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Frequently Asked Questions

Why does Third Day Capital focus on individuals?

Individuals and institutions (e.g. pension funds, insurance company investments, state employee benefit funds, etc) have, in many cases, mutually exclusive objectives and parameters, and as a result, providing investment management services for institutions typically subjects individuals to an investment management style that works against their goals and objectives. The following table summarizes the various aspects of investment management for individuals and institutions.

As you can see, institutions are driven by a completely different set of objectives. Institutions are generally tax-exempt, and hence, do not ascribe any value to “tax-sensitive investing”. Therefore, holding periods can be much shorter without incurring the negative tax consequences associated with speculation. Institutions’ singular focus on investment performance, coupled with the highly competitive nature of the investment management industry, results in institutions pursuing very short-term investment performance because there are literally thousands of other investment managers performing better at that point in time.

As a result, institutions place an onerous burden on investment managers to show continued relative out-performance over periods as short as 3 months. Hence, institutional investment managers are incented to engage in activities that boost short-term performance at the expense of long-term capital growth, such as high trading activity and short investment horizons. Stocks that are performing well relative to the broad markets at that point in time (called momentum stocks) become very attractive, and are often used to boost near term performance despite the increasingly likelihood that at some point those stocks will suffer larger than average declines.

Unless significant barriers are erected between an advisor’s investment process used for institutional and individual clients, individual clients are forced to accept an investment process that is contrary to their specific goals and interests. Advisors are reluctant to erect such barriers, because it would mean a significant increase in expenses and infrastructure, and significantly reduce the profitability of the advisory firm.

Rather than subject our clients to the institutional pressures or erect the barriers necessary to protect our individual clients from the institutional investment process, we focus solely on individuals and their families by providing the advice and quality of service they require.

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Why should individuals focus on the return of the portfolio first and foremost relative to the required rate of return necessary to achieve their goals?

Individuals invest to achieve specific goals that are unique, and as such, must achieve a specific rate of return to achieve those goals. In our opinion, an investment program should be evaluated against the progress towards those goals. For example, if a client wishes to create an educational fund for their grandchildren, the portfolio must achieve a minimum return based on how much money is invested and when, and what the expected educational costs will be. The fact that the markets go up or down does not alter the goal or the required rate of return to achieve that goal.

The market’s performance provides some useful information about the environment in which the client is attempting to achieve their goals. However, clients that compare their portfolio’s performance against a benchmark such as the Dow Jones Industrial Average (a mere 30 stocks out of a universe of more than 3,000), lose sight of the purpose of the portfolio and its goals, and instead get caught up in the game that institutional investors play.

Moreover, while the performance of an equity index makes good dinner conversation, index returns are not applicable to individual clients in a real-life setting. Other factors such as taxes, transaction costs, inflation, risk, volatility, emotional attachment to a security, and bear markets distance an index from what most clients generally seek: the preservation of wealth, such that over time, their after-tax, after-inflation return is sufficient to accomplish their specific goals.

Clients should always evaluate the performance of the portfolio first and foremost against the progress it is making toward achieving the investment objective(s), and then if they wish, to compare its performance against a broader benchmark.

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Why does Third Day Capital use individual stocks and bonds as opposed to mutual funds?

Individual stocks and bonds allow an investor to custom-tailor their portfolio to suit their needs. While mutual funds are valuable for investors without the means to build a properly diversified portfolio, investors with portfolios that exceed approximately $100,000 can feasibly build a diversified portfolio without incurring exceptional expenses. Empirical evidence suggests that the minimum number of stocks required to build a diversified portfolio is about 25-30, which equates to about $3,000 to $4,000 per stock, an amount that allows an investor to purchase enough shares to benefit from lower transaction costs.

Unlike mutual funds, investors using individual stocks and bonds can select securities that match their investment horizon, forego specific companies that they deem to be unattractive due to various industry and/or social considerations, and exert much greater control over the tax-efficiency of a portfolio, often at a lower cost than mutual funds.

