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Investment Strategy – Step 5

Step 5: Build Your Portfolio

Building on the first four steps, we construct a portfolio suited to your needs, goals, investment horizon and risk attitude.  The building blocks for the portfolio typically are institutional asset class funds or Exchange Traded Funds (ETFs), which is an excellent way to implement a diversified portfolio investment so as to maximise the probability of achieving your goals.  In the event that an institutional asset class fund or an ETF is not appropriate, retail funds or individual securities may be used.

The result of this process is a diagnostic report of your current situation with our recommendations for repositioning your portfolio to maximise your probability for success.  In addition to the above considerations, these recommendations take into account portfolio costs as well as the potential tax impact of the restructuring.

For most people, building a truly diversified portfolio is difficult.  Imagine that you wanted to build a diversified portfolio of 500 shares worldwide. To do a good job, you may need to have $5 million or more to invest. Many investors do not have, or choose to invest, this much.

Even if you have enough money to build a diversified portfolio, you may not have enough time. Choosing 500 shares that you can buy with confidence is difficult enough. Once you had bought the shares, you would still have a lot of work ahead of you. You would receive masses of information on a large number of companies, and you would have to review your portfolio regularly to decide whether it still suits your objectives.  It would be a lot of work to even calculate the performance of your portfolio and decide whether it was good or bad.

An easier way to implement a diversified portfolio is through institutional asset class funds. By buying an institutional asset class fund, in a single transaction you invest in a broad diversified portfolio in a specific asset class. These institutional asset class funds combine your investment with those of other investors to build up a pool of money large enough to buy a diversified portfolio. The portfolio manager’s full-time job is making sure that the securities in the portfolio continue to be suitable for the fund’s investment objective.

Initial Asset Classes

The asset classes below have been selected from the asset classes available that meet the outlined constraints, are suitable for your risk tolerance and can assist you in reaching your investment goals.1

Expected Rate of Return

The term “expected return” is a term of specialised use, which is generally understood to mean the statistically achievable return (based on historical data) over a sufficiently long-time horizon. Expected returns are theoretical returns.  They are not estimated returns and are in no way indicative of actual or future performance.  In administering the managed portfolios, the expected rate of return of each asset class is the forecast arithmetic annual mean for the next five years.  The expected rate of return is recalculated quarterly.  These forecasts have been developed using the Capital Asset Pricing Model concept, originally developed by Nobel Prize-winning financial economist William Sharpe of Stanford University.  The longest possible time series data have been used, in conjunction with generally accepted investment principles, to arrive at theoretically valid expected returns and standard deviations. (For some asset classes data is available as far back as 1926.)

Standard Deviation

The standard deviation is a measure of volatility. In general the higher the standard deviation, the greater the volatility or risk. An asset class’s annual total return can be expected to fall within one standard deviation of its expected rate of return roughly two-thirds of the time, and within two standard deviations approximately 95% of the time. In other words, an asset class with a one-year standard deviation of 5% and an expected return of 8% would be expected to vary between +13% and+3% (±5%) about 68% of the time, and between +18% and -2% (±10%) about 95% of the time.

Manager Selection for Each Asset Class

Many investors feel that they could have earned better returns than they did during the last few years. Unfortunately, most investors are using the wrong tools and put themselves at a significant disadvantage to institutional investors.

Almost all investors would benefit by using institutional asset classes. An asset class is a group of investments whose risk factor and expected returns are similar. Originally, institutional asset class funds were not available to individual investors. Often, the minimum investment for these funds was in the millions of dollars, effectively removing them from reach from all but the wealthiest investors. That was their goal because these funds were for institutional accounts, such as large pension plans. Working with our firm provides our investors with access to these institutional asset class funds.

There are four major attributes of institutional asset class funds that attract institutional investors:

1. Lower Operating Expenses

All managed funds, ETFs, and separately managed accounts have expenses that include management fees, administrator charges, and custody fees. These are expressed as a percentage of assets. The average annual expense ratio ranges from 1% to 1.5% for retail equity managed funds.2  In comparison, the same ratio for asset class funds and ETFs is typically only about one-quarter of this expense. All other factors being equal a lower cost leads to a higher rate of return.

2. Lower Turnover Resulting in Lower Cost

High turnover is costly to shareholders because each time a trade is made there are transaction costs, including commissions, spreads and market-impact costs – costs of which most investors are unaware. These hidden costs may amount to more than a fund’s total operating expenses if the fund trades heavily or if it invests in small company shares whose trading costs are very high.

Institutional asset class funds have significantly lower turnover because their institutional investors want them to deliver a specific asset class return with as low cost as possible, versus “beating the market” through research, market timing, or tracking a specific index which must be reconstituted periodically.

3. Lower Turnover Resulting in Lower Taxes

If a managed fund sells a security for a gain, it must make a capital gains distribution to shareholders because managed funds are required to distribute all of their taxable income each year, including realised capital gains.

In one study, Stanford University economist John B. Shoven and Joel M. Dickson3 found that taxable distributions have a negative effect on the rate of return of many well-known retail equity managed funds.

They found that a high-tax-bracket investor who reinvested the after-tax distribution ended up with an accumulated wealth per dollar invested of only 45% of the fund’s published performance.  An investor in the middle tax bracket realised just 55% of the published performance.

Because institutional asset class funds have lower turnover, they often have significantly lower tax.

4. Consistently Maintained Market Segments

Most investment advisors agree that the largest determination of performance is asset allocation—how your money is divided among different asset categories. 

However, you can only accomplish effective asset allocation if your investments in your portfolio maintain consistent asset allocation. That means your funds need to stay within their target asset classes. Unfortunately, most investment funds effectively have you relinquish control of your asset allocation as they overweight particular parts of the market in their quest to achieve higher rates of return than the market as a whole.  In contrast, because of their investment mandates, institutional asset class funds and ETFs must stay fully invested in the specific asset class they represent.

1DFA: Returns Program.
2Arch Capital Sample.
3A study commissioned by Charles Schwab and conducted by John Shoven, a Stanford University economics professor, and Joel Dickson, a Stanford PhD candidate, measured the performance of 62 equity funds for the 30-year period from 1963 through 1992.

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