The Function-Centric Investing paradigm or function-centric capital allocation, are concepts I developed and is one of the most dominant aspects of my personal investment philosophy and style (that I use along side value investing). In particular, this paradigm directs the way in which I allocate capital. Functional investing is flexible, adaptive to changes, and is effective in directing investments towards achieving your goals. It is best used with a detailed long term plan.
Whether it be growth, dividend, passive, active, etc., most investment styles & strategies focus on using asset allocation to some degree, where a portfolio is divided by different percentages into asset classes/types and categories.
Common asset classes/types include:
• cash equivalents
• equities / stocks
• fixed income
• precious metals
Common categories of different asset types include:
• GICs, CODs, money market funds, etc.
• large-cap, mid-cap, small-cap
• US, Canadian, European, emerging market
• technology, consumer staples, industrial, financial, utilities, energy, healthcare, etc.
• income trusts
• ETFs, index funds
• bonds (corporate, government, short-term, long-term, US, Canadian, foreign).
• gold & silver bullion, other precious metals.
The most common and conventional asset allocation strategies that are used in many investment styles, have a combination of asset types from a certain category, or a single asset type from different categories. Others use a single asset type or from one category.
• 60% US stocks, 30% US bonds, 10% USD cash equivalents (different asset types, all categorized by US)
• 60% Large-cap, 40% small-cap stocks. (all equities, categorized by different market cap).
• 50% dividend, 50% growth stocks (all equities, categorized by dividend vs growth).
• 100% dividend (categorized only by dividend).
• 100% bonds (categorized by fixed income).
• 100% market index ETFs (categorized by asset type)
But no matter the combination, the allocation of assets adhere to the set percentages, categorizations, and asset classes. So you wouldn’t find any Canadian equities in a portfolio that has an allocation of 60% US stocks, 30% US bonds, and 10% US cash equivalent holdings. Similarly, you wouldn’t find corporate bonds in either an ETF portfolio used by passive investment styles, or in an all equities portfolio used by growth investment styles.
The main idea of function-centric investing is that capital allocation is not directed according to any specific category or asset class. The style is open to any asset regardless of type, industry/sector, or market. Essentially, the allocation of capital is not constrained by percentages to any conventional category. Instead, every asset is meant to fulfill a specific role or function. Each role/function directly contributes to the investor’s goals & priorities, at a particular stage in the investor’s overall long term plan. The investments would satisfy and address each functional area of concern, rather than a particular scheme of asset allocation that is often dictated by inflexible investment styles. The focus is on function & purpose, rather than conventional investment categories (type, sector, market, etc).
Some assets would also be held for longer periods of time or added to, while other assets may be held for shorter periods or reduced. When an asset no longer performs the intended function or is no longer needed for the next stage, it is sold off. The mixture of assets, the category they belong, and the percentage of capital that should be allocated, all depend upon the specific details of the plan. However, those specifics will also likely dictate that the mixture & weighting change at certain stages. Therefore, a portfolio can consist of a wide range of investments, such as inverse ETFs, technology stocks, market-linked GICs, corporate paper, junior mining stocks, currencies, etc., at any given stage.
Main Benefits Of Function-Centric Investing
Function-centric investing is flexible, adaptive, and ensures that each investment is directly contributing towards reaching your goals as detailed in your long term plan.
This style allows you to invest in opportunities or divest away from risks according to changes in economic & investment conditions, without being tied to any particular class / type of asset or market (stocks, real estate, bonds, currencies, precious metals, businesses, etc). This style does not conflict with the need for large changes that may be necessary under certain scenarios within an investor’s plan.
Investors often tend to become fixated on certain asset types or categories (stocks, gold, bonds, real estate, tech, market cap, growth, dividend, ETFs, etc). What typically happens is that material changes occur in economic & investment conditions that impact specific asset types or industries/sectors where the investor has allocated a significant portion or an entire portfolio to them. Sometimes, investors refuse to acknowledge the signs of deterioration related to the specific assets/markets until it is too late. But more likely their set strategy/style and related asset allocation rules leave no room for large changes and cannot adapt when conditions deteriorate. The investor is often left confused and conflicted about their investment style and changing its corresponding asset allocation. The assets or categories deteriorate further while the investor is floating in limbo, the portfolio goes into turmoil, and heavy losses ensue.
