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We are waiting watchfully for a good re-entry point for US equities using the substantial cash position we raised last summer.

The critical factors we are watching to identify a prudent re-entry point — information we will use to become comfortable that the storm we avoided has passed by — are:

1. Technical Market Factors
2. Valuation Fundamentals
3. Risk Levels
4. Government Intervention Policies
5. Economic Conditions

Economic conditions are poor and the time frame to recovery still seems longer than the 6-12 months that the markets are generally assumed to discount in advance. Q4 earnings reports may be telling.

Government intervention policies are not yet fully established or implemented.  Unkowns abound with respect to Congressional action on several fronts, ranging from possible 4.5% new mortgages to auto company bailouts.  A new president and cabinet plan some sort of massive stimulus package that has yet to be defined and debated.  We need to wait until January or February to begin to get good clarity on that.  Foreign government and supra-national agency (e.g. IMF) policies are continuing to be announced.  Eventually, if enough money is applied to the problems, reflation of economies will happen, but what will happen between then and now, and how long it will take to get to the other side, is not yet clear.

Risk levels are still extraordinary.  Michael Santoli wrote in this week’s Barron’s about research published by Vince Farrell as follows:  “Since 1950, over a span of nearly 15,000 trading days, the Standard & Poor’s 500 has gained or lost 4% or more in a day only 68 times (33 down, 35 up).  Of those 68 days, 28 have occurred in the past three months.” We think that is a clear indication of the abnormally high current risk level.

Valuation fundamentals are opaque, but probably unfavorable.  While P/E ratios are average or slightly below, the “E” is still coming down.  Dividends are still being cut.  Congress is still talking about prohibiting dividends by companies receiving bailout money. Business failures are still rising.  The possible economic collapse due to bank failures has been replaced by possible economic collapse due to auto company failures.  Basic materials costs have already collapsed due to lack of manufacturing demand. Key economies in China and India are still growing, but the rate of growth is falling.

Technical factors for the asset categories we are watching are mixed.  We are monitoring ten bellwether asset categories as macro level representations of the larger world of investment assets (asset type / proxy fund):

• US Stocks (VTI)
• Non-US Developed Market Stocks (EFA)
• Emerging Market Stocks (EEM)
• US Real Assets (VNQ)
• Global Commodities (DJP)
• US Aggregate Bonds (AGG)
• US Treasuries 7-10 Years (IEF)
• US Dollar Index (UUP)
• Crude Oil (USO)
• Gold Bullion (GLD)

Simple, short-term candlestick charts for each of the asset category proxy funds shows some categories doing well, some doing badly and some trying to do better.

click images to enlarge

AGG, IEF and UUP are strong.  USO and DJP are doing badly.  VTI, EFA, EEM, VNQ, and GLD are trying to do better.

From a rotation perspective, we do have some concerns about Treasuries (IEF) and the Dollar (UUP).  When risk appetites return, rotation out of Treasuries to riskier bonds or stocks will likely depress Treasury prices.  Also when the trillions of new Treasury issuance take place to fund the bailout, Treasury prices may fall to compensate buyers for the risks they are asked to assume.  Similarly, the Dollar may have strengthened in great part due to the rush to the liquidity and relative safety of Treasuries.  The Dollar is strong, but there are questions about how long that can last as questions about the US economy persist and with historically low short-term interest rates.

For now, bond allocations are doing mostly OK.

Closer Look at US Stocks:

Let’s take a closer look at US stocks as represented by the S&P 500 index.  We are looking at VTI (total US stocks) generally, but the S&P 500 has a longer history, which makes it better for long-term historical views.

The top level technical issue is establishing the major trend as up, down or sideways.  The time frame used to determine trends depends on investment time horizon.  Just to cover all the bases for different prospective investors, let’s look at a wide time range — 27 years, 3 years, 1 year, and 3 months.

The charts that follow have some annotations identifying some potentially interesting attributes of the charts patterns.

The 10-year Treasury bond interest rate is plotted on the same space as the S&P index levels (right scale for S&P index, and left scale for Treasury yield).  The charts also present simple moving averages as overlays of the index levels, and present price and volume oscillators that variously indicate money flow, momentum, direction and extreme conditions (overbought and oversold).

