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Even without any trades, wealth portfolio composition will change as prices change.  Prices change as the market receives new information, reevaluates the risk and expected return of each asset and liability. Therefore, in aggregation, your portfolio risk and expected return will change. Monitoring is essential to insure that your wealth portfolio does not drift too far away from your objectives.

Monitoring is also required to execute your time-dependent portfolio revisions. Examples include lowering your risk profile as you approach retirement and managing the cash inflows and outflows of your wealth portfolio. Furthermore, new investment opportunities are continuously arriving that can be used to lower investment costs, enhance diversification and improve expected return performance.

 

Portfolio monitoring and revision process

  •  Review investment objectives. What are your relevant life changes that may affect your risk tolerance, health, income, family goals and obligations?

  • Adjust your benchmark strategic asset allocation.

  • Review the market environment. How has it changed? Start with the Treasury yield curve. What are the risks and compensation available in the major sectors of the bond and stock markets? Consider the appropriateness of municipal bonds for enhanced after-tax returns and diversification in your bond portfolio. Any change in real assets, loans and private business opportunities?

  • Compare your current wealth portfolio allocation to your benchmark and consider revision alternatives that are consistent with your objectives and the current market environment.

  • Implement revisions.

 

No Brainers

  • Maximize your tax-deferred retirement contributions
  • At every opportunity rollover a company tax-deferred plan (401K, 403b, 457b, etc.) to a traditional IRA
  • In order to lower overall taxes paid, allocate more of the higher dividend yield stocks and bond investments to the tax-deferred IRA account and more of the lower dividend yield stocks to the brokerage account.
  • Reduce the cost of implementing your financial plan with no load, low expense ratio funds and avoid unnecessary advisory fees.
  • Avoid Target Date Funds
  • Avoid Annuities
  • Never Buy Whole Life Insurance

 

Management of Risk Exposures

Implementing an initial wealth portfolio focused on direct risk exposures will make it considerably easier to obtain your preferred tactical investment allocation and manage revisions with the least number of future trades. Invest in the composition of aggregate benchmarks rather than purchasing the whole benchmark. Then it will be relatively easy to implement sector tilts, rebalance and manage cash flows.

Bond Portfolio Management Examples:

The U.S. investment grade bond market is well represented by the Vanguard Total Bond Market ETF and a likely benchmark candidate. The interest rate, default and prepayment risk factors are bundled in relatively fixed proportions. These proportions change gradually by net new issuance and relative price changes.  This ETF is approximately 47% Government bonds, 26% corporate bonds and 23% Agency mortgage-backed securities (MBS). The remaining 4% is in some additional securitized bonds (i.e., commercial mortgage-backed and asset-backed securities), convertible bonds and cash.

Therefore, you can closely replicate this benchmark with Treasury, Agency MBS and Corporate bond mutual funds and ETFs. All the default risk is in the corporate bond sector, prepayment risk is primarily in the MBS sector and interest rate risk is in all three sectors. The government and corporate bond sectors can easily be further subdivided into short, intermediate and long-term funds to manage interest rate risk.  Unbundling the risk dimensions into separate funds allows the investor to allocate wealth to risks that provide more or less compensation per unit of risk.

Click on the brokerage account, new revision, and use the account actions dropdown menu to add a new investment. Then use the bond fund screener to download the Vanguard MBS, corporate bond, and three Treasury (short, intermediate and long-term) low expense ratio ETFs.

Ripsaw’s fund screener is designed to be an efficient search process for specific risk exposures. There is a setup for fund family, maximum expense ratio, active, index, ETF and mutual fund criteria parameters.  Then there is a decision-tree selection process to obtain a specific risk exposure. For example, click on bond fund, and then consider changing the set up criteria. After making any criteria changes or not, click on NEXT.  Under the US Funds column, select US Treasury (AAA), and then select a Short Term, Intermediate Term, Long Term or Other category. Ripsaw will then display an output list of funds that satisfy all your criteria in order of ascending expense ratios.  Click on the information drop down menu, select Bond Details and scrolling to the right will further help you determine which funds you want to include for potential investment.

