By
David
Taube
:
This piece is part of a new, ongoing series here on the
ETFs & Portfolio Strategy
page at Seeking Alpha.
The concept is for a money manager or RIA to field a hypothetical
portfolio construction question from an SA user about how to best
construct a portfolio that will help them meet their financial
goals and then proceed to build an effective portfolio that will
take their risk/reward profile into account. All participants in
this series are real-world professional investors who are
available to help individuals, companies, and financial
professionals construct intelligent portfolios. To submit a
question for a future edition of Build My Portfolio, email
Rebecca at rbarnett@seekingalpha.com.
This edition of Build My Portfolio features David Taube. David
is CEO and CIO of
Kalorama
Wealth Strategies
, LLC, a fee-only investment advisory and financial planning firm
in Washington, D.C., which he founded in 2005. David specializes in
the development and implementation of investment and retirement
plans. He also assists clients with other aspects of their
financial planning, including cash flow and net worth analysis,
insurance review, tax analysis, and estate plan review. David is a
Certified Financial Planning professional and a member of the
Financial Planning Association, a CFA charter holder, with
membership in the CFA Institute and the CFA Society of Washington,
D.C. and formerly a CPA licensed in the State of Maryland.
David,
I am a 56-year-old plastic surgeon who makes roughly $600k a
year after taxes. I have fully paid off the mortgage on my house,
which is currently valued at approximately $1.4M. I also own a
second home in Napa valued at roughly $490k. After all expenses,
I have roughly $150k a year to put into savings.
My wife passed away four years ago of breast cancer and I have
recently begun dating again with an eye on eventually getting
remarried. I have three kids, the youngest of which is my
25-year-old daughter, who is currently enrolled in a top-tier law
school. My two sons both followed me into medicine - one is in
residency and the other is in private practice.
In terms of money I already have put aside, I have always been
100% invested in stocks as my belief has been that since stocks
outperform bonds in the long-run, as long as I had a lot of time,
I was best off being fully in equities. I currently have $3.8M
($300k is in my Roth IRA; the other $3.5M is not in a tax
sheltered account) spread more or less evenly across three
American Funds Mutual Funds (all A-share class): Growth Fund of
America, EuroPacific Growth Fund and the New World Fund.
My long-term financial goals are as follows: Have enough money
to help cover the cost of my grandchildren's private education as
those costs continue to rise and doctors (i.e. my 2 sons) are
assured less of a large paycheck. Retire by the time I'm in my
low 70s - I have no desire to retire before then as I thoroughly
enjoy work. Other family members of mine have lived to relatively
old age - my grandfather passed away just a few years ago at the
age of 100 and my parents are still going strong at age 78 with
no real health problems to speak of. I have a great aunt that is
also still alive and in excellent health for a 97 year old. It's
safe to assume I will need enough to live for about 20 years in
retirement. Please help me build my portfolio so I can achieve my
long-term financial goals.
Thanks!
Rich
Orange County, California
Dear Rich,
Congratulations on accumulating a sizeable portfolio! Your decision
to invest 100% in stocks with a long-term focus was very prudent,
but as your time horizon gets shorter and the need arises to draw
from your investments, you may want to reconsider this strategy.
Most investors maintain an allocation to bonds to minimize the risk
and volatility of the overall portfolio.
Along with maintaining a long-term focus, Kalorama Wealth
Strategies believes that broadly diversifying among asset classes,
and periodically rebalancing a portfolio comprise the three
investment principles that can make an investor successful. Our
philosophy also includes minimizing costs and taxes so that the
investor will earn the greatest after-tax return.
Kalorama Wealth Strategies follows a globally-diversified
investment strategy using multiple asset classes or investment
styles. Portfolio construction uses a Strategic Asset Allocation
with a target or neutral weighting for each of the asset classes or
investment styles. Rebalancing tolerances are set above and below
the targets as a guideline for when the allocation should be
rebalanced. Portfolios are reviewed for rebalancing at least once a
year and more often during periods of market volatility.
The overall investment strategy is based upon Modern Portfolio
Theory ((MPT)) and the premise that asset allocation is the most
important decision in determining portfolio returns, not market
timing or security selection.
It is time in the market, not timing the market
. The goal is to invest in uncorrelated asset classes or investment
styles.
By broadly diversifying the portfolio, each period the investor
captures the returns of the top-performing asset classes. History
and research have shown that by following this strategy (i.e.,
capturing the top-performing returns), the investor will outperform
more narrowly invested portfolios with less risk (based on using
standard deviation as a measure of volatility).
Periodically rebalancing the portfolio to maintain the asset
allocation strategy forces the "Buy Low, Sell High" paradigm. The
investor is required to sell over-weighted or outperforming assets
and use the funds to purchase under-weighted or underperforming
assets. Having a rebalancing discipline also helps to reduce the
emotional investment decision-making that may create panic selling
in a bear market and aggressive buying in a bull market.
