John O’Connor
Cherry Tree Wealth Management
What is your overall investment philosophy?
Our investment philosophy is a combination of indexing and factor investing. We believe that markets are efficient, but there are some factors or common characteristics which can help investors outperform the market over long time periods. We look for factors that work in different market environments and all around the world. The factors we use include value, company size, profitability and low volatility. They don’t work every year, but over time they have added considerable value.
We use high-quality bond funds as the ballast of our portfolio. Bonds provide stability for clients who are withdrawing money and serve as dry powder when buying opportunities arise in the stock market. If you look back at 2008, one of the only real diversifiers was high-quality bonds. Pretty much everything else went down.
What model portfolios do you offer clients?
We create custom portfolios of mutual funds and ETFs for all our clients. We start by taking a deep dive into the client’s goals and risk tolerance. Using custom portfolios allows us to tailor the fund choices to each individual situation. Do they have taxable or tax-deferred accounts? Do they live in a high income tax state? Do they want to emphasize sustainable or socially responsible investments?
We give our advisors guidance on how to build a portfolio and then we trust each advisor to make the best choice for the clients. We recommend that advisors invest between 25% and 40% of the typical client’s stocks internationally. We also recommend moderate tilts to factors we like, but we advise against getting too aggressive. While factors can add to returns, they also have periods when they underperform. It’s important to help smooth out those periods to help clients maintain confidence in the strategy.
Our sample portfolio is appropriate for a Minnesota resident who is in a high tax bracket and wants a moderate amount of risk (see chart). There are no socially responsible funds included, but we do have fund solutions for that.
How do you use active and passive funds?
We use a blend of active and passive funds, but not in the way you might think. We skip traditional, high-cost active management. Studies show that it’s not a winning game. Instead, we use rules-based asset allocation funds such as those from Dimensional Fund Advisors. Purists would not call these funds passive because they make subtle improvements to indexing. We don’t get caught up in the debate about whether a fund is passive or active. The most important thing that we look for in funds is consistency in the investment process and low costs. That leads us toward pure indexing products as well.
Are there any managers you have high conviction in?
We have high conviction in many funds from Dimensional, Vanguard and WisdomTree. This is based on our shared philosophy and their proven processes. As such, we are more interested in the thought leaders at these companies than the portfolio managers. People such as Eugene Fama, Kenneth French, Joe Davis and Jeremy Siegel inspire a lot of the innovation at these companies.
Any changes in allocations or managers from last year?
All of our portfolios have target bands set for stocks and bonds. When one area does really well, we trim some to bring it back to its target. US small-cap stocks have done really well this year. As a result, we have been trimming those and moving that money to bonds. We have also started slowly adding to emerging markets, as those stocks have gone on sale. They could still go lower, but we believe that in 10 years’ time we’ll be happy that we started buying now.