Mutual funds invest based on the collective investment objectives of the investors in the fund, hence the term “Mutual”. This by definition means that the mutual fund will not and cannot invest according to the unique investment objectives of each, individual investor in the fund. As a result, each mutual fund investor must forego a customized investment portfolio in favor of an investment approach that applies to the “lowest common denominator”. While investors in a specific fund may share similar goals, there can be a wide range of goals when a mutual fund is investing on behalf of hundreds of thousands, if not millions of individual investors.

The mutual fund industry’s competitiveness can work against an individual investor in much the same way institutional investors work against individual investors. With more than 7,000 mutual funds to choose from, many investors have embraced a “what have you done for me lately” mentality and select mutual funds based solely on short-term performance metrics. If a fund performs well, it stands to attract a significant amount of new money, but the reverse is also true. If a fund’s performance is poor and investors withdraw enough money, the fund is forced to liquidate stocks to cover the withdrawals. This forced selling can result in a self-perpetuating feedback loop, whereby the fund must sell its stocks to cover redemptions, which brings the price of its stocks down, which further depresses performance, creating more redemptions and more forced sales. Patient investors who correctly espouse a long-term investment approach for stocks generally suffer significant losses in such a situation.

The hyper-competitiveness of the industry can lead to investment practices that, while not illegal, are unethical and detrimental to all of its investors. If a fund espouses a specific investment style (e.g. large cap value), and that style begins to underperform other styles (this is a natural phenomenon in the markets as investors move from greedy to fearful and back over time), the fund manager is tempted to change the style of the fund to match “what is working” at the time. This is referred to as “style creep”, and is effectively a bait and switch tactic used to prevent investors from withdrawing money. But investors, if they are not paying attention, end up investing in a manner other than what they originally intended, and likely do not want. There are a number of other marketing gimmicks mutual fund managers play, but for the sake of time and space, we’ll refrain from expanding on them here. If you have further questions, or would like to discuss the matter further, feel free to contact us.

The vast majority of mutual funds are not invested based on tax considerations, since a significant amount of money invested in them is non-taxable retirement money in IRA’s or 401k’s. Taxes are a critical element in determining whether a client achieves their goals. In addition, investors who purchase shares in a mutual fund are buying tax liabilities on capital gains that were previously generated but not realized. These liabilities are called embedded capital gains, and are only passed on to investors in the fund when the capital gain is realized (i.e. the stock is sold). As a result, it is possible for an investor to purchase shares of a mutual fund and incur capital gains taxes even if the share price of the fund goes down. This is the worst case scenario for a mutual fund investor, who not only lost money on the value of the fund, but is now required to pay taxes on the gains generated prior to their investment and which they did not benefit from. Granted, the investor could sell the shares of the mutual fund and realize a loss to help offset the gains the fund distributed; however the loss may not fully offset the gains, and transaction costs such as loads reduce the benefit of doing so.

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Why does Third Day Capital not use low-cost index funds?

Index funds came to prominence as the result of empirical evidence that suggests the markets are “efficient” and that outperforming the broader market is difficult to achieve over time. The basis for this stance is the notion that investors are rational, and as such, the price of a stock reflects all of the publicly available information about the company at that point in time. Without an information edge, investors should seek to invest in properly valued stocks at the lowest possible cost.

While markets may achieve some form of “efficiency” over time, there are periods when markets are “inefficient”. Investors are not rational, and emotional factors such as greed and fear are impossible to eliminate, even for professional investors. As such, there are periods in which stocks are not “properly priced”, giving investors the opportunity to generate above market returns.

However, we don’t use index funds for a more important reason: index funds were created based on the premise that an investor’s required rate of return is equal to the market’s rate of return. In fact, it is not. As discussed above in question # 2, individual investors should not, except in rare situations, equate the rate of return required to meet their objectives to the market rate of return.

Markets simultaneously reflect all investors’ objectives but do not reflect each investor’s objectives. Taking our example of a commingled mutual fund even further, consider the markets as the collective mechanism by which all investors work to achieve their specific objectives. As such, the markets comprise the collective investment objectives of millions of investors, some of which are individuals, some are institutions, some are taxable, some are non-taxable, some are short-term investors, and some are long term. It is this collective mechanism that index funds are designed to address.

