Objective information about financial planning, investments, and retirement plans

4 Benefits of Portfolio Rebalancing

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The past year has been volatile for investors. Between a dip in the markets last year, a shaky start to the current year and the Brexit vote in the U.K. it has been quite a roller coaster ride for investors. In spite of all of this, major market indexes stand at or near record levels. In the course of all of this, your portfolio may have strayed from your target allocation and it might be time to rebalance.  Here are 4 benefits of portfolio rebalancing.

4 Benefits of Portfolio Rebalancing

Balancing risk and reward

Asset allocation is about balancing risk and reward. Invariably some asset classes will perform better than others. This can cause your portfolio to be skewed towards an allocation that takes too much risk or too little risk based on your financial objectives.

During robust periods in the stock market equities will outperform asset classes such as fixed income. Perhaps your target allocation was 65% stocks and 35% bonds and cash. A stock market rally might leave your portfolio at 75% stocks and 25% fixed income and cash. This is great if the market continues to rise but you would likely see a more pronounced decline in your portfolio should the market experience a sharp correction.

Portfolio rebalancing enforces a level of discipline

Rebalancing imposes a level of discipline in terms of selling a portion of your winners and putting that money back into asset classes that have underperformed.

This may seem counter intuitive but market leadership rotates over time. During the first decade of this century emerging markets equities were often among the top performing asset classes. Fast forward to today and they coming off of several years of losses.

Rebalancing can help save investors from their own worst instincts. It is often tempting to let top performing holdings and asset classes run when the markets seem to keep going up. Investors heavy in large caps, especially those with heavy tech holdings, found out the risk of this approach when the Dot Com bubble burst in early 2000.

Ideally investors should have a written investment policy that outlines their target asset allocation with upper and lower percentage ranges. Violating these ranges should trigger a review for potential portfolio rebalancing.

A good reason to review your portfolio

When considering portfolio rebalancing investors should also incorporate a full review of their portfolio that includes a review of their individual holdings and the continued validity of their investment strategy. Some questions you should ask yourself:

  • Have individual stock holdings hit my growth target for that stock?
  • How do my mutual funds and ETFs stack up compared to their peers?
    • Relative performance?
    • Expense ratios?
    • Style consistency?
  • Have my mutual funds or ETFs experienced significant inflows or outflows of dollars?
  • Have there been any recent changes in the key personnel managing the fund?

These are some of the factors that financial advisors (hopefully) consider as they review client portfolios.

This type of review should be done at least annually and I generally suggest that investors review their allocation no more often than quarterly.

Helps you stay on track with your financial plan 

Investing success is not a goal unto itself but rather a tool to help ensure that you meet your financial goals and objectives. Regular readers of The Chicago Financial Planner know that I am a big proponent of having a financial plan in place.

A properly constructed financial plan will contain a target asset allocation and an investment strategy tied to your goals, your timeframe for the money and your risk tolerance. Periodic portfolio rebalancing is vital to maintaining an appropriate asset allocation that is in line with your financial plan.

The Bottom Line 

Regular portfolio rebalancing helps reduce downside investment risk and ensures that your investments are allocated in line with your financial plan. It also can help investors impose an important level of discipline on themselves.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.  

4 Things To Do When The Stock Market Drops

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The stock market has started out the new year with some hefty declines. We are seeing firsthand the impact that China has on our markets. CNBC is calling this the worst start to a new year in almost a century. What should you do now? Here are 4 things to do when the stock market drops.

4 Things to do When the Stock Market Drops

Breathe 

Cable news networks like CNBC have a field day during steep, sudden stock market corrections like we are seeing this week. It’s easy to get caught up in all of this hype. Don’t let yourself be sucked in.

Step back, take a deep breath and relax.

Take stock of where you are 

Review your accounts and see the extent of the damage that has been done. Depending upon how you are invested it may be minor or a bit more significant. Investors who are well-diversified have probably been hurt but not to the extent of those with a heavy allocation to equities and other areas that have been hit.

Review your asset allocation 

Has your portfolio weathered this storm and the declines of this past summer as you would have expected? If so your allocation is likely appropriate. If not, then perhaps it is time to review your asset allocation and make some adjustments. Proper diversification is great way to reduce investment risk.

Go shopping 

Market declines can create buying opportunities. If you have some individual stocks, ETFs or mutual funds on your “wish list” this is the time to start looking at them with an eye towards buying at some point. It is unrealistic to assume you will be able to buy at the very bottom so don’t worry about that.