With a little trial and error, the $ 100,000 in a money market fund is reallocated to the revised portfolio below. The revised portfolio is a good replication of the Vanguard Total Bond Market ETF benchmark. The ratings, maturity and bond sector buckets of the revised portfolio are all very close to the benchmark.

 

 

 

 

Consider an individual (or fund manager) that is measuring performance relative to the total U.S. investment grade bond market and has a long-term horizon. Tilting portfolio weights toward Agency MBS and corporate bonds are expected to earn their respective prepayment and default risk premiums. Given a neutral view on interest rates, how can this investor increase the Agency MBS and corporate sectors by 10% each (implying a 20% reduction in U.S. Treasuries) while simultaneously maintaining the benchmark interest rate risk? The following revised portfolio example accomplishes these objectives.

 

 

 

 

Reducing Treasuries by 10% to invest in corporate bonds lowered the AAA rating weight and increased the AA to BBB weights as intended. That is, an increase in default risk for higher expected returns.  Since Agency MBS are rated AAA, reducing Treasuries another 10% to invest in MBS did not affect the portfolio AAA rating, but did increase prepayment risk for which additional compensation is expected, on average.

The 20% reduction in Treasury weights was spread across the short and intermediate term ETFs in order to overweight the 20 to 30 year bucket relative to the benchmark. Rather than match all the maturity buckets to the benchmark, this adjustment was made to offset the lower interest rate risk in the revised portfolio’s 20 to 30-year bucket. The additional MBS now in this bucket has a lot less interest rate risk than the 20 to 30 year Treasuries in the benchmark. This is because 30-year MBS are fully amortizing bonds (principal repayment in every monthly cash flow) and a significant percentage of them will prepay. Both effects move cash flows on MBS forward, and hence, have less interest rate risk than a 30-year Treasury bond with a constant coupon and the entire principal payment delayed until the end of 30 years.

This is why an MBS portfolio is typically considered an intermediate-term portfolio. At origination, a MBS is close to the interest rate risk of a 10-year Treasury. As interest rates decline, prepayments increase and it is more closely interest rate risk matched with a 5-year Treasury. Further rate declines accelerate prepayments to interest rate match short-term Treasuries.

Corporate bonds have a less sensitive, but directionally similar reduction in interest rate risk. Bad news about the economy will cause a decline in Treasury rates (prices bid up in a flight to quality) and spreads to Treasury on corporate bonds will increase as default risk increases (price decline). Increased default risk means the probability of having earlier and smaller cash flows have increased. This lowers interest rate risk. The Vanguard Total Corporate Bond ETF has 48% in BBB bonds. That will reduce interest rate risk relative to their maturities.

We used our knowledge of the behavior of MBS and corporate bonds to adjust the maturity structure of the portfolio to match interest rate risk rather than maturity matching. Precision would be improved with analytic measures of effective duration that will be in Ripsaw Plus.

 

Stock Portfolio Management Examples:

The total U.S. Stock Market can be subdivided into large, mid and small capitalization weights with further subdivisions based on value, blend and growth characteristics. Specialty sectors are also available. Even if you were to match the risk of the benchmark, you could allocate the high dividend yield components to a tax-deferred plan and the low dividend yields to your taxable brokerage account. That strategy will increase after-tax returns at no additional risk.

First consider just closely replicating the stock benchmark with large, mid and small capitalization funds. Click on the brokerage account, new revision, and use the account actions dropdown menu to add a new investment. Then use the stock fund screener to download the low expense ratio Fidelity Small Cap Index mutual fund, Vanguard Mid-Cap ETF, and iShares Core S&P 500 ETF. With a little trial and error, the following revisions create a stock portfolio that closely matches the U.S. total stock market benchmark.