The charts use these indicators in the panels below the price chart panel (descriptions adapted from  John Murphy’s www.StockCharts.com)

• Average Directional Index (ADX): ADX (a bounded oscillator) indicates the strength of a current trend whether up or down.  It is an oscillator that fluctuates between 0 and 100. Readings above 60 are relatively rare. Low readings, below 20, indicate a weak trend and high readings, above 40, indicate a strong trend. The indicator does not grade the trend as bullish or bearish, but merely assesses the strength of the current trend regardless of direction.
• Relative Strength Index (RSI): RSI  (a bounded oscillator) compares the magnitude of gains to the magnitude of losses, and expresses the calculation as a number within a band from 0 to 100. It does not measure strength relative to another security, but rather measures the strength of directional moves by a single security.  It is useful for identifying extreme conditions (movements too far, too fast in either up or down direction) called “overbought” (typically over 70) and “oversold” (typically under 30).
• Moving Average Convergence/Divergence (MACD): MACD (an unbounded, centered oscillator) uses three moving averages to indicate direction and momentum.  It subtracts a longer moving average from a shorter moving average creating a line that oscillates around a center at zero with no upper or lower limits.  The third and shortest moving average moves around the oscillator to serve as a signal line when it crosses the oscillating line.
• Chaikin Money Flow (CMF): CMF (an unbounded oscillator) evaluates the cumulative flow of money into and out of a security.  It establishes a point value for the closing price position within the period’s price range, then multiples that by the volume for the period and then maintains a running total for the selected number of periods.
• The Money Flow Index (MFI): MFI (a bounded oscillator) is a momentum indicator that is similar to RSI in both interpretation and calculation (with a range from 0 to 100), except that it is volume-weighted.   It compares “positive money flow” to “negative money flow” to reflect the momentum of money flowing in and out of a security.

S&P 500 Monthly from 1981

(A) the October 1987 crash is the only period in the last 27 years that visually resembles the price change since September.

(B) the point in 1994 where HTML was introduced to enable internet images — when the internet took off and so did the dot.com bubble.

(C) the 2002-2003, post dot.com, post 9/11 bottom which appears to be a potential bottom level for the current market (a possible “support” level)

(D) the yield on 10-year Treasury bonds

(E) RSI showing a potentially oversold current condition

(F) MACD showing negative momentum and no sign of a reversal

(G) ADX showing a moderately strong trend, which the price chart visually shows as downward.

S&P 500 Montly for 3 Years

Red and green arrows highligting some points at which down (red) indications were present, and at which up (green) indicators were present.

S&P 500 Weekly for 1 Year

Horizontal lines emphasize the current values of the 13-week, 26-week and 52-week simple moving averages (”SMA”) which may be “attractors” for the price in a reversion to mean scenario.

S&P 500 Daily for 3 Months

The 10-day SMA is about to make a bullish cross of the the 20-day SMA, but it made such a cross in early November, only for the price to fall shortly thereafter.  There were big government intervention surprises back then, but there may be at this time too — GM, Ford and Chrysler. The 20-day, 50-day and 200-day SMA’s are downward tilted, which is still bearish.    ADX says trend is moderate but weakening — possibly a pre-positive sign.  RSI is so-so.  MACD made a bullish cross-over in late November, but it did that in early November too.  CMF Money flow has turned as positive as it was in September, before the big market crack.  MFI money flow momentum has been increasing in November, but is not in an extreme condition.

Third Party View:

Market Edge Second Opinion is a technical service that uses multiple technical criteria.  They rate our ten bellwether asset categories as follows (”+” means improving and “-” means worsening — our short hand for Market Edge’s more complete explanation):

• AVOID (+): US Stocks (VTI)
• NEUTRAL (+): Non-US Developed Market Stocks (EFA)
• NEUTRAL (+): Emerging Market Stocks (EEM)
• AVOID (-): US Real Assets (VNQ)
• AVOID (-): Global Commodities (DJP)
• NOT RATED: US Aggregate Bonds (AGG)
• NOT RATED: US Treasuries 7-10 Years (IEF)
• LONG (-): US Dollar Index (UUP)
• AVOID (-): Crude Oil (USO)
• LONG (-): Gold Bullion (GLD)

Summary:

No matter the assessment, each investor has their own risk tolerance, future financial sources, liabilities and investment time horizon.  It is impossible to say what everyone should do, because we are all different.  You need to make your own assessment of your situation, the market conditions and probable futures.