Before making any investment be sure that it fits your strategy and your financial plan. Also make sure the investment is still a solid long-term holding and that it is not cheap for reasons other than general market conditions.

The Bottom Line 

The stock market declines we’ve seen since the start of 2016 have been steep and unnerving. Don’t panic and don’t let yourself get caught up in all of the media hype. Stick to your plan, review your holdings and make some adjustments if needed. Nobody knows where the markets are headed but those who make investment decisions driven by fear usually regret it.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email.

8 Portfolio Rebalancing Tips

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My last post discussed 4 Benefits of Portfolio Rebalancing. This post continues on the rebalancing theme and looks at some ways to implement a rebalancing strategy. Here are 8 portfolio rebalancing tips that you can use.

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Set a target asset allocation 

Your asset allocation should be an outgrowth of a target asset allocation from your financial plan and/or a written investment policy. This is the target asset allocation that should be used when rebalancing your portfolio. 

Establish a time frame to rebalance 

Ideally you are reviewing your portfolio and your investments on a regular basis. As part of this process you should incorporate a review of your asset allocation at a set interval. This might be semi-annually for example. I generally suggest no more frequently than quarterly. An exception would be after a precipitous move up or down in the markets.

Take a total portfolio view 

When rebalancing your portfolio take a total portfolio view. This includes taxable accounts as well as retirement accounts like an IRA or your 401(k). This approach allows you to be strategic and tax-efficient when rebalancing and ensures that you are not taking too little or too much risk on an overall basis.

Incorporate new money 

If you have new money to invest take a look at your asset allocation first and use these funds to shore up portions of your asset allocation that may be below their target allocation. A twist on this is to direct new 401(k) contributions to one or two funds in order to get your overall asset allocation back in balance. In this case your will need to take any use of your plan’s auto rebalance feature into account as well. 

Use auto pilot 

For those with an employer sponsored retirement plan such as a 401(k), 403(b) or similar defined contribution plan many plans offer an auto-rebalancing feature. This allows you to select a time interval at which your account will be rebalanced back to the allocation that you select.

This serves two purposes. First it saves you from having to remember to do it. Second it takes the emotion and potential hesitation out of the decision to pare back on your winners and redistribute these funds to other holdings in your account.

I generally suggest using a six-month time frame and no more frequently than quarterly and no less than annually. Remember you can opt out or change the interval at any time you wish and you can rebalance your account between the set intervals if needed.

Make charitable contributions with appreciated assets 

If you are charitably inclined consider gifting shares of appreciated holdings in taxable accounts such as individual stocks, mutual funds and ETFs to charity as part of the rebalancing process. This allows you to forgo paying taxes on the capital gains and provides a charitable tax deduction on the market value of the securities donated.

Most major custodians can help facilitate this and many charities are set-up to accept donations on this type. Make sure that you have held the security for at least a year and a day in order to get the maximum benefit. This is often associated with year-end planning but this is something that you can do at any point during the year.

Incorporate tax-loss harvesting

This is another tactic that is often associated with year-end planning but one that can be implemented throughout the year. Tax-loss harvesting involves selling holdings with an unrealized loss in order to realize that loss for tax purposes.

You might periodically look at holdings with an unrealized loss and sell some of them off as part of the rebalancing process. Note I only suggest taking a tax loss if makes sense from an investment standpoint, it is not a good idea to “let the tax tail wag the investment dog.”

Be sure that you are aware of and abide by the wash sale rules that pertain to realizing and deducting tax losses.

Don’t think you are smarter than the market 

It’s tough to sell winners and then invest that money back into portions of your portfolio that haven’t done as well. However, portfolio rebalancing is part of a disciplined investment process.  It can be tempting to let your winners run, but too much of this can skew your allocation too far in the direction of stocks and increase your downside risk.

If you think you can outsmart the market, trust me you can’t. How devastating can the impact of being wrong be? Just ask those who bought into the mantra “…it’s different this time…” before the Dot Com bubble burst or just before the stock market debacle of the last recession.

The Bottom Line 

Portfolio rebalancing is a key strategy to control the risk of your investment portfolio. It is important that you review your portfolio for potential rebalancing at set intervals and that you have the discipline to follow through and execute if needed.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email.

Smart Beta ETFs the Next Big Thing?

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For those of us involved in financial services it is hard to check your Twitter stream or visit an industry website without seeing the term smart beta. ETF providers have really taken to this trend and have introduced many new ETFs based on some aspect of smart beta.

