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This is the 5th piece in our Positioning for 2012 series. Readers can find the entire Positioning For 2012 series here.

Larry Swedroe is principal and director of research for both Buckingham Asset Management, LLC, a Registered Investment Advisor firm in St. Louis, Mo, and BAM Advisor Services, LLC, a service provider to investment advisors across the country, most of whom are affiliated with CPA firms. BAM Advisor Services currently has 130 participating firms. Buckingham currently has $3.5 Billion in assets under management, while the BAM network of advisors has an additional $10.9 Billion in AUM.

Swedroe was among the first authors to publish a book that explained passive investing in layman’s terms — The Only Guide to a Winning Investment Strategy You'll Ever Need. He has authored or co-authored 10 more books including 2011's The Quest for Alpha and Investment Mistakes Even Smart Investors Make and How to Avoid Them (which hit bookshelves in November). Swedroe authors the Wise Investing blog for CBS’s personal finance Web site

Seeking Alpha's Jonathan Liss recently spoke with Larry to find out how he planned to position clients in 2012 in light of his unique understanding of how concepts like risk, diversification and long-term asset class returns interact in properly constructed portfolios.

General Portfolio Strategy

Seeking Alpha (SA): How would you generally describe Buckingham's investing style/philosophy?

Larry Swedroe (LS): None of our advice is based on our opinions. Instead, it is based on what could be called the science of investing, [mainly based on] evidence from peer reviewed academic journals. And the evidence is overwhelming that the strategy most likely to allow you to achieve your goals is a passive one.

Thus, our investment strategy is to avoid the typical focus on trying to manage returns, something that cannot be done, but instead focusing on the things we actually can control, the amount of risk we take, diversifying those risks away as much as possible, keeping costs low and keeping tax efficiency high.

We use passively managed funds for equities and commodities and individual bond ladders for fixed income (except for small accounts where funds are used).

SA: Within equities, are there any particular sectors or themes you are currently overweight or underweight?

LS: We avoid investing in sectors as we view that as speculation, not investing. We tend to have high allocations to value and small stocks relative to the market weightings. That allows us to diversify across risk factors and also to use the risk premiums in small and value to hold less overall beta exposure. That in turn reduces the potential dispersion of returns, or what might be called “tail risk.” Also, our clients typically have low correlation of their human capital to the risks of small and value stocks.

SA: Which asset classes or investment styles are you overweight? Which are you underweight? Why?

LS: We tend to underweight growth and especially small growth. Small growth stocks have been found to be what might be called the black hole of investing. The same is true of all stocks that have what could be called “the lottery effect.” Investors try to hit the home run and end up overpaying for these stocks. In the case of small growth stocks it is caused by trying to find the next Microsoft (MSFT). But the same effect can be found in penny stocks, stocks in bankruptcy and IPOs (which we also avoid).

SA: Was there an asset class that exceeded your expectations in 2011?

LS: Bond returns outperformed our expectations, which are always equal to the current yields. We don’t make any interest rate forecasts, and we minimize credit risks, generally avoiding corporate bonds for example and only investing in AAA/AA munis.

SA: To which index or fund - if any - do you benchmark your performance? Has this changed recently, and if so, why?

LS: Every client has a portfolio that is tailored to their unique situation. Thus, they have a unique asset allocation that is right for them.

Since we use only passive portfolios, their portfolios are in effect their own benchmarks. Or one could compare the returns to a similarly weighted portfolio of index funds (we generally use the funds of DFA and Bridgeway, not index funds).

SA: Why do you prefer DFA and Bridgeway funds specifically?

LS: Index funds are great vehicles. But a well-designed passively managed fund will take all the benefits of indexing (low cost, broad diversification, low turnover and thus high tax efficiency) and add further value through structure. And they can add value by minimizing the negatives of indexing including forced turnover and inclusion of all securities in an index.

For example, these funds can tax manage (avoiding intentionally taking short-term gains and harvest losses) and avoid the negative effects of reconstituting transparent indices. They can also add value by intelligent, patient trading, avoiding forced trades index funds must make to avoid tracking error. And being a provider of liquidity rather than a taker. They can also add value by adding screens to eliminate investing in IPOs, penny stocks and stocks in bankruptcy that have been shown by research to have poor risk/return characteristics. And they can add value by including momentum screens.

Bridgeway and DFA are the two equity fund families we currently use to implement passive strategies. Bridgeway, through its OMNI Small Value funds (BOSVX) (BOTSX), adds value through both structure and patient trading and screening for momentum. Instead of a simple single screen, such as BtM (Book to Market), Bridgeway uses four value screens and also has greater exposure to the small and value risk factors than the typical small value index fund.

