By Dave Moenning
on Apr 05, 2017 09:18 am
A
big part of my job these days is assisting financial advisors in the development
of portfolios for their clients and their firms. I like to say that I have 30
years of mistakes under my belt in this business and that we will do our
darndest not to repeat any of them. In short, I strive to work together with
advisors to design portfolios that are in line with their view of the world and
yet don't go off the reservation too far in terms of overconcentration in terms
of methodology, strategy or manager selection.
Yesterday,
I described the initial phase of the portfolio design process. We first define
the objective, then the benchmark, and finally, the time frame. From there, my
team goes to work in building portfolios that incorporate a more modern approach
to diversification. This is something we call Modern Portfolio Diversification -
or MPD, for short - which goes beyond the traditional diversification by asset
class, incorporating multiple investing methodologies (i.e. passive, strategic,
tactical, equity selection, alts, etc.), multiple strategies, and multiple
managers.
Getting
back to yesterday's missive, recall that after several calls with an advisor, my
team had been tasked with creating a series of risk-targeted, asset allocation
strategies that would attempt to "be around" the benchmarks during most calendar
years and then try to "lose less" when the bears went on the attack.
The
question, of course, is how do you accomplish this?
Step
1: Understand Your Objective
While
it may sound obvious, the first step in designing a portfolio is to truly
understand the benchmark you are trying to outperform. Believe it or not, the
selection of a benchmark is usually an afterthought for most advisors. But as
Yogi Berra is famous for saying, "If you don't know where you are going, you
might wind up someplace else."
Too
many advisors allow their clients to look at an index like the S&P 500 to
gauge how their portfolio performed. However, such an approach sets you up for
failure. Because, unless you are running a domestic, cap-weighted, equity
portfolio, the S&P is likely the wrong benchmark.
Again,
while this sounds uber simplistic, the first and most important step in
successful portfolio design is to correctly identify what you are trying to
accomplish and what benchmark you will be measured against.
So,
once you have identified the appropriate benchmark, you need to dig into that
benchmark and recognize how the thing works. For example, you must understand
the makeup of the index or benchmark as well as the allocations to asset
classes, regions, "styles," weighting, and/or factors.
For
example, a 60/40 mix tends to be the objective of a great many advisors. Yet, it
is important to note that this benchmark represents only the U.S. stock and bond
market. Will your portfolio invest outside the U.S.? For most, the answer is
unequivocally, yes.
Granted,
the majority of companies in the S&P 500 do business globally. However,
recognize that the S&P and the Aggregate Bond Index are U.S. indices - and
the simple fact is that most advisors like to incorporate foreign stocks and
bonds, real estate, commodities, alternatives, etc. in their portfolios. So, is
a benchmark using only stocks and bonds in one country really a good idea?
The
recent performance of global markets and asset classes drives this point home.
Generally speaking, the U.S. has been the place to be for many years now and
diversification into global markets has wound up creating "diworsification" in
terms of portfolio performance.
So,
if you want to utilize global markets and/or asset classes other than U.S.
stocks and bonds, using 60/40 as your benchmark is really kinda silly.
Times
Change
Another
consideration here is the reality that portfolios tend to change with the times.
For example, currently a passive approach to the U.S. stock and bond market is
all the rage. The money flow stats on funds and ETFs make this very clear -
money is flowing into passive index ETFs at an eye-popping rate.
As
such, it is important to be aware of the fact that your portfolio may start to
drift toward whatever is happening on a macro basis as the years go by - this is
natural. And because of this, locking yourself into an index or a specific mix
of indices becomes problematic over time.
My
Solution
To
be sure, I have wrestled with the benchmark dilemma for a very long time. And
under the category of full and fair disclosure, I've made most of the mistakes
mentioned above (as well as a bunch of others!).
I've
come to the conclusion that unless you are a portfolio manager working for a
mutual fund or ETF company that runs a very specific type of portfolio - small
cap growth, for example - using a specific index as your benchmark means that
you are going to wind up changing your benchmark every couple of years. And in
short, such a practice is frowned upon by the regulatory bodies.
My
answer is to think about (a) the risk level a client wishes to employ and (b)
the alternatives an investor would have when deciding whether or not to use my
investing services.
Again,
I know this sounds simplistic, but for most investors, the alternative to
utilizing a professional money manager is to invest directly in mutual funds
and/or ETFs. Or for the millennials, to go online and let Betterment or Schwab
build a risk-targeted portfolio for them.
It
is for this reason that I prefer to utilize the risk target categories created
by Morningstar. In my humble opinion, Morningstar's "Target Risk Allocation"
categories make very nice benchmarks as they represent what I deem to be a
real-world investing approach.
For
example, the Morningstar Moderate Risk Allocation is a modern-day, real-world
60/40 approach. It includes 58% equities (spread across regions, sizes, and
styles), 33% bonds (including both domestic and foreign), 6% inflation hedges
(commodities and TIPS), and 3% cash. Yes fans, most portfolios have some cash in
them at all times - but the popular market indices do not.
So,
for me, the first step in designing a portfolio for an advisor and their clients
is to identify which of the Morningstar Target Risk Allocations is appropriate.
By doing so, I know exactly the risk level being utilized as well as the
allocations to asset classes, styles, etc.
Tomorrow,
we'll explore the three ways to add alpha to your portfolio, which is really the
crux of the matter at hand.
Thought
For The Day:
Talent
is wanting something badly enough to work for it. -Tim Cox
Current
Market Drivers
We
strive to identify the driving forces behind the market action on a daily basis.
The thinking is that if we can both identify and understand why stocks are doing
what they are doing on a short-term basis; we are not likely to be
surprised/blind-sided by a big move. Listed below are what we believe to be the
driving forces of the current market (Listed in order of importance).
1. The State of the U.S. Economy
2. The State of
Trump Administration Policies
3. The State of
Global Central Bank Policies
Wishing
you green screens and all the best for a great day,
MiB: The Return of Ken Fisher
This week on our Masters in Business radio
podcast, we sit down for the second time with Ken Fisher of Fisher Investments,
which manages about $80 billion in client assets.
The last time we had Fisher on as a guest, as
I was walking him to his next appointment, he started discussing how he built
his business. Despite having just had a 90 minute conversation, we continued
speaking for another 45 minutes. As I listened to him describe how he built his
firm, it was apparent to me I missed a giant swath of conversation that
listeners would like to hear. This podcast makes up for that prior fail on my
part.
Fisher explains why customer service is an
overlooked aspect of asset management, and tells us what his firm does that is
unique. He also describes the stock market as in its “usual unique” position.
He discusses how stock picking has always been
challenging, but the analytics to prove by how much simply did not exist. He
references Jack Bogle’s 1961 paper — it explained why the cost structure of
active management was destined to lose against a low cost index. It took decades
before that reality became both understood and well known.
Fisher, a top down student of the market,
tells us that P/E has never been predictive, and that stocks are less expensive
that people believe. He believes behavioral issues are much more important than
valuations.
All of the many books Fisher discusses
can be found
here.
You can hear the show on Bloomberg Radio, or
stream/download the full show, including the podcast extras, on iTunes, SoundCloud and
on Bloomberg.
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