[This blog was originally published by The Alliance Report at www.TheAllianceReport.com]
When family investors think about adding value to their portfolios, they tend to think of finding a manager who will deliver exceptional outperformance. But over time, managers as a group will subtract value from portfolios due to their fees and trading costs.
Fortunately, there are ways families can reliably add value. Let’s look at a few of the more important of these techniques.
Asset allocation. Ok, your eyes are glazing over. Although many studies have shown that asset allocation adds the most value to portfolios, once it’s done it’s done, and clients naturally ask, “So what have you done for me lately?” But let’s not forget that the asset allocation strategy originally developed for your portfolio, if it was a good one, will continue to pay very high dividends for years to come. Measuring your risk and returns against those of your old portfolio, and measuring your returns again a so-called “naïve” benchmark (that is, a stock/bond/cash benchmark with the same risk level as the customized portfolio) are two ways to observe how much value is being added.
Tactical positioning. Although investors have been warned ad nauseam to avoid the sin of market timing, the simple fact is that long term asset allocation strategies assume that markets are in equilibrium, that is, that all market sectors are rationally priced. In fact, this is rarely the case, and therefore it’s important to position a portfolio with reference to current market valuations. So long as the positioning is valuation-based and is consistent with strategic ranges defined for the portfolio, tactical positioning will add significant value over time, especially on the downside.
Opportunistic investments. However bad the markets are, there are always pockets of value somewhere. And even during bull markets, when sensible investors won’t buy expensive stocks, there is likely to be something cheap if you look hard enough. The problem is that most family advisors aren’t investors to begin with and wouldn’t know a good buy if it bit them in the you-know-what. But if you’ve hired a firm that is an investor first and a consultant second, that firm will know how to identify, structure, implement and size investment opportunities that, over time, will add real value to your portfolio.
Manager selection. As noted above, selecting good managers is the first thing most investors think of when talking about adding value, but the sad fact is that in almost all cases your managers as a group will subtract value from the portfolio. Selecting managers who will outperform net of all costs in the future, while they are managing our capital (rather than in the past, when they weren’t), is extraordinarily difficult. So how can manager selection add value?
- First, select your managers with care. While it’s very difficult to identify managers who will outperform, it’s not so difficult to identify managers who are extremely competent, reasonably priced, and who invest in predictable ways.
- Second, adopt a skeptical attitude. Unless you are very certain that a manager will add value, your default position should be to index. I don’t necessarily mean “index” in the “Vanguard S&P 500 Index Fund” sense, since capitalization-weighted indices present serious issues. But passive and structured products can represent the default option.
- Third, try not to think about individual managers as representing permanent positions in your portfolio. Instead, think about managers as arrows in your quiver of value-adding techniques that can be used opportunistically as appropriate. For example, consider the case of a manager who follows a defensive style, buying only high quality companies and raising cash when he doesn’t like the looks of the market. We may have no idea whether that manager will outperform over a long period of time, but we can be pretty certain he will outperform in treacherous market environments. If that’s the kind of market we expect, that’s the kind of manager we want. Once markets recover, we may not be so enthusiastic about that manager.
- Fourth, size your managers appropriately. Your largest positions should normally be in passive products like tax-aware index funds or structured funds. Around that position you can build satellite positions in managers whose styles – very different from index or “closet” index funds – give them a chance to outperform. These positions won’t typically be as large as the passive position.
- Finally, think counter-cyclically. If we know a manager is very competent, and if we observe that he has underperformed in recent years, we can be pretty sure he will outperform over the next market cycle.
Monitoring and rebalancing. Boring as it is, very careful monitoring and (especially) rebalancing of investment portfolios pays ongoing dividends. Note that this does not imply taking frequent actions in the portfolio. Indeed, the default position should be not to act, since so many investment mistakes happen as a result of emotional responses to transient market events. But thoughtful monitoring will identify areas that need to be watched carefully. Is your small cap growth manager shooting the lights out even though the small growth benchmark is stalled? Maybe he’s a very smart guy – but maybe he’s jumped aboard a tech bandwagon that’s going to run off a cliff
Regarding rebalancing, frequent by-the-numbers rebalancing might work for institutional investors, but it doesn’t work for taxable family portfolios. Instead, rebalancing must be done in a thoughtful and tax-sensitive (and cost-sensitive) way. Strategic bands around target allocations should be wider for families than for institutions, and even when an allocation is out-of-guideline the costs associated with rebalancing need to be assessed against the benefits. Rebalancing is important, because it is directly associated with the risk level of the portfolio. But taxable investors can also go broke rebalancing.
In summary, adding even small increments of value using each of the techniques mentioned above may not be as exciting as finding the next Warren Buffett, but it’s a lot more certain. And those small increments compound remarkably over time. In the words of Albert Einstein, “The most powerful force in the universe is compound interest.”
Please note that this article is intended to provide interested persons with an insight on the capital markets and is not intended to promote any manager or firm, nor does it intend to advertise their performance. All opinions expressed are those of Gregory Curtis and do not necessarily represent the views of Greycourt & Co., Inc., the wealth management firm with which he is associated. The information in this report is not intended to address the needs of any particular investor.