Ripsaw’s fund screener is designed to be an efficient search process for specific risk exposures. There is a setup for fund family, maximum expense ratio, active, index, ETF and mutual fund criteria parameters.  Then there is a decision-tree selection process to obtain a specific risk exposure. For example, click on Stock Fund and consider changing the set up criteria. After making any criteria changes or not, click on NEXT. Under US Funds, select US Small Capitalization tilt, and then choose between Blend, Value Tilt or Growth Tilt. Ripsaw will generate output of a list of funds that satisfy all your criteria in ascending expense ratios.  Click on the information drop down menu, select Stock Details and scrolling to the right will further help you determine which funds you want to include for potential investment.

All fund names have a primary objective, but there is overlap. When selecting funds to include in your portfolio, try to get your primary maximum exposure at the lowest cost. This will make the investment weighting trial and error process much easier. Using the stock details in the fund screener, we noticed that the Vanguard Small Cap Index was only 41.47% in small cap exposure and 58.19% in mid cap. That means we would have to use much more of this fund to get to our small cap fund objective than necessary. It would also limit our flexibility in getting a desired mid-cap exposure. Hence, we selected the low cost Fidelity Small Cap Index with 78.73% in small cap exposure and 21.27% in mid cap.

The trial and error process is also made easier by starting with the small cap fund that had almost no exposure to large cap.  Vary the percentage allocation to get close to the benchmark small cap weight in dollars. Use the difference from benchmark icon to work with dollar differences. Then work with the large and mid cap funds to get close to their respective dollar weights in the benchmark.

 

 

 

 

 

Now consider a long-term investor that wants to tilt their portfolio toward small capitalization stocks for additional expected returns with little give up in diversification. In revision mode, we can experiment with how much large cap stocks to sell and how much small cap to buy. For example, take 10% from large cap and 2% from mid cap to increase the small cap investment to 19.6%.

Another good reason to separate the stock market into capitalization buckets is new private investment opportunities. Suppose entrepreneurs you trust and have known for many years offer you an opportunity to invest in ABC Storage LLC with a successful history. The dividend is expected to be 15% plus a 50% capital gain potential within 5 years. That is significantly more attractive than your small stock portfolio, but less liquid with reduced diversification. Since the current investment portfolio is very liquid, a reasonable position in a less liquid stock for a much higher risk-adjusted expected return may be reasonable. The price for a share is $ 8,000. You can set ABC Storage LLC up as a manual account in Ripsaw.

What should you sell to make the investment? Since the company qualifies as small capitalization (under $ 1 Billion), the least effect on your capitalization distribution (observed in the wealth dashboard) is to sell from the Fidelity Small Cap ETF and transfer the cash to the manual account ABC Storage LLC. 

Now let’s consider how to simultaneously manage the capitalization and value/growth distributions in your wealth portfolio. That will require the flexibility inherent in six funds with the following tilt combinations: Large Cap Growth, Large Cap Value, Mid Cap Growth, Mid Cap Value, Small Cap Growth and Small Cap Value. Below is a revised portfolio with six low cost funds that satisfy these characteristics. The investment weights applied to these funds result in closely matching the U.S. total market benchmark in all characteristics.

 

Now consider a long-term investor that wants to tilt their portfolio toward small capitalization stocks and value stocks for additional expected returns with little give up in diversification. Selling large cap growth stocks, buying small cap value stocks, selling mid cap growth stocks and buying mid cap value stocks can accomplish this. The portfolio below provides approximately an $ 8,000 (8%) overweight in small cap stocks at the expense mostly of large cap stocks and an approximately $ 4,000 (4%) overweight in value stocks at the expense of growth stocks relative to the total US stock market benchmark.

 

After implementing a portfolio revision decision, monitoring a wealth portfolio is required to maintain a strategic asset allocation or execute a tactical trade. This can be analyzed with a new revision to decide how much can be accomplished with cash inflows and outflows as well as trades.