Portfolios should be built for each individual investor – bespoke if you will. The portfolio should include all assets of the investor, not just stocks and bonds.
Someone who owns their own company should consider that ownership as part of the equity allocation. An investor who owns large real estate holdings should avoid REITs and an investor who receives a defined benefit should include it in the fixed asset allocation.
Determining an IPS
The first step is to create the Investment Policy Statement (IPS). The IPS is the foundation that articulates the goals and objectives of the investor.
To properly form the IPS, the following needs to be considered: First is time horizon – the longer the time frame allows for greater risk. Secondly, taxation – which includes both the marginal tax rate and estate tax issues (a low marginal tax rate makes tax free municipal bonds less attractive).
Third is the objectives of the portfolio – should the goal be income, growth, or speculation? Finally, risk tolerance – since this is an emotional question, this can be hard to quantify.
The biggest mistake made by retail investors usually involves emotional decisions. Selling when markets are down, buying only after the markets have rebounded. For the nervous investor, avoiding a big loss is critical.
Asset allocation
Once the IPS is completed, the next step is to decide on the asset allocation. How much should be committed to stocks, bonds, alternative investments, and commodities?
The biggest influencer of portfolio performance is asset allocation – not stock/bond selection, not market timing.
The number and complexity of the asset classes used depends on the size of the portfolio and sophistication of the investor and the advisor.
The asset classes selected should have very low correlation to each other. Owning eight mutual funds that all invest in large cap US stocks is not diversification since all eight funds will move together in the same direction, up or down.
A portfolio that has different asset classes that move independently of each other is how diversification should work.
Fund selection
Once the asset allocation is decided, the choice of how to fund each asset class needs to be determined. Should the investor use passive investments or active investments? Should the investor use mutual funds, ETFs, or separately managed accounts (SMAs)?
Are alternative investments a good choice? Each of these choices has positive and negative attributes. The most common investments are mutual funds for retail investors, soon to be second behind ETFs.
For smaller investors, they are a good choice. However, mutual funds have two big flaws in down markets: When markets fall, retail investors tend to panic and rush to sell.
To meet the redemption requests, the fund must liquidate holdings to raise cash. In other words, they are forced to sell at the worst time.
To make matters worse, mutual funds have what is called embedded capital gains.
Assume Fund A bought Apple stocks 20 years ago at a cost of $5 a share. Now assume the investor bought Fund A yesterday and Fund A decides to sell the position in Apple the next day at a price of $145 a share.
That entire capital gain on the Apple position passes on to the new investor even though the fund was held for only one day.
ETFs are the cheapest choice, but most are passive – they are designed to match, not beat, a benchmark.
SMAs are actively managed accounts that hold individual positions for each client. This is one of the most expensive options, but a good manager can beat a benchmark. Also, because the account holds individual positions, tax harvesting is a good tax minimization tool.
Tax efficiency
Another often overlooked aspect of asset allocation is tax efficiency. This can get quite complicated, but some simple rules are as follows.
Since interest income from bonds is taxed as ordinary income and investment gains in tax deferred accounts are deferred, the fixed income allocation should be in the IRA or 401K.
Since long-term (assets held at least one year) capital gains and dividends are tax-preferred items, they should be placed in fully taxable accounts. Investors with low marginal tax rates should not invest in tax free municipal bonds.
Rebalancing
Rebalancing the asset allocation is very important, if the asset allocation calls for 50% exposure to stocks and because of a bull market, that allocation is now 60%, the position should be reduced to get back to the target allocation.
The question is when? The simplest way is to reallocate on a regular basis, say quarterly. This eliminates guesswork and emotion.
The problem with this strategy is that selling investments at a gain creates a taxable event. This strategy also does not consider asset valuations.
There can be situations that make sense to hold an asset class above the target amount because of favorable valuation or dollar flows into the asset class.
Clearly reallocating on a discretionary basis requires an in-depth knowledge of the markets and carries both potential positive and negative outcomes.
What to avoid
The larger the portfolio, the more asset classes that can be introduced. This can be a big list of options, many of which are not very good investments.
Remember, the more complex the investment option, the higher the fees. Investors who adhere to disciplined asset allocation should avoid non-constrained investments – investments that allow the manager to own virtually any asset class, that allow the manager to short an asset or introduce leverage.
Having these in the portfolio destroys the asset allocation. These would include hedge funds and managed futures.
The better choices are private equity, private credit, and infrastructure and since private equity is very illiquid, the market demands it pay superior returns.
It should be part of the equity exposure. Private credit traditionally has a floating rate component, an important factor in a higher interest rate environment.
Lastly, infrastructure investments hold real assets versus paper assets – an asset class that does well in high inflation. Both should be put into the fixed income allocation.
Finally, the portfolio needs to adapt to changes with the investor. The older the investor, the less risk there should be. If the financial situation of the investor changes, the portfolio should be adjusted accordingly.
Lastly, markets continually evolve – the portfolio needs to also evolve.
John Kauth is CEO and co-founder of Intercontinental Wealth Advisors