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A tale of two investment strategies


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In today's investment world, there is a great debate among money managers about the best approach for investors looking to live off their money. One option is the approach used by many university endowments, pension fund managers, and asset consultants, which involves investing in numerous asset classes with a lot of different money managers. This might include a combination of index funds, private equity funds, hedge funds or even exchange traded funds.

We advocate a more concentrated income-focused investment approach using individual dividend-paying equities. My partner and Northstar CEO Charlie Farrell was featured recently in the Wall Street Journal discussing this very subject.

The "endowment" investment strategy was made famous by David Swenson, the Chief Investment Officer at Yale University. From 1990 through 2007, Swenson's model of investing had phenomenal returns. In fact, his model was so successful most of the asset consulting industry copied it. Swenson's thesis became the basis for modern portfolio theory. For 18 years, this particular way of investing outperformed a balanced investment model consisting of a 60 percent allocation in the S&P 500 Index and 40 percent invested in the Barclay's Aggregate Bond Index.

Swenson made the case that endowments should be fully invested at all times and avoid asset classes with low expected returns such as bonds and commodities. He also had very little of Yale's portfolio invested in U.S. equities, preferring alternative investments, such as private equity, hedge funds, and absolute return funds.

Since the financial crisis and subsequent rebound this endowment model hasn't worked as well for two reasons. First, when the crisis hit in the fall of 2008, most college endowments were too invested in illiquid and hard to sell investments, such as private equity and hedge funds. Since these colleges still had to meet operating expenses and fund major construction projects using their endowments, they were forced to raise cash wherever they could.

When they couldn't sell the investments they had in private equity or hedge funds they were forced to sell debt instead at very high interest rates to meet their obligations. Secondly, once the markets rebounded from the crisis, these endowments didn't experience the benefit of the upswing because they had very little invested in two of the best performing asset classes: large cap U.S equities and long duration U.S Treasury bonds.

Even Warren Buffet invests in large companies that pay dividends just like we do at Northstar. One primary difference in the approach, however, is that he keeps the dividends for Berkshire Hathaway, whereas we provide our clients with a choice.  The dividends can either be paid out to our clients directly or the cash can be reinvested into more shares of dividend paying companies. Buffet is such a believer in owning individual companies that he famously bet that investors in the S & P 500 index would handily beat returns of hedge funds over 10 years. He made this bet in January of 2008, a full nine months before the collapse of Lehman Brothers. Now, with only four years left on the bet, he is ahead by 30 percent.

For the 20 years that Northstar has been in business, we have advocated earning income from your investments in the form of dividends paid by individual companies. We prefer dividends because their returns are never negative. On the other hand, investing to beat the market with a total return approach can be quite negative in bear markets. It can also be very risky to own illiquid investments, particularly during times of stress.

So the question is, what are the baby boomers going to live on as they begin to retire in droves? Projections show that Social Security will barely cover medical expenses. Should they roll the dice and invest in an endowment style portfolio? If they do that, they are largely hoping market prices will keep rising despite a six-year bull market that is getting long in the tooth. Or, should they invest in companies that return some of their profits back to their shareholders in the form of dividends?

We believe selling equity positions to meet income needs is too risky. What happens if the markets fall just when you need cash? Selling at the wrong time will rapidly erode principal at the very worst time. We would much rather own individual equities that pay meaningful dividends and increase their dividends as a hedge to inflation.

I think Warren Buffet would like our investment strategy better.

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Fred Taylor

Fred Taylor is president and co-founder of Northstar Investment Advisors, LLC. The firm specializes in managing personalized investment portfolios for individuals, families, and retirees with a focus on income generation. He is a member of the Colorado Forum and also served as an economic advisor to Colorado Governor Bill Ritter from 2008 to 2010.

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