Nobody follows a trend quite like the folks who market mutual funds or ETFs and smart beta is the hip thing that all of the “cool kids” are doing. At a recent ETF industry conference sponsored by Morningstar (MORN) this was virtually all anyone was talking about in the sessions I attended.

What is smart beta and is it really smart?  Are smart beta ETFs the next big thing in ETF investing?

Smart Beta Defined 

According to Investopedia (for whom I am a frequent contributor):

“Investment managers that follow a smart beta investment strategy seek to passively follow indices, while also taking into account alternative weighting schemes such as volatility. That’s because smart beta strategies are implemented like a typical index strategies in that the index rules are set and transparent. Smart Beta strategies will differ from standard indices, such as the S&P 500 or the Barclays Aggregate, in that the indices focus on areas of the market that offer an opportunity for exploitation.” 

We will attempt to expand on that definition a bit below. 

Factor investing 

Most smart beta ETFs take an aspect or a factor from a traditional index. Traditional index ETFs passively track a market value weighted index like the S&P 500.  Some popular factors include low volatility, momentum; equal-weighted indexes, dividends and quality are common factors. An equal-weighted index would give equal weighting to a huge stock like Apple (APPL) and to the smallest stock in terms of market capitalization in the S&P 500 Index.

An example of a smart beta ETF based on a factor is the Powershares S&P 500 Low Volatility ETF (SPLV).

This ETF invests in the 100 stocks in the index that have exhibited the lowest volatility over the past 12 months. A sound idea in theory and perhaps ultimately in practice.

Like many smart beta ETFs the inception date of SPLV was May 5, 2011 over two years after the low point of the markets during the financial crises. The index the ETF follows was essentially created in the lab via back-testing, much like the Peter Boyle character in the movie Young Frankenstein. This means that most of the “history” of this ETF is via back-testing and not real performance data. As a presenter at the Morningstar conference said, he’s never seen a back-test that did not yield a positive result.

Looking at SPLV’s results, the ETF trails the S&P 500 index in terms of trailing three year returns 12.95% to 14.77% on an average annual basis for the period ending 10/19/2015. However for the year-to-date period through the same date SPLV has gained 1.27% versus 0.41% for the index.

Looking at another measure, standard deviation of return which measures the variability of the ETF’s returns (up and down) over the three year period ending 9/30/2015, the standard deviation for SPLV is +/- 9.63% versus +/- 9.74% for the index. My guess is that a selling point of this ETF would be lower volatility but over the past three years the smart beta ETF is only fractionally less volatile than the index and an investor would have considerably less money if they had held SPLV over a more traditional ETF like the SPDR S&P 500 ETF (SPY).

Is an investment in SPLV a bad idea? I don’t know because I have no idea how this ETF will hold up in a pronounced bear market. Yes it has performed better than the full index so far in 2015 including the volatility in August and September. How will it do if we hit a rough patch like 2000-2002 or 2008-2009? Good question.

A growth area 

According to data from Morningstar as of 6/30/2015:

  • There were 444 smart beta products listed in the U.S.
  • These products accounted for $540 billion in assets under management which was 21% of all U.S ETF assets.
  • Of the new cash flows into ETFs over the past 12 months, 31% went into smart beta products.
  • The assets in these products grew 27% over the same period.
  • A quarter of new ETF launches over the past five years were smart beta products.

Who uses smart beta ETFs? 

From what I have heard and read smart beta ETFs are being used largely by financial advisors and institutional investors versus individuals. You might say so what? These folks are likely investing your money either via your relationship with a financial advisor who may use them in a portfolio or use a TAMP (turnkey asset management program) program offered by a third-party to manage your money.

Reasons to use Smart Beta 

Morningstar cites several reasons investors and advisors might consider smart beta ETFs:

  • To manage portfolio risk
  • To enhance portfolio returns
  • For tactical asset allocation, meaning an allocation that is based in part on the advisor’s assessment of market conditions
  • Reducing fees versus actively managed mutual funds
  • To use an active strategy grounded by an index core

Many, including me, view strategic beta as a form of active management. A presenter at the Morningstar conference suggested that any smart beta ETF with an expense ratio of 50 basis points or higher should not be considered as this is the lower end of the fee range for the better actively managed mutual funds offering an institutional share class.

What does this mean for individual investors? 

Again I suspect that most of the money invested here will be institutional or via financial advisors. As an individual investor working with a financial advisor who suggests using smart beta ETFs in your portfolio, you should ask them to explain their rational. Why are these ETFs a better choice than an asset allocation strategy using more traditional index products?