Generally, it looks to us as if the markets are trying to behave in a hopeful manner, perhaps in recognition that governments are determined to fix things up, but with a backdrop of terrible economic conditions, uncertain timing of uncertain outcomes, at a time when risk of absolute loss due to default and bankruptcy and risk of violent value fluctuations are front and center.

You, or you and your advisor, must decide where in the risk spectrum you should insert your money. Are you a 25-year old “early saver”?  Are you a gambler by nature?  Are you a “prudent man”?  Are you done saving to increase your portfolio and now nurturing it for the long term?  If you lost 20% would your life style be compromised?  If you lost 50% could you maintain your lifestyle?  Do you have specific liabilities for which you should protect matching assets? Are you a non-profit or other organization with investment guidelines or restrictions?  Can you sleep at night with the risks you have or are thinking about taking? These are some of the kinds of questions you need to answer before you decide what to do and when.

Richard Shaw
QVM Group LLC

Asset allocation is important to reduce risk.  Approximately 90% of portfolio total return comes from the asset classes you select and the relative weights you give them.

The word “never” is a dangerous term to use, particularly with respect to investing, but we believe it is probably safe to say that an allocated portfolio will never return as much as the best performing asset class, and it will never perform as badly as the worst performing class.

The important assumption is that an allocated portfolio is “expected” over the long-term to produce the blended mean return of the asset classes in the portfolio, and to do so with less volatility and less extreme draw-downs than the more volatile classes in the portfolio.

Unrealistic Expectations:

“Expected” is a tricky operative term.  We always ask new clients to indicate what returns they expect from their portfolio.  The answers are often way out of line with practical potential.  One reason for unrealistic expectations is memory of bubble years, while another may simply be inadequate information. This article is intended to deal with the information aspect of expectations.

Time Frame:

The largest issue with expectations may be the historical time window you use to develop a view.  Some periods create higher expectations than others. We think you need to study the long-term and worst periods, as well as recent periods and current trends to make sure that you understand how things may turn out.

Simple Allocation Example:

Let’s look at one very simple asset allocation (not a recommendation — just an illustration) to see how different time periods support different expectations.

A 60% S&P 500 / 40% Lehman Aggregate Bonds allocation is a classic moderately aggressive balanced portfolio allocation — balance with an equity bias.

That allocation is a popular one, such that Vanguard has offered a balanced fund on that simple allocation formula since 1986 (symbol VBINX).

US Stock/US Bonds as a Personal Risk Tolerance Yardstick:

While we would recommend more than two asset classes in a well constructed portfolio, we think that studying various combinations of S&P 500 (proxy SPY or IVV) and Lehman Aggregate Bonds (proxy AGG or BND) is a useful way to begin thinking about the mix of equity and fixed income assets that is suitable for you — particularly as it relates to risk and your risk tolerance.

You can diversify assets beyond this simple yardstick in a variety of ways with other US equity and fixed income categories, foreign varieties of equity and fixed income, and with other asset types such as real assets, commodities and cash.

In any event, we think being familiar with the characteristics of a spectrum of US equity and fixed income is important as a starting point for developing perspective on return opportunities and risks.

Weekly Short-Term Allocation Results Online:

Each week we update a short-term view of eleven blends (e.g. 90/10 through 10/90) of the S&P 500 and Lehman Aggregate Bonds yardstick on our website.

Very Long-Term 60/40 (81 years):

Vanguard published the long-term returns, best year and worst year, as well as the frequency of down years for several allocation ratios, including 60/40 from 1926 through 2006.

Their study determined the average return to be 8.9% with the worst year down nearly 27% in 1931, the best year up nearly 37% in 1933 (two years later), and down years approximately 1 in 4 years.

click images to enlarge

Short-Term 60/40 (1-wk, 4-wk, 13-wk, 26-wk, 52-wk):

Our short-term monitor of the 60/40 allocation (along with ten other US stock / US bond allocations) reveals more than a 22% decline for a rolling 52-week period.  That, not surprisingly, is near the worst experience in 1931.