Vehicles used to construct a portfolio include exchange-traded
funds (ETFs) and actively-managed no-load mutual funds. ETFs are
typically the sole vehicle used in taxable accounts, while mutual
funds are used in tax-deferred accounts. For each of the asset
classes and investment styles, we undertake extensive quantitative
and qualitative analysis to identify the top performing fund and/or
manager available.
The first step in building a portfolio is to determine the
investment policy
, which is how the overall portfolio will be split between equity
(stock) and fixed-income (bond) investments. The next step is to
diversify the portfolio within the broad stock and bond asset
classes with a strategic mix.
The first decision is how much of the overall portfolio should
be invested internationally. Depending on an investor's risk
tolerance, we typically allocate 20% to 30% to international-only
investments. The equity international investments are split between
large-cap and small-cap companies in developed and emerging
markets.
Based on our belief that investing in uncorrelated asset classes
or investment styles will enhance long-term returns, we then
specifically allocate 10% of the overall equity portfolio to the
real estate and energy/natural resource sectors. Historically,
these asset classes have had low correlations with other
investments, thereby enhancing the risk-return characteristics of
the portfolio.
The remaining equity portfolio is divided among domestic growth
and value, large and small-cap companies.
An all-equity ETF portfolio may include the following funds:
- Vanguard Large Cap (
VV
)
- Vanguard Small Cap (
VB
)
- SPDR Dow Jones Global Real Estate (
RWO
)
- Market Vectors RVE Hard Assets Producers (
HAP
)
- Vanguard MSCI EAFE (
VEA
)
- iShares MSCI EAFE Small Cap (SCZ)
- Vanguard Emerging Markets (VWO)
With ETF portfolio holdings being based on a target index, major
considerations for fund selection include the operating expense
ratio, underlying index and holdings, and historical
performance.
Investing in indexed-based investments is a zero-sum game. They
all have the same zero-return starting point on January 1 so paying
a higher expense ratio is a potential drag on performance. Due to
their lower operating expenses, this typically leads us to Vanguard
ETFs when they are available for an asset class or investment
style.
In addition, the Vanguard domestic equity ETFs are based on MSCI
indices, which represent a broader portfolio than Standard &
Poor's index-based ETFs (i.e., 500 stocks for large caps and 600
stocks for small caps) and have out-performed both the S&P and
Russell-based indices since their inception (based on compound
annual returns). The MSCI index series also provides broader
diversification for international ETFs.
For an investor with an allocation to bonds, the process is
similar. We start by allocating 20% to 30%, split between developed
and emerging market debt, primarily in sovereign issuers. For
risk-tolerant investors, we may include up to 20% in high-yield and
convertible bonds. The balance of the bond portfolio is divided
among funds invested in U.S. Treasury and Agency securities,
Treasury Inflation Protected Securities (TIPS), and a total return
fund invested in multiple asset classes such as treasuries,
corporate bonds, as well as mortgage- and asset-backed securities.
Municipal bonds may be used if a high-income investor has a large
taxable portfolio.
A bond ETF portfolio may include the following funds:
- iShares BarCap 7-10 Year Treasury (IEF)
- SPDR BarCap TIPS (IPE)
- Vanguard Total Bond (BND)
- SPDR BarCap High Yield (JNK)
- SPDR BarCap Convertible Securities (CWB)
- iShares S&P National AMT-Free Muni (MUB)
- SPDR BarCap International Treasury (BWX)
- PowerShares Emerging Markets Sovereign Debt (PCY)
Even though Vanguard has a limited selection of bond ETFs, low
expense ratios still play a large part in the selection of
investments on the bond side of the portfolio. For example,
although the SPDR BarCap TIPS (IPE) ratio of 0.18% may only be two
basis points lower than iShares BarCap TIPS (TIP), the
out-performance for the past two years has been more than the
expense differential. Again, lower costs would lead us to SPDR
BarCap High Yield Bond (JNK) compared with iShares iBoxx $ High
Yield Corporate Bond (HYG) (40 basis points versus 50,
respectively), with significantly better annual performance in 2009
and 2010.
The benefit of combining assets whose expected returns are not
highly correlated includes the potential for enhanced returns at
the portfolio level. Broad diversification limits the impact on the
total portfolio of losses in individual investments or asset
classes. A globally-diversified portfolio containing many asset
classes with different characteristics of return, risk and
correlations decreases portfolio risk - or volatility - and
provides the best opportunity for meeting long-term investment
objectives.
Disclosure:
Kalorama's client portfolios are long all of the securities and/or
asset classes mentioned in this article.
Disclaimer Statement:
This article is for informational purposes only and is not
financial, legal, or tax advice. It does not constitute an offer by
Kalorama or any of its representatives to provide any investment
advice or service. All investment advisory services are offered
through the presentation of Kalorama's Form ADV Part 2, personal
contact with Kalorama representatives, and the execution by a
client and Kalorama of an investment advisory agreement.
Please consult with your advisor before making any
decisions.
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