If you will using smart beta ETFs on your own, be sure that you fully understand the underlying index which was likely created post-financial crises via back testing. Understand that smart beta strategies may look good on paper but in reality they can take a number of years to prove themselves.  Lastly understand that strategies that look good in testing may not work as well when millions of dollars are actually invested there real-time.

For financial advisors 

Most financial advisors that I know are very deliberate in testing new products and investing ideas before using them with clients. With the rise of third-party advisors such as TAMPs and ETF strategists, financial advisors still need to understand the underlying products and strategies being used to invest their client’s hard-earned money.

The Bottom Line 

Smart beta is the next evolution of ETF investing or so say the firms trying to gather assets into these products. I’m not saying that smart beta isn’t an enhancement or that I am against new investing inovations. I am leery of any investment vehicle designed to solve a problem or fill a role in portfolios that have not gone through a full stock market cycle. With any investment vehicle that you are considering, be sure to fully understand the benefits, the risks and the costs. How smart is smart beta? We really won’t know until the market goes through a full cycle that includes a significant correction.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner.

How Much Apple Stock Do You Really Own?

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Apple (AAPL) stock has been a great investment over the years. Based upon its stock price and the number of shares outstanding it is the largest U.S stock based upon market capitalization.  This means it is the largest holding in popular index mutual funds and ETFs like Vanguard 500 (VFINX) and the SPDR S&P 500 ETF (SPY).

Chuck Jaffe recently wrote an excellent piece for Market Watch discussing the impact that a recent drop in Apple stock had on a number of mutual funds that hold large amounts of Apple.  He cited a list of funds that had at least 10% of their assets in Apple.  On a recent day when Apple stock fell over 4% these funds had single day losses ranging from 0.22% to 2.66%.

The point is not to criticize mutual fund managers for holding large amounts of Apple, but rather as a reminder to investors to understand what they actually own when reviewing their mutual funds and ETFs.

Stock overlap 

In the late 1990s a client had me do a review of their portfolio as part of some work I was doing for the executives of the company. He held 19 different mutual funds and was certain that he was well-diversified.

The reality was that all 19 funds had similar investment styles and all 19 held some of the popular tech stocks of the day including Cisco (CSCO), Intel (INTC) and Microsoft (MSFT). As this was right before the DOT COM bubble burst in early 2000 his portfolio would have taken quite a hit during the market decline of 2000-2002.

Understand what you own 

If you invest in individual stocks you do this by choice. You know what you own. If you have a concentrated position in one or more stocks this is transparent to you.

Those who invest in mutual funds and other professionally managed investment vehicles need to look at the underlying holdings of their funds.  Excessive stock overlap among holdings can occur if your portfolio is concentrated in one or two asset classes. This is another reason why your portfolio should be diversified among several asset classes based upon your time horizon and risk tolerance.

As an extreme example someone who works for a major corporation might own shares of their own company stock in some of the mutual funds and ETFs they own both inside their 401(k) plan and outside. In addition they might directly own shares of company stock within their 401(k) and they might have stock options and own additional shares elsewhere. This can place the investor in a risky position should their company hit a downturn that causes the stock price to drop.  Even worse if they are let go by the company not only has their portfolio suffered but they are without a paycheck from their employer as well.

Concentrated stock positions 

Funds holding concentrated stock positions are not necessarily a bad thing. A case in point is Sequoia (SEQUX) which has beaten its benchmark the S&P 500 by an average of 373 basis points (3.73 percentage points) annually since its inception in 1970.  Sequoia currently has about 26% of its portfolio in its largest holding and another 8% in the two classes of Berkshire Hathaway stock.  Historically the fund has held 25-30 names and at one time held about 30% of the portfolio in Berkshire Hathaway (BRK.A).  Year-to-date through August 14, 2015 the fund is up 16.5% compared to the benchmark’s gain of 2.88%.

The Bottom Line 

Mutual fund and ETF investors may hold more of large market capitalization stocks like Apple and Microsoft than they realize due to their prominence not only in large cap index funds but also in many actively managed funds. It is a good idea for investors to periodically review what their funds and ETFs actually own and in what proportions to ensure that they are not too concentrated in a few stocks, increasing their risk beyond what they might have expected.

Please feel free to contact me with any questions, comments or suggestions about this article or anything else on The Chicago Financial Planner. Thank you for visiting the site.

Schwab Intelligent Portfolios: The Evolution of the Robo Advisor?

