All truths are easy to understand once they are discovered; the point is to discover them.”
- Galileo Galilei

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Glossary

Active Vs. Passive

As you familiarize yourself with Principia, you will quickly notice our strong focus on implementing a passive asset class management approach as the best investment strategy to offer our clients. While each investor has distinct objectives, investors tend to fall into two general groups for the core of their portfolios - they adopt either an actively managed or passively managed investment approach.

An Efficient Debate
A long-standing debate about the stock markets has been whether or not they are "efficient." The Efficient Market Hypothesis (EMH) is the basis for the body of academic work known as Modern Portfolio Theory, upon which the American Law Institute built its prudent investing guidelines for trust fiduciaries. EMH states that markets quickly and accurately reflect available information, and are setting "fair" prices for buyer and seller. Inefficient markets, in contrast, would enable a savvy investor to exploit security prices that do not accurately reflect all available information or do not respond quickly to new information.

Few would argue either extreme - that markets are purely efficient or inefficient. But those who actively invest believe that markets are at least inefficient enough to make it worth the treasure hunt. They will pay the costs involved in attempting to find mispriced stocks, bonds, sectors or markets to buy and sell. We heed the academic evidence indicating that markets are too efficient to accept the costs involved in identifying mispriced securities.

Investors Can Be Their Own Worst Enemies
Despite the academic evidence, many investors still are tempted to pursue that undiscovered stock-picking method or broker who can successfully pick the winners and avoid the losers. Behavioral economists have studied this tendency toward investor overconfidence - as well as a large array of behavioral traits (such as regret avoidance, irrational exuberance, and the endowment effect, to name just a few).

Illuminating these ingrained behavioral instincts under the light of academic scrutiny, researchers have detected numerous examples of how they can have a significant negative impact on a portfolio's long-term outcome for those who are unwary of their existence. To provide one example related to overconfidence, the consulting firm FutureMetrics studies the performance of major U.S. corporate pension plans; their most recent analysis included 201 firms during the 17-year period 1987-2003. Out of the 201 pension plans attempting to outperform the benchmark, 13 percent (26 plans) succeeded. Eighty-seven percent failed to outperform the simple passive benchmark. It would be logical to assume that individual investors, with far fewer resources available to them, would likely fare even worse.

What is an Investment Policy Statement?

An Investment Policy Statement (IPS) is a written document that serves two major functions. First, it is a blueprint in the building of investment portfolios. Second, it becomes a written business plan in the ongoing strategic management of investments. The purpose of an Investment Policy Statement is to provide meaningful direction and guidance for individuals, trustees, and investment professionals regarding the strategic placement and management of investment assets based on established and documented investment goals and objectives. Additionally, an Investment Policy Statement is intended to ensure prudence in the implementation of the investment program, yet include parameters that allow for enough flexibility to capture investment opportunities.

Read the Principia Investment Policy Statement

Fiduciary

Black's Law Dictionary describes a fiduciary relationship as "one founded on trust or confidence reposed by one person in the integrity and fidelity of another." A fiduciary has a duty to act primarily for the client's benefit in matters connected with the undertaking and not for the fiduciary's own personal interest. Scrupulous good faith and candor are always required. Fiduciaries must always act in complete fairness and may not ever exert any influence or pressure, take selfish advantage, or deal with the client in such a way that it benefits themselves or prejudices the client. Business shrewdness, hard bargaining, and taking advantage of the forgetfulness or negligence of the client are totally prohibited by a fiduciary.

As fiduciaries, investment advisors must make fair and complete disclosure of all material facts and must employ reasonable care to avoid misleading their clients. The utmost good faith is required in all their dealings. Simply put, fiduciaries must exhibit the highest form of trust, fidelity and confidence, and are expected to act in the best interest of their clients at all times. The distinction between an investment advisor or financial planner with a fiduciary interest and a salesperson is crucial. An investment advisor, under common law and by some statutes, is a fiduciary. An investment advisor must always provide services and advice in the best interests of the client. Whereas salespeople may have their own motives and interests at heart and offer goods and services for a price, a fiduciary must serve the client, if necessary at the cost of the fiduciary's own interests.

Rebalancing

Once a portfolio is formed, the asset class proportions comprising the allocation will diverge from the target proportions as security prices fluctuate. Left free to drift, a portfolio can evolve into an asset mix with decidedly different risk and return characteristics than the target mix. This drift automatically ensures that a portfolio is overexposed to asset classes at their market highs and underexposed to them at their market lows. In order to rebalance a portfolio to the target proportions money must be periodically reallocated from the most recent better-performing investments to the relative underperformers. In this sense rebalancing is inherently "buy low, sell high" or contrarian in nature.

Some advisors rebalance through an automated process. This can create excess trading and expenses and prevent high-performing asset classes from contributing adequately to returns. At Principia we personally review stock/bond ratios and individual equity asset allocations for each client every quarter. We suggest rebalancing when asset classes have significantly diverged from the client's investment model.

Tax Management

Recognizing that some clients are tax-sensitive while others are tax-exempt, Principia offers several tax-managed strategies that target market segments like value stocks and small cap stocks, which have higher expected returns but are otherwise costly or unsuitable for taxable investors. The tax-managed strategies deliver the same consistent exposure to their asset classes that Principia is known for, but with a special emphasis on maximizing after-tax returns.

Like other tax-managed portfolios, Principia's strategies offset capital gains and losses, but they don't stop there. Equity portfolios generate dividends that traditional tax management typically ignores-in spite of the fact that taxes from dividends are often stronger than taxes from capital gains. This is especially true among small cap and value stocks that distribute more income than larger cap growth stocks. The challenge becomes reducing dividends without diluting exposure to the factors that drive returns. Principia's tax-managed strategies simultaneously attempt to minimize taxable gains and dividend yield with specific exposure to the economic factors in returns, without sacrificing precise asset class exposure and solid, broad diversification.

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