If history slightly mimics itself, the long-term picture may hold out hope for a recovery of 30% or more in 2010.  Unfortunately, future history isn’t quite so predictable as past history is certain.

A $1,000,000 portfolio as of 12/31/2007 in a 60/40 allocation would be worth about $780,000 today.  A 30% recovery, would put the portfolio at about $1,014,000.

Long-Term 60/40 (22 years 1986-2007):

Twenty two years isn’t as long as 81 years, but it does span a lot of territory and is more closely aligned with the kind of globalization of trade we experience today than the 81 year history.

Our table below shows the 22 years from 1986 through 2007 to be a kinder time than the 81-year history in terms of frequency of down years (approximately 1 in 5), with a much less severe wost year (-9.16% versus -24.7%), and a higher annualized rate of return (10.17% versus 8.9%).

Sadly, that return was not available for all other starting years.  For example, a 60/40 allocation initiated at the beginning of 2000 returned only 4.03% through 2007.  The good news, and to the point of allocation, is that a 100% S&P 500 allocation made at the same time, returned only 1.68%.

The 100% S&P 500 allocation had only 1 in 5 down years from 1986-2007, but the worst down year was -22.10% as opposed to the -9.16% worst year for the 60/40 allocation.

Stock vs Bonds vs 60/40 Blend 1986-2007

The S&P data is shown in yellow highlight.  The Aggregate Bond and 60/40 data are shown in yellow, pink or green depending on their value.  Yellow indicates the value equals the S&P 500 value. Pink indicates the value is worse than the S&P value, while green indicates the value is better than the S&P value.

But Extend One Year and See Quite a Different Story (1986-2008):

If for the sake of illustration, we treat the current 2008 market results as calendar year 2008, we see even more clearly how important the time window selected is for creating return expectations.

The 22 years from 1986 through 2007 is nearly the same length of time as the 23 years from 1986 through 2008, but what a different story.

A 60/40 allocation initiated in 1986 and held for 23 years through today produced a 8.53% return (remarkably similar to the 8.9% of the 81 years from 1926-2006).  It experienced 5 down years out of 23 years overall (~ 1 in 4.5 years).  The worst year was -21.82%, much closer to the 81 year worst of -24.7% than the -9.16% for the 22 years from 1986-2007.

What a difference one year makes in setting up expectations!

Stock vs Bonds vs 60/40 Blend 1986-2008 (11/10/08)

Reality Check on Our Prior Advice:

About two years ago (01/02/07) Seeking Alpha published one of our blog posts titled, “Realistic Expectations for Returns Going Forward“.  We were probably a bit too optimistic in the upper end of a possible range, but we were definitely cautioning against too much optimism in the face of a bubbly emerging market.

A central theme was the difficulty of consistently beating benchmarks in successive years without some down years, and the limits of performance by even the recognized best institutional managers.

Back then we said;

The reality of plausible long-term returns, consistent with likely investor behavior in the face of down periods, is not as great as many would think. Most investors can’t take the pain of staying in during thick and thin. Consequently, they get out too late in down legs, and stay timid too long and miss important parts of up legs. The result is performance below their benchmark.

There are the shooting stars each year that double or more, and if we could pick those correctly and never make bad choices, we could become rich beyond imagination. The problem is that it doesn’t happen.

Look at the most celebrated current mutual fund manager Bill Miller. He exceeded his 15-year (1991-2005) S&P 500 benchmark average 12.7 % with his 15-year Legg Mason Value Trust [LMVTX] portfolio average of 16.4%. Very impressive, but almost nobody has done that with such consistency. Others have done better in terms of total return, but not necessarily by exceeding the benchmark in each discreet year.

Looking more broadly …”World’s Best Money Managers” … for large-cap US equity (roughly the same category as the S&P 500), as published by Nelson’s (part of Thomson Financial). These results include institutional portfolios, such as pension funds and separate accounts, as well as mutual funds.

… the average 10-year (1996-2005) performance of the top 40 managers was 14.95% versus Bill Miller’s 10-year 17.57% average. There were 3 of the top 40 managers who did better than Miller with returns of 18.05%, 22.67% and 26.97% (Capital Management Associates, Warwick Capital Management and Hillman Capital Management, in that order).