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Charles Schwab (SCHW) recently launched its much anticipate entry into the Robo Advisor space, Schwab Intelligent Portfolios.  Schwab instantly will become a major player here simply because they are Schwab.

I honest don’t know if Intelligent Portfolios are a good thing for investors or not.  I do suspect that the introduction of Schwab Intelligent Portfolios represents a big step in the evolution of Robo Advisors.

Competitor reactions to Schwab Intelligent Portfolios 

Betterment CEO Jonathan Stein appeared on CNBC recently and frankly I was taken aback at how critical he was of the new Schwab offering.

Wealthfront’s CEO wrote a very critical post about Schwab’s entrance into the Robo Advisor space.

These reactions alone tell me that Schwab’s Intelligent Portfolios are a big deal and a potential game changer in the Robo Advisor world.  Wealthfront and Betterment are two of the stronger players in the Robo Advisor space.  Both are well-funded and Betterment has forged a deal with Fidelity to allow them to offer Betterment to the advisors who custody assets with Fidelity Institutional.  The reactions of these executives tell me they are more than a bit concerned about Schwab entering their space.

Schwab Intelligent Portfolios 

Schwab Intelligent Portfolios have a low $5,000 minimum investment, they carry no management fees, investors will not incur any direct transaction costs and there are no account fees.

Like most Robo Advisors, Intelligent Portfolios will be powered by algorithms using ETFs across 20 different asset classes, as well as a cash allocation invested in a bank account at a Schwab-affiliated bank.

The Schwab Intelligent Portfolios are bit different than other Robo Advisor models in that they will allocate a significant percentage of an investor’s portfolio to several Schwab ETFs based on the fundamental indexing approach of advisor Rob Arnott. The service will utilize model portfolios for investors based upon their goals and risk tolerance.

Additionally each of the portfolios has a significant allocation to cash via Schwab’s affiliated bank. The allocation would range from 7% for a 30-year-old investor to 15% for a more conservative 65 year-old investor. The cash allocations have initially drawn a skeptical reaction from some financial advisors.

While there will be no fees for the service, Schwab will make money from the expense ratios of the ETFs, as well as the money invested via the Schwab affiliated bank.  The Intelligent Portfolios will include tax-loss harvesting for investors with at least $50,000 invested as well as automatic rebalancing.

Additionally Schwab has announced the launch of an institutional version of the Intelligent Portfolios during the second quarter of 2015 for use by financial advisors who custody assets with Schwab Institutional.

The Evolution of Robo Advisors 

Schwab’s Intelligent Portfolios represents the latest entry into the Robo Advisor space by a major financial services firms.

Fidelity Investments has formed partnerships with Betterment and Learnvest that allows financial advisors who custody assets with them to offer these services to their clients under their own umbrella.  This is a great way for these advisors to court younger clients who might not meet their normal minimums and work with them in a meaningful way until they might become full-service clients in the future.

Vanguard has launched its own Robo Advisor service and it has drawn over $4.5 billion in assets without any advertising.  Most of this money has likely come from investors with money already at Vanguard and represents an additional 20 to 40 basis points in revenue on money that is already there.

For the very reasonable fee Vanguard offers clients a financial plan, asset allocation advice, rebalancing and ongoing financial advice.  They likely will roll this service out more widely in the near future and they reportedly are thinking of offering a version for financial advisors whom their institutional sales group already calls on.

Overall the Robo Advisor offerings by Schwab, Fidelity, Vanguard, TD Ameritrade and some others represent the next step in the evolution of Robo Advisors.

At some point I envision the use of Robo Advisors by the likes of Schwab and the financial advisors who custody with them almost like Major League Baseball uses the minor leagues as a farm system.  Clients who want solid advice but who don’t meet the minimums of many financial advisors will start out in some sort of online service and as their accounts grow and their needs evolve they will move to the “big leagues” and become full service clients.

Overall I view the evolution of the Robo Advisor as a good thing for both clients and financial advisors.  For clients this represents another choice in how to get financial advice.  For financial advisors it represents a viable way to serve clients who the financial services industry has not done a good job of serving in the past.

Read more about Robo Advisors 

We Interrupt This Program To Bring You… RoboWars a great piece on I heart Wall Street.

Broken Values & Bottom Lines the piece I mentioned above by Wealthfront CEO Adam Nash.

I asked three robots how I should invest, got three different answers by Yahoo! Finance’s Michael Santolli.