DFA funds add value in similar ways and they also have core funds, or multi asset class funds, that reduce trading costs, reduce turnover and thus improve tax efficiency and also reduce the need to rebalance (which can lead to transaction costs and tax inefficiency).

SA: Do you ever buy individual stocks for client portfolios?

LS: Never! We believe that has more to do with speculating than investing. In other words, buying individual stocks is taking uncompensated, idiosyncratic risks. Prudent investors only take compensated risks, risks for which you must be compensated because you cannot diversify them away.

SA: Some describe the current era as “The Great Deleveraging.” Do you agree/disagree, and does this macro consideration affect your investment planning process?

LS: I would agree that we are in a period of deleveraging. But that has no impact on our investment strategy because that is information that the market already has incorporated into prices.

SA: 2010-11 saw a notable rush for the exits from equities and equity vehicles. Is this a cyclical, or secular shift? What would it take to bring them back?

LS: This is the typical individual investor cycle that we see. Most investors act as if they were driving a car forward while looking through the rearview mirror. That causes them to buy what did well (high) and sell what did poorly (low). Not exactly a prescription for success. They will come back after periods of good performance.

SA: Do you believe gold is a genuine hedge in uncertain markets? If so, how much exposure to it or other precious metals do you have? If not, where are you turning for potential downside diversification?

LS: Gold does provide a hedge against some economic and geopolitical risks, but it clearly is not a hedge for the very thing most investors buy it for: inflation. Gold cannot be an inflation hedge when you can have multi-decade long periods where gold falls 70% and inflation rises 4% [a year].

I do recommend investors consider having exposure to commodities in general as a long-term inflation hedge (as commodities are a source of inflation). Given the low correlation to stocks and bonds and the high volatility, one needs only a small allocation, say 3-5%, to have an impact.

Also if one adds commodities (such as the DJ-UBS Index), then one should consider adding some duration to the bond side. Bonds and commodities hedge each other’s risks well. We have yet to experience a negative year for both bonds and commodities (though it is possible).

SA: Is there any particular vehicle you prefer to capture commodities exposure? For vehicles that track a basket of commodities by holding futures, how damaging is contango to long-term performance? Is there a better way to gain this exposure?

LS: We used to use the PIMCO fund. However, we were always concerned about their active trading strategies for the collateral. We were finally able to convince DFA to create a fund (DCMSX) with lower costs that also passively managed the collateral and also improved returns by avoiding trading on the roll dates for indices. This is a big deal.

Macro Investing Themes

SA: Global Macro considerations dominated the headlines in 2011. Do you see 2012 unfolding differently? If so, how?

LS: Yes, it is always different, but my crystal ball is always cloudy. So I don’t make forecasts. Investors should learn what Warren Buffett knows: A market forecast tells you nothing about where the market is going but a lot about the person doing the forecast.

There are good studies on the ability to forecast and the only thing that correlates with accuracy is fame, and the correlation is negative: The more famous the forecaster, the less accurate the forecast.

SA: Will Eurozone contagion continue to drive the market’s direction, and how are you protecting client assets from potential fallout there?

LS: If it happens, it certainly can be expected to do so. And if it doesn’t that will also drive the market. Investors need to understand that it is only surprises that drive prices (what is knowable is already in prices) and by definition surprises are not forecastable. Which is why we focus on managing risks.

We protect against this type of risk in several ways. First, through global diversification. Second, by not taking more risk than our clients have the ability, willingness or need to take. Third, by having high tilts to small and value and low exposure to beta, for most clients. Fourth, making sure our fixed income investments are only of the highest quality, so that they will perform well when they are needed most.

SA: So under specific circumstances such as the current situation in the eurozone, you don’t lighten up on particular problem areas at all in client portfolios?

LS: That would not make sense. The reason is simple. If we know there are problems, the market surely also knows and that means the problems are already incorporated into prices. And why would you buy when things look safe, and thus valuations are high and thus expected returns are low, only to sell when risks show up, and thus valuations are low and expected returns are now high? That doesn’t seem like a rational strategy, yet it is exactly what most investors do, and it explains why they do so poorly, underperforming the very funds in which they invest.

Buffett for example, not only warns against the foolishness of market timing, but adds that if you are going to try and time the market, he advises to buy when others are panicking. We do that simply through the process of rebalancing. We get to buy low, when expected returns are high, and sell when expected returns are low.