Certainly, managers mandated to work in a particular region, style or sector could have long excess return streaks, but their mandate won’t let them get out of the way when the cycle turns against them. And, apparently managers with broad mandates have not been able to do too much more than about 15% on average over the last 10 or so years according to Thomson Financial.

In summary, the US market produced a recent 10-year return in the vicinity of 10%, and the best money managers with broad mandates have produced returns in the range of 13% to 18% over the same recent 10-year period.

We would conclude that unless you are a major risk taker, a minor genius, and incredibly consistent, you should plan on a range of 9% to 15% with a tendency toward 10% for your own investments.

Harvard, Yale and Princeton Endowments:

Top university endowments have billions in assets, cadre’s of full-time analysts, pick of the cream of the crop in institutional advisors, access to asset classes not available to any but the very-rich and institutions — far more resources and options than almost anyone reading this article will ever have.

How have they done? What can their results tell us about realistic expectations?

The headline story for this week’s Barron’s, “Crash Course” was about how even the best endowments have been kicked in the stomach by the current market.  This year will go a long way to bring their long-term results back toward “normal”.

The article pointed to 10-year trailing returns (as of June 30) for Harvard, Yale and Princeton as 13.8%, 16.3%, 14.2%.  They said the average endowment has returns of about 6% for the 10-year period versus 3% for the S&P 500.

Barron’s speculates that, since June 30, endowment returns may have been in the range of minus 25%.  If that were so, the 10-year returns of the Ivies, might be something like 11+% to 13.5+% as of 12/31/2008.

Conclusion:

Diversify asset classes in any long-term portfolio design.

Look at multiple short-term, long-term and very long-term periods before setting up expectations.

Be aware of current trends and things coming down the track when setting up short-term expectations.

Be realistic about potential returns, and whether you can endure the volatility and maximum draw-down years associated with the return you wish to achieve.

If you expect long-term returns in the 10+% range, be prepared for a volatile ride in riskier assets.

If you are thinking about bigger numbers, such as 12% to 15% annualized over long periods, you probably can’t get it done with just US stocks and bonds, if you can do it at all.

Richard Shaw
QVM Group LLC

There is nothing left in the charts to suggest support for the S&P 500 index if it pierces the approximate 800 level (roughly 80 for its proxy SPY).

The index has been volatile within a range between generally 850 and 1,000 over the past few weeks.

Only fundamentals remain to gauge opportunity. The fundamentals of “E” stink. The fundamentals of P/E are not supportive, because the ratio is above the long-term average.

If the index pierces 800 (SPY goes below 80), it will resemble the Road Runner cartoon character Wiley Coyote when he would race off the edge of a cliff to find himself suspended in mid-air over a deep canyon.

Wiley’s attempts to run on air back to the solid cliff never worked. We hope if that happens to the S&P index, it can catch a branch as sometimes happens in the movies to break its fall.

See our prior study of charts suggesting a possible 400 to 800 range for the S&P index, and our prior study comparing the long-term index “as reported” trailing P/E ratio to the current ratio.

click image to enlarge

We hope for the best, but have prepared for the worst. Admittedly, our mentality for some months now resembles the 1950’s bomb shelter mentality.  Not to worry though, we have plenty of canned food and water stored in our financial hideaway built of cash and bonds.

Accounts we manage are 80% to 90% cash, with most of the invested portion in corporate, Treasury and municipal bonds.  We have made minor, but punishing test investments in equities since late summer, without success.  We use trailing stops on all of our positions.

We have decided to be late to the party on the way back up to avoid destroying capital on the way down.  In such an historic period of negative economic and stock market records, we think the math favors letting braver souls create the eventual reversal.  We will invest later, unfortunately having to climb over the bleached bones of those who courageously went before us only to fall to the canyon bottom.

We will go back in, but not yet.  Minimizing risk is more important than maximizing return for most of our clients whose portfolios are mature, and who cannot replace the assets within them.  Better to avoid loss now and then do OK after a confirmed trend reversal, than to risk massive loss in the current market in an attempt to predict the trend reversal to capture all the potential on the way up.