I’ve written several pieces on the topic for Investopedia:

Schwab’s New Robo-Advisor Service Explained

Robo-Advisors and a Human Touch: Better Together?

Is An Online Financial Advisor Right For You? 

I invite you to contact me to ask any questions that you might have, to tell me what you like or don’t like about the site, and to suggest topics that you would like to see covered here in the future. 

Please check out our Resources page for tools and services that you might find useful.

Do I Own Too Many Mutual Funds?

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In one form or another I’ve been asked by several readers “… do I own too many mutual funds?”  In several cases the question was prompted by the number of mutual fund holdings in brokerage accounts with major brokerage firms including brokerage wrap accounts.  One reader cited an account with $1.5 million and 35 mutual funds.

So how many mutual funds are too many?  There is not a single right answer but let’s try to help you determine the best answer for your situation.

The 3 mutual fund portfolio 

I would contend that a portfolio consisting of three mutual funds or ETFs could be well-diversified.  For example a portfolio consisting of the Vanguard Total Stock Market Index (VTSMX), the Vanguard Total International Stock Index (VGTSX) and the Vanguard Total Bond Index (VBMFX) would provide an investor with exposure to the U.S. stock and bond markets as well as non-U.S. developed and emerging markets equities.

As index funds the expenses are low and each fund will stay true to its investment style.  This portfolio could be replicated with lower cost share classes at Vanguard or Fidelity if you meet the minimum investment levels.  A very similar portfolio could also be constructed with ETFs as well.

This isn’t to say that three index funds or ETFs is the right number.  There may be some additional asset classes that are appropriate for your situation and certainly well-chosen actively managed mutual funds can be a fit as well.

19 mutual funds and little diversification 

A number of years ago a client engaged my services to review their portfolio.  The client was certain that their portfolio was well-diversified as he held several individual stocks and 19 mutual funds.

After the review, I pointed out that there were several stocks that were among the top five holdings in all 19 funds and the level of stock overlap was quite heavy.  These 19 mutual funds all held similar stocks and had the same investment objective.  While this client held a number of different mutual funds he certainly was not diversified.  This one-time engagement ended just prior to the Dot Com market decline that began in 2000, assuming that his portfolio stayed as it was I suspect he suffered substantial losses during that market decline.

How many mutual funds can you monitor? 

Can you effectively monitor 20, 30 or more mutual fund holdings?  Frankly this is a chore for financial professionals with all of the right tools.  As an individual investor is this something that you want to tackle?  Is this a good use of your time?  Will all of these extra funds add any value to your portfolio?

What is the motivation for your broker? 

If you are investing via a brokerage firm or any financial advisor who suggests what seems like an excessive number of mutual funds for your account you should ask them what is behind these recommendations.  Do they earn compensation via the mutual funds they suggest for your portfolio? Their firm might have a revenue-generating agreement with certain fund companies.  Additionally the rep might be required to use many of the proprietary mutual funds offered by his or her employer.

Circumstances will vary 

If you have an IRA, a taxable brokerage account and a 401(k) it’s easy to accumulate a sizable collection of mutual funds.  Add in additional accounts for your spouse and the number of mutual funds can get even larger.

The point here is to keep the number of funds reasonable and manageable.  Your choices in your employer’s retirement plan are beyond your control and you may not be able to sync them up with your core portfolio held outside of the plan.

Additionally this is a good reason to stay on top of old 401(k) plans and consolidate them into an IRA or a new employer’s plan when possible.

The Bottom Line 

Mutual funds remain the investment of choice for many investors.  It is possible to construct a diversified portfolio using just a few mutual funds or ETFs.

Holding too many mutual funds can make it difficult to monitor and evaluate your funds as well as your overall portfolio.

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.  

What is a Hedge Fund?

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The term hedge fund is used often in the financial press.  I suspect, however, that many investors do not really know what a hedge fund is.

What is a Hedge Fund?

 

 

 

 

Investopedia defines a hedge fund as follows:

“An aggressively managed portfolio of investments that uses advanced investment strategies such as leveraged, long, short and derivative positions in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark).” 

Here are a few basics about hedge funds to help you understand them.  Note this is certainly not meant to be an in-depth tutorial but rather is meant to provide an introduction to hedge funds.

Who can invest in hedge funds? 

In order to invest in a hedge fund you must be an accredited investor.  The current definition of an accredited investor is someone with a net worth of $1 million (excluding the equity in their home) and at least $200,000 in income ($300,000 with a spouse) over the past two years.  Many hedge fund investors are institutional investors such as foundations, endowments and pension plans.  About 65 percent of the capital invested in hedge funds comes from institutional investors.