SA: International equities proved volatile for both developed and developing markets over the past 2 years. Do you see a clear winner going forward?

LS: My crystal ball is always cloudy, as is everyone else’s even if they don’t know it. Remember there are only three types of forecasters. Those that don’t know where the market is going. Those that don’t know they don’t know. And those that know they don’t know but get paid lots of money to pretend they do.

SA: Where are the real growth stories overseas right now?

LS: This is basically an irrelevant question because if there is a growth story it’s already [baked into] prices. Also what most investors don’t know is that there is a negative correlation between country growth rates and stock returns. So if you want high returns you invest in slow - not high - growth countries.

SA: How much exposure to emerging markets do you have both in terms of stocks and bonds? Are China, India or other major EMs better positioned to withstand a serious global economic downturn than the U.S.?

LS: We typically have about 40% exposure to international stocks with about a quarter of that being emerging markets. Our developed vs. emerging allocation is in line with global market caps. We have avoided emerging markets bonds as we only invest high credit quality fixed income. Furthermore, our equity investments are completely unhedged with respect to currency. We feel this is enough exposure to emerging markets currency.

SA: So you believe in strict cap-weighting? What is your take on some of the alternative indexing methodologies that have gained in popularity in recent years, things like fundamentally or dividend weighted indexes?

LS: We don’t believe necessarily in strict market cap weighting. Obviously we don’t do that with client portfolios as we typically have large tilts to small and value stocks, as much as 10 or more times market cap weights for those types of stocks. But within an index or asset class we believe market cap weighting is likely to be the best strategy.

Having said that, as I noted above, we also believe in using screens such as for IPOs and penny stocks and also for momentum. And we want to be able to be patient traders, providers of liquidity---and thus the funds we use don’t strictly market cap weight.

SA: The Iran nuke situation and a potential Israeli, U.S. or global attack. How serious would such an event be to oil prices and subsequently, the global economy/exchanges? Is this something you're positioning for and if so, how?

LS: Obviously this would be a very serious situation and would almost certainly drive energy prices much higher and global equity prices lower. That risk is built into client portfolios is the financial planning process. However, we don’t just consider the “known” risks like this one, but the “unknown” ones. We make sure that our clients understand that just because something hasn’t happened doesn’t mean it cannot or will not. That gets back to making sure our clients don’t take more risk than they have the ability, willingness or need to take and only investing in the highest quality fixed income assets.

SA: Is the housing market in U.S. still an issue, or not so much anymore? Will prices continue to fall? Do you have exposure to either REITs or residential real estate in client portfolios?

LS: We recommend clients consider including an allocation to REITs as a good diversifier of risks. Thus, those that have room in tax advantaged accounts will typically have a small allocation, that is rebalanced, like all other asset classes. We don’t tactically asset allocate because the evidence is strongly against trying to do so.

Fixed Income

SA: Where do you see Treasury yields in 12 months? Are Treasuries worth buying at current (low) yields? For clients requiring income, where have you been turning in this low yield environment?

LS: The evidence is strong that there are no good bond forecasters, just as there are no good equity forecasters. Thus we use the current yield curve as the best estimate of tomorrow’s yield curve. And we don’t change investment strategies based on levels of rates. That leads to investors making big mistakes of chasing yield in the form of either taking too much credit risk or too much duration risk.

SA: What is the ideal asset allocation for someone with a long-term horizon (greater than a decade) and no need to touch their investments? Can investors continue to rely on stocks after the 'lost decade' we just experienced?

LS: There is no ideal. Each investor is different. My book The Only Guide You’ll Ever Need for the Right Financial Plan teaches investors how to develop an asset allocation that is just right for them. It provides the questions to ask to help create that right plan. The issues revolve not only around the investment horizon but also about the willingness to take risk, stability of labor capital, and the need to take risk (considering one’s marginal utility of wealth).

Having said that, for those investors that have already “won the game”, meaning they have enough, and thus have a low marginal utility of wealth, I recommend a portfolio with very low exposure to equities (20-30%) and a very high tilt to small and value, with 30-50% international (with a developed to emerging markets ratio of 3:1) and the rest in the highest quality fixed income investments (including a strong preference for TIPS).

Disclosure Statement: Every BAM client has different allocation. Not all clients will even own the same funds. Across different client portfolios we are long many DFA equity funds and the two Bridgeway Omni Small Cap funds mentioned above ((BOSVX) (BOTSX))

Source: Larry Swedroe (Passively) Positions For 2012: Avoiding Stock And Sector Picking, Economic Forecasting, And All Other Forms Of Speculation