Lottery operaters say to gamblers, “you can’t win if you don’t play”.  We say to investors, “you can’t play tomorrow, if you don’t survive today.”

We hope our re-entry comes soon, but we have no way to predict when the time will be right.  However, it should be possible to recognize when time is right when it arrives by focusing on fundamental measures of value, by waiting for mean reversion to be on our side, and for apparent levels of risk to be much smaller.

Richard Shaw
QVM Group LLC

Whether we are coaching you as you manage your assets, or whether we are managing assets for you, if your investment account is mature, we follow this general approach — appropriately tweaked to your specific process preferences and needs.

A mature account is one for which expected new money additions are minimal compared to the size of the accumulated assets — where replacement of lost assets is not a practical or feasible option.

The approach also works well for non-mature accounts, but the “matching” issues may not be currently a necessary management issue.

THE BASIC IDEA

Your investment portfolio is not only about pursuit of realistic returns; it is also about risk management.

Matching investment assets with capital expenditure needs, and matching investment cash flows with needed spending from investments are among the most important aspects of portfolio risk management.

1.    Maturity matching: You should seek a portfolio that has maturities and ready liquidity at predictable values at predictable times to fund your portfolio dependent expected capital expenditures (capital budget).

2.    Cash flow matching: You should seek a portfolio that will provide sufficient cash flow to fund your expected spending (cash flow budget).

If your investment cash flow cannot be sufficient to fund your spending, then the difference should be treated as an annual capital item handled by maturity matching under the capital budget.

3.    Risk Limits: All the while, you need to be assured that you are being adequately compensated by cash flows and expected capital gains for the volatility and permanent capital loss risks you assume.

4.    Asset Allocation: Your asset class selection and class target weights should be consistent with your capital budget, your cash flow budget, and your risk limits.

5.    Process Management: The asset classes, target allocations and the securities selected to represent each class should be managed by a process that maintains the appropriate relationships between the capital budget, cash flow budget and risk limits (collectively, the management parameters).

MATURITY MATCHING

You have certain known or potential capital expenditure goals and obligations that can be estimated as to amount and timing.

If you have significantly more assets than required to meet your ultimate goals and obligations, you may be able to assume high levels of risk with all of your assets to pursue gains.

If you don’t have assets that substantially exceed your future needs, or if you simply want to conservatively manage what you have for whatever reason, these guidelines should be applied:

1.    Obligations due within 1 year should be funded with money market assets.

2.    Obligations due from 1 to 10 years should be funded with bonds in the same amounts as the obligations, and with average durations that match, or at least approximate, the timing of those obligations.

3.    Obligations due in more than 10 years may be funded with fixed income assets or with assets with greater potential for capital appreciation, such as common stocks or certain other non-fixed income assets.

CASH FLOW MATCHING

To the extent possible, the asset classes and the securities within the classes should be selected and weighted to provide investment income that at least matches the non-capital spending budget.

While capital spending is handled by matching with asset maturities, operational spending should be dealt with through investment income to the extent reasonably possible and consistent with risk limits.

Operational spending that cannot be covered by investment cash flow should be projected and treated as a scheduled capital expense with matching asset maturities.

RISK LIMITS

A balance between growth potential and loss potential is essential.

The more mature the asset pool (the less ability to replace assets with future earnings) the more the balance should lean toward conservation and sustainability — reducing loss potential at the expense of growth potential.

The less mature the asset pool (the more the ability to replace assets with future earnings), the more the balance should lean toward potential growth with the associated assumption of more risk.

The risk budget should take into consideration at least:

• market risk (volatility, liquidity and valuation)
  

• credit risk (quality, duration and interest rates)

• inflation risk

• currency risk

• geopolitical risk

• issue selection risk.

ASSET ALLOCATION

The classes in the portfolio should, to the extent possible, have low correlation of returns.

About 90% or more of portfolio return is generated by asset class selection and weights.  Only about 10% or less of long-term return is generated by security selection.  Therefore, time and effort is most effectively used concentrating on asset classes.

Asset classes should be considered in terms of long-term and short-term history, current market conditions, and expectations for future markets that will not be precisely like past markets. Substantial discussion of how and why classes may perform differently in the future is essential.