During the 2008-2009 financial crisis, many different assets & industries fell together at the same time. Passive investment styles saw market index ETFs plummet. REIT investors saw many real estate companies go belly up or cancel their dividend. Physical real estate investors were left with large amounts of debt and falling property values. Dividend investors who held mainly dividend paying financial stocks suffered large losses from the collapse of many favored “blue chip” financials like Washington Mutual, Fannie Mae, AIG, Lehman, Bear Stearns, etc. Growth investment styles saw many promising start-ups file for CH11, or have had their growth engines put on hold indefinitely as a result of accepting steep financing conditions (due to the lack of credit & liquidity).
However, gold & silver performed very well, as did select currencies, and inverse ETFs (stock indices, real estate, etc). A significant transition to cash holdings, in order to reallocate capital into undervalued assets later, was also a good move. Function-centric investing and capital allocation would allow an investor to switch to any of these assets & categories, depending on the intended purpose (capital preservation, transitional capital, hedging, opportunities of the moment, etc).
But perhaps the most important benefit to function-centric investing & capital allocation is that it provides a meaningful connection between your investments and goals. Every single investment is an important building block in the larger and more complex picture. It helps address each area of concern that may be detailed out in your long term plan. Even when conditions occur that make certain assets/sectors unattractive, the investor can look for replacements that satisfy the same function & purpose to maintain that connection. The functionality/purpose of investments may differ greatly at various stages within your plan. At some point the assets or category may no longer be suitable, and therefore would not be working towards your goals. But this style allows for such changes, whereas conventional asset allocation and investment styles tend to be rigid.
For function-centric investing / capital allocation to really work effectively, one needs to create a detailed long term plan. When I talk about a detailed long term plan, I don’t just mean a plan that has the simple goal of “making money”, “achieving an annual return of 15% per year”, “invest in dividend stocks for passive income in retirement”, or even “to have a net worth of $1,000,000 within 10 years”. Those are just statements that don’t tell you much, similar to “build a 3000 sq ft house”. A statement doesn’t give any direction, whereas a plan would include much more detail in that respect. As you can imagine, the plan has to go beyond the typical “risk tolerance” and “time horizon” terms that are used in the financial industry. It needs to include & handle different scenarios, conditions, stages, priorities, risks, options, etc. But such a detailed plan requires work that most investors may not be willing to take on. Though it’s not quite as much work as you might think!
Catered To The Individual
Why is this style inefficient for large banks and fund companies? Using this style means detailed customization, down to the individual level. The goal of large banks and mutual fund companies is to sell investment products and their services en masse, and therefore they are more interested in total assets under management or client volume. They also cannot deviate from the allocations set out in their prospectuses.
Functional investing is more suited for DIY individual investors, because it requires a detailed plan that integrates an individual’s goals & life events, and includes alternative scenario planning. Institutions can’t spend the required amount of time & effort to create such a plan with all clients. Nor do they know their clients well enough to be able to make one that actually includes all the necessary customizations. The industry has attempted to cater to more individuals by providing different types of funds managed under different investment styles, as replacements for customized plans. However, funds are an investment type, and not a substitute for a plan. There is no fund that can cater to everyone. Only you know your own goals & preferences, down to such a detailed level, including alternative what-if scenarios.
Is Function-Centric Investing Worth Considering?
The benefits of function-centric investing & capital allocation (coupled with a detailed long term plan) have allowed me to consistently achieve positive returns over the course of many years. It has helped me outperform the broader market with low risk, while capitalizing on various trends including market downturns. But more importantly, the returns have directly contributed towards reaching real & tangible goals at various stages of my long term plan. This includes paying for my wedding expenses, my trip to Japan, the ability to pay off my mortgage, etc. It also contributes towards goals that have yet to be reached, such as financial independence among others.
This aspect of my style has also resulted in owning a wide variety of assets across different sectors/markets at various points. It has included physical real estate, gold, various ETFs, bonds, REITs, equities across multiple sectors (pharmaceutical, manufacturing, environmental, …) etc.
Is function-centric investing worth considering? I firmly believe it plays an integral part of netting consistent profits, over the long term, in an ever changing world.
UPCOMING: In an upcoming article, I will expand on the benefits & advantages with examples. I will also be following up with an article on long term planning.
Thanks & Happy Investing! — The Investment Blogger © 2012