your allocation needs to take into account many factors, both personal (goals, risk tolerance, etc.) and theoretical (what assets should be included, what is the expected return and risk, etc.).

Blue Water uses their knowledge of capital markets and Nobel Prize winning financial and economic concepts to craft effective asset allocations and easy-to-use investment strategies.

Our asset allocation decisions are driven by five key factors.

Three Equity Factors: Most finance academics and investment professionals acknowledge that there are three primary factors influencing portfolio returns. These three principles are based on the timeless fundamental that risk and return are directly related.

Market: Stocks have higher expected returns than fixed income. Most investors expect to receive higher returns from stocks than bonds because stocks are riskier. Therefore, the percentage invested in stocks vs. bonds affects overall expected return.

Size: Small company stocks have higher expected returns than large company stocks. Stocks of small companies are riskier than those of large companies. The percentage invested in small vs. large affects overall expected return.

Price: Lower-priced “value” stocks have higher expected returns than higher-priced “growth” stocks. Value stocks are riskier than growth stocks. The percentage invested in value vs. growth affects overall expected return.

The Relevant Factors in Asset Class Structure

Average Annual Returns: 1964-2003.
Equity data courtesy of Fama/French.
Bond data courtesy of © Stocks, Bonds, Bills and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated works by Roger C. Ibbotson and Rex A. Sinquefield).

Investing is not without risk, but some risks you are compensated for and others you are not. Positioning your portfolio to experience the compensated risk factors and minimize the uncompensated risk factors helps increase your expected return and reduce unnecessary portfolio risk.

Example: A person who owns an individual large company stock is taking on a lot of unnecessary risks (specific company risk, industry risk, and perhaps interest rate risk and exchange-rate risk). This person is not consistently rewarded though for the unnecessary risks. They are only rewarded for taking market risk.

A person who owns the S&P 500 index is also only rewarded for market risk (S&P 500 is not considered small or value). This person, however, has minimized their exposure to unnecessary risks through diversification (500 stocks vs.1 stock).

We utilize these three equity factors in our portfolio construction to offer a way to capture expected return premiums greater than the broad stock market.

Two Fixed Income Factors: We believe that the role of fixed income in a portfolio is not to produce income, but to reduce portfolio risk (volatility). We consider these two factors.

Maturity: Longer-term bond investments are riskier than shorter-term bond investments.

Default: Bond investments of lower credit quality are riskier than bond investments of higher credit quality.

Quarterly: 1964-2004.
One-Month Treasury Bills, Five-Year Treasury Notes, and Twenty-Year Government Bonds courtesy of Ibbotson Associates. Six-Month Treasury Bills courtesy of CRSP (1964-1977) and Merrill Lynch (1978-present). One-Year Treasury Notes courtesy of CRSP (1964-May 1991) and Merrill Lynch (June 1991-present).

Historical data does not indicate there has been a reliable return premium for extending maturities into longer bonds. Therefore, we emphasize shorter maturities (6 years and under), higher quality bond issues, and a diversified global approach (currency risk is hedged).

You may not be able to control the direction of the market, but you can control costs, taxes, and asset allocation. Concentrate on these three things and diversify against the risks you cannot control.

At Blue Water, we offer very effective portfolio management. Your assets are positioned in an extremely diversified portfolio to best accomplish your financial goals.

Once your asset allocation is designed, we primarily use “asset class” funds to implement our strategy. Asset class funds are dedicated to covering a particular risk exposure, or asset class (large value, international, etc.). They are not subject to the style drift and turnover of actively managed funds. Asset class funds also provide much broader, deeper coverage of the chosen asset classes than traditional index funds. Ongoing monitoring, periodic rebalancing, performance reports, and meetings are used to keep your portfolio on track and adjust to life’s changes.

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