To prevent a single class from overwhelming the portfolio returns, the maximum weight should be 25% per class.

To assure that a single class has the potential to contribute meaningfully to portfolio returns; the minimum weight should be 5% per class.

To minimize exposure to security issue selection risk, no active management fund or non-core index fund should have a weight more than 5% (core, broad market index funds may be weighted to the extent of the asset class weight).  No individual stock or bond should be weighted more than 1.5 to 2%.

The overall asset allocation plan should include a set of allocation policy target weights (target weights) for each class.  A collar of minimum and maximum weights should accompany the target weights.  That provides some short-term flexibility around long-term allocations.

We prefer to sub-divide asset classes into these three categories:

• Strategic Core
• Tactical Emphasis
• Active Focus.

Each sub-category should be given a minimum and maximum weight within the class.  The result is a two-dimensional matrix of asset classes and asset class sub-categories.   Specific securities are selected to represent each sub-category of each asset class.

It is only necessary to utilize the Strategic Core sub-category to build a perfectly adequate and simple portfolio.  However, a progressively more complex portfolio can be developed by selecting securities for the Tactical Emphasis and/or the Active Focus categories

The Strategic Core should generally be populated with broad, diversified no-load, low expense funds, or ETFs.

Tactical Emphasis is generally populated with narrower no-load funds, ETFs or ETNs that increase the exposure to selected sectors, industries, regions or countries that are included in the broad funds of the Strategic Core.

Active Focus, if not left empty, is generally populated with specialty no-load funds or individual stocks or bonds.

See our prior article on Basic Suitability Issues in Portfolio Design for additional thoughts on appropriate portfolio risk based on “economic age” and financial condition.

See our weekly updated observation of a sample of asset allocation models proposed by notable sources (El Erian, Swensen, Standard & Poor’s, Money Magazine, American Association of Individual Investors, Ferri). Note these are not our recommendations, just observations of representative ideas from other people — potentially thought and discussion provoking.

BENCHMARKS

A simple benchmark portfolio should be selected against which to measure the management of the actual portfolio.

See our article on practical return measurement issues in portfolios with interim deposits and withdrawals.  Benchmarks don’t have “ins” and “outs”, but real world portfolios do.

The benchmark could be as simple as a two class model with US stocks and US bonds (i.e. 60% US stocks and 40% US bonds), or as complex as a single broad index fund for each asset class at the target weight for the class.

See our weekly updated short-term performance tables for 11 different simple two class (US stocks / US bonds) benchmarks.  Long-term performance of different US Stock / US Bond allocations from Vanguard are also provided there.

PROCESS MANAGEMENT

Portfolio design and continuing review should be done in terms of the management parameters (maturity matching, cash flow matching, risk limits, asset classes, target weights and security selection).

Tactical deviation from the allocation target weight within the minimum and maximum range for a class may be considered if supported by clear logic about the relationship between classes or changes in future expectations for the class.

Periodic rebalancing (and optional rebalancing triggered by threshold deviations form assigned weights) should be performed to satisfy the management parameters.

Rebalancing can be pursued more aggressively in a tax-free or tax deferred account due to no wash sale tax consequences of buying and selling securities.

See our article on the need for a tax-loss harvesting security substitution list for taxable accounts.

See our article on wash sale prohibitions with respect to IRAs and related party accounts.

Asset class target weights, minimum weights, and maximum weights should be considered for change no more than annually, but preferably not more often than at 3-year intervals.

Security selection for the Strategic Core holdings should be reviewed at such time as superior alternatives are available, but not more frequently than annually.

Security selection for the Tactical Emphasis holdings should be reviewed annually.

Security selection for the Active Focus holdings should be reviewed quarterly, or earlier on an event driven basis, if necessary.

Advisor and client should confer at least quarterly to review the portfolio — more often if events dictate, or if client prefers more communication.

Among other things, they should consider overall performance versus the benchmark, the performance of specific securities within the portfolio, current and expected market conditions, rebalancing, tax loss harvesting and security substitution, and any other possible needed adjustments or redesign.

Whether you call on us to assist you, or you use other advisors, or you manage your own assets, we recommend you adopt an approach similar to the one we have just described.

Richard Shaw
QVM Group LLC