What is the minimum investment? 

The minimum required to invest is often $1 million or more though some smaller hedge funds and funds of funds may have lower minimums.  New companies like Sliced Investing are seeking to change these high minimums by allowing investors to invest as little as $20,000.

Do I have access to my money? 

Unlike mutual funds, ETFs, closed-end funds and individual stocks hedge funds typically do not offer daily access to your money.

Some hedge funds allow investors to subscribe (invest) or redeem their money monthly, for others this might be quarterly or based upon some other time period.  Most hedge funds will require advanced notice for redemptions which might be as long as 180 days.  This allows the fund managers time to raise sufficient cash and allows for an orderly sale of fund investments especially if the redemption is a significant amount.

Some hedge funds also require a lock-up which means that there are no redemptions allowed during this initial period.  A typical lock-up period is one year, though some are as long as two years.  In some cases the lock-up period is “soft” meaning that redemption can be made but there will often be a penalty ranging from 2 percent to as high as 10 percent. 

Some hedge funds may also have the ability to enforce “gates” on redemptions which means they can decide to process only a portion of the redemptions requested.  This provision came into focus during the 2008-2009 market downturn as hedge fund redemptions requests swelled as many investors sought to raise cash.

What types of fees are charged? 

The fees charged by hedge funds vary widely.

Many hedge funds charge a management fee of 2 percent or more.

There might also be incentive fees of 10 to 20 percent of the fund’s profits or more.  This rewards the fund manager for superior performance.  The flip side of this is that the manager generally only collects an incentive fee if the fund’s performance exceeds its former highs, known as a high water mark.

If a fund loses 5 percent in a given year, no incentive fees will be paid to the manager the following year until the 5 percent loss is made up.

The term two and 20 is a common one in the hedge fund world meaning that the fund would charge a 2 percent management fee and a 20 percent incentive fee.  This may seem pricey but if the performance is stellar then investors won’t mind paying it. 

What types of investment strategies are available? 

There is a vast range of investment strategies across the hedge fund landscape.  These might include long-short, global macro, market neutral, convertible arbitrage, distressed securities and many others.  Additionally there are a number of fund of funds offered which means that the fund offers a collection of strategies and fund managers under one umbrella.   

What should I consider before investing in a hedge fund?

From reading the above you might ask yourself why would I invest in hedge funds?  Let’s remember that hedge funds are considered alternative investments.  Ideally they will have a relatively low correlation to the traditional long-only equity and fixed income investments in your portfolio.  At their best well-managed hedge funds can add balance and reduce the overall risk of your portfolio, in some cases the strategies are designed to provide absolute returns across all investing environments.

Before investing in a hedge fund or any alternative investment make sure you have considered and fully understand the following:

  • The fund’s investment strategy.
  • How this investment strategy fits with your overall portfolio and investing strategy.
  • What the fund “brings to the table” that you can’t get with more traditional long-only stock and bond investments.
  • Who is managing the fund and their history and investment track record.
  • The required minimum investment.
  • Any redemption restrictions and/or lock-up periods.  Make sure that you won’t need to tap this money during this time period. 

The Bottom Line 

Like any investment option you might consider it is important to understand the pros and cons of hedge funds in general and any specific fund or strategy that you might be considering for your portfolio.

Disclosure: This blog post was written for Sliced Investing pursuant to a paid content arrangement I have with the company’s representatives as part of an effort to raise awareness about alternative investment options. All views expressed are entirely my own, and were not influenced or directed by Sliced Investing.

Photo courtesy of Wikipedia

Robo Advisors – A Brave New World?

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The piece below is written by Doug Dahmer and originally appeared under the title “Robo-Advisors” – rise of the machines on Jon Chevreau’s site Financial Independence Hub.  Jon is at the forefront of a movement he calls “Findependence.”  This is essentially looking at becoming financially independent so that you can pursue the lifestyle of your choosing.   Jon is a Canadian author and journalist, check out his book Findependence Day.  Jon has contributed several prior posts here as well. 

I know Isaac Asimov’s Three Laws of Robotics, I read Arthur C. Clarke’s 2001: A Space Odyssey and I love the Terminator movies (I’ll be back!).

From all this I know three things: Robots are very smart. Robots always start off to help you. Robots have a tendency to turn on you.

One of the newest crazes and buzzwords in personal finance is: “Robo-Adviser.” If you’re not familiar with the term, it refers to investment management by algorithm in the absence of human input.