Hence, individual investors should not be willing to accept the market’s collective objectives, risk tolerances, volatility, and rate of return. Instead, they should pursue an investment policy that suits their own unique objectives, risk tolerances, volatility, and required rate of return. Unless individual investors pursue their own investment policies, supported by a customized portfolio, they, by default, accept the market’s collective objectives, risk tolerances, volatility and rate of return as their own. Doing so greatly increases the risk the individual investor will fail to achieve their own objectives.

Because we are singularly focused on helping our clients achieve their own, unique objectives, Index funds have no role to play in our clients portfolios.

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How is Third Day Capital’s investment approach unique?

Our unique investment approach is a result of our unique backgrounds. Our experience is both broad and deep, including economics, general business evaluation, accounting and financial statement reporting, and fundamental securities research. We have experience performing comprehensive, fundamentally-based due diligence on companies in every industry, which we apply to every company we evaluate. Our experience allows us to build the tools necessary to efficiently gather and process a significant amount of information, something very few firms focused on working with individuals can replicate.

We perform the due diligence first-hand, and by doing so, ensure that the companies in which we invest are appropriate for each and every one of our client’s unique investment objectives. While we rely on some of the same informational sources as other advisors do in order to create an efficient process, our experience allows us to dig further and develop our own independent assessment of a company’s investment merits. We interview management teams, visit their facilities, and speak with their customers, suppliers and competitors in an effort to fully understand how they operate, what risks they face, what opportunities they can capture, and most importantly, what the business is worth today and what it is likely to be worth in five years.

We build our own detailed financial projections that help us make an independent determination about how the company is likely to perform going forward, and if the investment thesis is correct, how the company should perform going forward. We use our internally-generated financial projections of profits, assets, liabilities, cash flow, returns on capital and company value as the road map for success, and frequently evaluate the company’s actual performance against our expectations. Our accounting backgrounds allow us to scour financial statements and incorporate items that don’t make their way into the conventional financial statements, such as pension obligations, stock options issuance and expenses, and operating leases.

We take our research process one step further, by expanding our efforts to the international stage. Historically, only large, multi-national corporations could target international markets or had to worry about foreign competitors. However, with the extension of trade partnerships, more efficient foreign currency trading mechanisms, and highly integrated logistics and transportation networks, companies of any size can target international markets today. These represent large opportunities, but also significant risks, since smaller foreign companies can just as easily target the U.S. markets. As such, we believe that advisors who only focus on domestic companies miss an increasingly important aspect of a company’s business prospects. More importantly, however, advisors that don’t incorporate a company’s foreign competitors into its investment thesis miss an increasingly important source of risk.

We do not rely on outside sources to make the investment decisions for us. Few financial advisors working solely with individuals have the experience necessary to perform the first-hand due diligence necessary to make informed decisions. The financial industry is separated between institutional and individual investment management, and seldom do the two cross-populate. Professionals that enter the institutional arena are trained to perform the same level of due diligence we perform, but remain in the institutional arena as analysts and portfolio managers of mutual funds and institutional portfolios. Institutional investors do not gain the experience and expertise necessary to work with the complicated affairs of individual clients. Financial advisors are the direct opposite; they have the experience and expertise to work with individuals, but most likely have never been exposed to the meticulous due diligence process that we undertake. As a result, they rely on Wall Street research, newspapers, and other second-hand publications and informational sources to make their investment decisions.

We believe we are our clients best advocates, and have structured the firm to ensure we can act as their advocates in the financial markets.

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Why do other firms split the role of financial advisor and investment manager?

