Michael T. Doll: Explore your investment options

We often hear at the beginning of each new year that this is going to be a stock picker's market. That has not occurred recently. Unmanaged index funds have done well. Trying to select individual stocks has not been necessary.

This doesn't mean, though, that we could not have a stock market where the individual stocks outperform its general index. What is the smartest way to invest should we experience such a market?

I would suggest an approach often referred to as the "core and explore" strategy.

It works somewhat like this. Keeping strictly to stocks for this example, one may purchase a few unmanaged exchange traded funds that invest in perhaps the S&P 500 stock index fund, the developed markets outside of the United States and the emerging markets.

This helps to build the core part of the portfolio. Now, let's assume we expect one or more sectors to outperform the others. For example, we may want to overweigh the financial sector. We already have exposure to that sector because of the core holdings of our portfolio. But we want more exposure.

Again, there are several steps to explore this sector. The next step could be to purchase an unmanaged index fund that follows the financial sector. There are many ways to do this. I prefer the low-cost boring ETFs (Exchange-Traded Fund) such as the Vanguard financials with an

expense ratio of 0 .12 percent. In addition to our core holdings, we are now somewhat overweighed in financials because of our sector ETF. If we are correct with our expectations and the financial sector as a whole outperforms, we should benefit. We can stop here with our exploring or explore further.

Let's assume further that, in addition to our sector ETF, we want even more exposure (and more opportunity) to that group. Don't forget that as we explore further, we are going to increase our risk.

The next step may be to identify an actively managed mutual fund that invests only in the financial sector. Now we are in to the "stock pickers" part of our exploration. Typically when I recommend a mutual fund, I look for what are called focus funds. That simply means that the fund manager does not buy the index such as the one above and then a few individual stocks, but focuses on only a handful of stocks in that sector that he or she believes will outperform the index.

We want to avoid the "closet indexers." There are a lot of them out there and one of the reasons why ETFs have become so popular. We can buy the unmanaged index fund ourselves, so why pay someone to duplicate what we can do ourselves? We also want low-cost providers. Morningstar or your adviser can help you to uncover the "closet indexers" as well as the low-cost providers.

Again, we could stop here with our exploration. We now have our core and are exploring our financial sector by investing in an ETF and a focus mutual fund investing in the same sector. If we are correct in our top-down approach, we will benefit.

Let's go a little further with our exploration of this sector. This would be where we select several individual stocks in the financial sector that we think can outperform the index in general. We could explore further, but let's stop here and see what our outcomes could be.

If we are correct, this exploration gives us the opportunity to outperform vs. the sector if some or all of our exploration is correct. Our financial ETF will perform in line with the index, up or down. The mutual fund and individual stock are our "stock pickers" part of our portfolio and give us the opportunity to outperform the financial index and thus improve our overall portfolio return. If all three of our explorers work ,we may really benefit.

If we are wrong about our sector selection, the stock picker part still has the opportunity to outperform the index. Experience shows that if we are wrong about our sector selection, all of our exploration in that sector will probably underperform the general market as well.

Why not just go with the individual stocks for maximum return potential or even only the focus mutual fund? If we are incorrect, these investments could lag relative to its financial index. We could be correct about the sector, but the individual stocks we select could have issues particular to them that decrease their value when the sector they are in outperforms.

Core and explore can give an investor the opportunity to outperform the market in an intelligent manner. One may never hit a grand slam with this strategy, but hitting doubles and even an occasional triple over time can be rewarding.

Michael T. Doll, an investment adviser with the Longboat Key Financial Group, can be reached at 941-383-2300, ext. 6, or Michaeltdoll@longboatkeyfinancial.com.

This story was originally published October 12, 2015 at 7:34 PM with the headline "Michael T. Doll: Explore your investment options ."