With a “Robo” you are asked to complete an on-line risk assessment questionnaire. Your responses determines the prescribed portfolio of ETFs (Exchange-Traded Funds) with a built-in asset allocation best suited to your needs. Once a year the portfolio is rebalanced to this prescribed asset allocation recipe. 

Dynamics change as shift from Saving to Spending

The “Robo” approach relies heavily upon a basic “buy/hold/rebalance” investment strategy. This passive strategy can work to your advantage during your accumulation years. These are the years when time is your friend, and dollar cost averaging through market cycles offers the opportunity to give your returns a boost.

However, as we get older and begin to prepare for and transition into our spending years, things change. Unfortunately, too few people realize that the investment strategies that served us well during our savings years turn on their head and work to our disadvantage as the flow of funds reverses and savings turns to spending. 

Dollar Cost Ravaging

Suddenly time changes from friend to foe where “dollar cost averaging” turns to “dollar cost ravaging” or what we call, the Mathematics of Catastrophe. (More about which in our next Hub blog). During the second half of your life the simplistic money management approach followed by “Robo- Advisers” can start to look like a “deed of the devil.”

Another concern is that “Robos” are unable to deal with the reality of expense variability. If you believe that in retirement, a fixed, annual withdrawal rate from a diversified portfolio will address your income needs I can with confidence suggest you are at best short-changing yourself and at worst setting yourself up for a cataclysmic financial failure.

I have been in this business a long time and know beyond a shadow of a doubt that a properly constructed life plan is very important in the second half of your life. It is only when you know what you want to do, when you want to do it and what it will cost to do it, that you can start to build the financial framework to make it happen.

Only through your life plan are you able to anticipate years of surplus and years of deficits and take the steps to bend them to your benefit. You need to bring together cash flow optimization, tax management and pension style investment management to make it happen and in the process add hundreds of thousands of dollars to your lifetime assets and cash flow. 

Robos ill equipped to link life to investment plan

Linking your life plan to your investment plan is the secret to success, but “robo investing” is not equipped to handle the nuances of that linkage. A Retirement Income Specialist knows that the type of money management you need is much more complex where the cash-flow demands outlined in your life plan need are linked to your investment plan. Tax planning, income optimization and risk mitigation means it is dangerous to leave your investment management running on auto-pilot.

Isaac Asimov’s first law of robotics holds that: A robot may not injure a human being or, through inaction, allow a human being to come to harm.

“Robo-adviser” firms would do well to review this law. When it comes to investors heading into the second half of their lives, “Robo Advisers” may well be about to break it. 

Doug Dahmer, CFP, is founder and CEO of Emeritus Retirement Income Specialists. With offices in Toronto and Burlington, Emeritus’ C3 process is one of the industry’s most comprehensive retirement planning processes. 

Online financial advisors or Robo Advisors are popping up all over the place and if you believe the financial press they are the future of financial advice.  In part I believe they are or will at least shape the future of financial advice.  I weighed in on this topic recently via  Is An Online Financial Advisor Right For You? for Investopedia.

Please feel free to contact me with your questions.  

Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner. Don’t miss any future posts, please subscribe via email. Please check out our resources page as well.

What I’m Reading-Packers Reign Supreme Edition

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It’s Cyber Monday (can you say contrived promotional event) and I have already been to O’Hare to drop my daughter off.  Amazing how crowded it was even at 5 AM.

Great football games over the holiday weekend, but none better than the Packers beating the Patriots yesterday in what was deemed a Super Bowl preview.  Feels good now but the next week is another game.

Here are a few financial articles I suggest for some good Post-Thanksgiving financial reading:

Jim Blankenship offers some Year-End Charitable Giving Tips at Getting Your Financial Ducks in a Row.

Mike Piper answers a reader question Which Accounts Should I Spend From Each Year In Retirement? at Oblivious Investor.

Christine Benz provides an example of A Conservative Retirement Saver Portfolio for ETF Investors at Morningstar.com.

Larry Light shared a piece from financial advisor and blogger Jeff Rose Make Your Money Last In Retirement (Pt. 2) at Forbes.

Ben Steverman writes Hedge Funds Lose Money for Everyone, Not Just the Rich at Bloomberg.

John Wasik shares Five Ways to Protect Yourself on Cyber Monday at Forbes.

For now the Packers reign supreme but the Falcons visit Lambeau for next week’s Monday Night game and they will pose a tough challenge.  Enjoy Cyber Monday and the rest of the week.