Financial advisors split the roles primarily because finding talented individuals who have experience working with the complexities of individuals and families and have the expertise to successfully evaluate securities and make investment management decisions is difficult, to say the least. The investment management industry is a dichotomy, whereby financial professionals choose one of two mutually exclusive paths:

  • institutional investment management where professionals focus on securities research and portfolio management without regard to financial planning, transaction costs, tax implications, or other important factors that individual investors must address, or
  • “retail” financial advice focused on financial planning, asset allocation, and mutual fund selection without any meaningful exposure to securities research or fundamentally evaluating businesses.

Our broad experience in both the institutional investment management and personal financial advisory realms allow us to successfully perform both roles. We marry the sophisticated investment selection processes utilized by mutual funds and other institutional investors with the considerations individual investors must face to produce a custom-tailored, professionally invested portfolio that seeks to maximize our clients’ after-tax, after-inflation wealth.

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Why does Third Day Capital focus first on wealth preservation, and secondarily on wealth appreciation?

Due to the exponential relationship between losses and gains, wealth preservation is a prerequisite to wealth appreciation. Consider the simple math: A client that loses 33% in their portfolio during one period must achieve a 50% rate of return in the next period simply to break even. As a result, clients that wish to generate wealth appreciation over time must first work to preserve wealth.

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How does Third Day Capital ensure client assets are safe?

Please see our discussion regarding our custodian, here.

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How is Third Day Capital compensated for its services?

We charge a fee based on a percentage of the assets we manage. It is an all inclusive fee, with the exception of trading costs, which our clients pay to the brokers used to execute their trades. We do not charge extra for various services, but rather attempt to provide our clients with comprehensive wealth management services for one, simple fee.

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Why is it important for Third Day Capital to have discretionary authority to invest client assets.

We request, and generally receive, discretionary authority from our clients principally because it allows us to invest their assets more efficiently. Opportunities in the markets are often fleeting, and being able to act efficiently allows us to capitalize on those opportunities.

We work with our clients up front to define an investment program that is appropriate for them. Moreover, we encourage our clients to place any restrictions on the portfolio they wish. Once the investment policy statement is defined and restrictions are documented, our clients trust us to implement the program on a day to day basis. In an effort to build trust, we frequently consult with our clients during the early stages of the relationship, and often discuss specific investments that will likely become part of their portfolio prior to making those investments. As the relationship matures and mutual trust is built, we generally buy and sell stocks according to the investment policy statement and discuss our actions with our clients at the end of the quarter.

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How often are client portfolios reviewed?

Client portfolios are reviewed at least every quarter to maintain compliance with the investment policy statement. However, we are frequently reviewing our clients’ portfolios throughout the quarter to ensure their compliance with their investment policy statements.

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Do you work with clients’ legal and tax professionals?

Yes. We prefer to work closely with our clients’ legal and tax professionals, and any other professionals they deem important. We try to provide support to our clients’ other professionals, by providing the information they need in a timely manner, and working with them to understand our clients’ goals and objectives so that we can work as a team to accomplish them. We would be happy to speak with your legal and/or tax professionals as part of your due diligence process.

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Can I meet my advisor at a time and place that is convenient for me?

Yes. We pride ourselves on our desire to meet our clients when and where it is convenient for them, including coming to their house if desired. We recognize that an important aspect of our value as an advisor is how and when we meet with our clients.

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Can I view my accounts online?

Yes. Our custodian provides the online functionality, and we encourage our clients to take a proactive role with their investments. However, we stress that we provide online access to clients as a service to them to periodically gather information about their accounts, and caution our clients against using the online access as a tool to evaluate portfolio and market fluctuations on a daily basis.

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What is a Digital Signature, and why do you use one?

A digital signature is a tool we use to help ensure our electronic communications with our clients are safe and secure. When you receive an email message from us that contains our digital signature, you can feel confident that 1) it came from us and is not a hoax, and 2) that the message was unchanged during delivery.

Moreover, if clients wish to, they can use our digital signature to encrypt messages and documents prior to sending them to us. We retain a second component of the digital signature, called the “private key”, that allows us to read the encrypted message. As long as our private key remains private, we will be the only ones capable of reading the message or document. For more information on how you can communicate with us safely and securely, feel free to contact us.

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