Management

Investors utilize various management styles when maintaining their investment portfolios. We’ll cover the following management styles in this chapter:

• Strategic asset management
• Tactical asset management
• Active portfolio management
• Passive portfolio management
• Bond management, including:
  • Bond ladders
  • Bond barbells
  • Bond bullets

Strategic & tactical asset management

Investment advisers typically utilize one of two asset management approaches: strategic or tactical.

Strategic asset management involves creating a long-term investment allocation strategy for an investor. For example, this could be a suitable asset allocation for a 40-year-old investor saving for retirement:

This is a typical allocation for an average 40-year-old (it matches the rule of 100). A strategic asset allocation has been set if the adviser recommends this portfolio structure for the foreseeable future. Once the recommendation is accepted, the adviser will move to match the allocation, which may involve liquidating securities the investor currently holds in their portfolio. If the investor were currently 100% invested in common stock, 40% would be sold and allocated to preferred stock, long-term bonds, and money markets.

After the new portfolio is set, the allocation will likely shift over time. If the common stock market outperforms the fixed-income market, the common stock allocation percentage would grow and the others would shrink. It’s possible the allocation could look like this after several months:

When the portfolio’s allocations shift too far away from the original strategic asset allocation, the adviser should recommend rebalancing the portfolio. To do so, 15% of the common stock should be liquidated, with the sales proceeds being invested in preferred stock, long-term bonds, and money markets in hopes of matching the original strategic asset allocation.

Tactical asset management involves deviating from the longer-term strategic asset allocation plan for short periods. This is often done to take advantage of short-term opportunities or shelter the portfolio from short-term risk. Before we go through the specifics of tactical asset management, let’s re-assume the original strategic asset allocation for our 40-year-old investor:

If an adviser wants to shift away from the long-term strategic asset allocation for short-term purposes, they’re utilizing tactical asset management. For example, let’s assume the adviser expects the fixed-income markets to significantly outperform the common stock market over the next six months. They could shift the portfolio to this allocation:

The portfolio will remain allocated this way for six months as the adviser believes preferred stock and long-term bonds offer higher return potential than common stocks. After six months pass, the adviser liquidates the “extra” investments in the fixed income securities and invests the proceeds back into common stock to obtain the original allocation. This type of short-term investment strategy is a good example of tactical asset management.

Strategic and tactical asset management both involve creating suitable asset allocations for investors, given their financial situation and goals. Strategic asset management allocates assets with a long-term mindset, while tactical asset management deviates from long-term plans to take advantage of short-term opportunities.

Active & passive portfolio management

We discussed active and passive management styles in the exchange traded funds (ETFs) chapter. Let’s revisit the topic to understand how it relates to suitability.

Active portfolio management involves picking a series of individual securities with an overall goal of “beating the market.” The “market” refers to the broad market for a given asset. For example, an actively managed large-cap common stock portfolio would attempt to beat the S&P 500, which is a broad stock index that tracks stock values of 500 large US-based companies.

The best investments are sought after when implementing an active management strategy. For example, a portfolio manager of an actively managed large-cap stock fund may choose 50 of the 500 stocks in the S&P 500 in hopes that their portfolio returns outperform the index. While it may sound relatively easy to pick the best investments in the market, very few portfolio managers can pull this off consistently. An analysis performed in 2019 found only 23% of actively managed funds outperformed their benchmark index over the previous 10-year period.

Passive portfolio management involves investing in the broad market without identifying the best investments in that market. Investing in all the securities in an index (like all 500 stocks in the S&P 500) would be difficult, if not impossible for most investors. That’s why index funds and ETFs exist.

There are two big reasons why some investors are proponents of passive management. First, actively managed portfolios consistently underperform their benchmark portfolios (as we established above). It’s an “if you can’t beat them, join them” philosophy. If it’s so challenging to pick the best investments in a market, why not just invest in the entire market?

The second reason relates to cost. Actively managed portfolios require much more research and analysis than passively managed portfolios, which costs money and time. Portfolio managers of passively managed portfolios don’t have to spend any time picking and choosing specific investments; they simply follow the index.

Expense ratios of passively managed funds are typically significantly lower than actively managed funds. In 2021, the average expense ratio for actively managed funds (0.60%) was five times that of passively managed funds (0.12%). While the difference (0.48%) may seem small, it can amount to a significant difference in return over long periods. To demonstrate this, let’s assume we have an actively managed fund and a passively managed fund, which both provide a 10% annual return over 30 years. This chart shows the cost of each fund, assuming the average expense ratio for both and an investment of $100,000 into each:

Expense ratios are sneaky because investors don’t pay out of pocket. Instead, the cost of running the fund is taken from the fund’s internal assets, which reduces the overall return. Over a long period, a lower expense ratio can save hundreds of thousands of dollars (or even more for larger positions). Returns must consistently outperform their benchmark to justify the costs associated with active management.

Investors that believe passive management is the better strategy will attempt to invest in securities that mirror index movements, sometimes referred to as indexing. Investing in index funds, ETFs, and even index options can accomplish this goal.

Bond strategies

Investors seeking bonds as a part of a long-term strategy in their portfolio may implement one of a few bond strategies. The most popular are:

• Ladders
• Barbells
• Bullets

Bond ladders

As the name may suggest, a bond ladder can be visualized as climbing up the rungs of a ladder. This type of strategy involves investing in numerous bonds with diverse maturities. For example, let’s assume an investor wants to purchase $10,000 worth of bonds with varying maturities. Assuming each bond is bought at its $1,000 par value, the portfolio could look like this:

• 3-year bond
• 6-year bond
• 9-year bond
• 12-year bond
• 15-year bond
• 18-year bond
• 21-year bond
• 24-year bond
• 27-year bond
• 30-year bond

The investor gains “maturity diversification” by spacing the bonds out evenly (by three years in this example). While the longer-term bonds will be subject to high levels of interest rate and inflation risk, the shorter-term bonds won’t be as exposed. Because of the risk factor, the longer-term bonds will likely have higher yields than the shorter-term bonds. ​

Bond investors utilizing this strategy tend to maintain a “revolving door” approach. When a bond matures, the proceeds are reinvested into a new long-term bond. Using the example above, let’s assume three years pass, and the shortest-term bond matures. The redemption proceeds could be used to purchase a new issue 30-year bond. That’s why this strategy is referred to as a ladder. As soon as one rung is passed (short-term bond matures), another rung is grabbed (proceeds invested in a long-term bond).

Bond barbells

Visualize a barbell you would lift in the gym - there are two ends with weights, with a skinny bar in the middle. A bond barbell is named after this type of instrument. The investor places their money into short-term and long-term bonds, but no intermediate bonds. For example, let’s again assume an investor wants to purchase $10,000 worth of bonds with varying maturities. Assuming each bond is bought at its $1,000 par value, the portfolio could look like this:

• 1-year bond
• 2-year bond
• 3-year bond
• 4-year bond
• 5-year bond
• 26-year bond
• 27-year bond
• 28-year bond
• 29-year bond
• 30-year bond

When implementing this strategy, the investor gains the benefits of both types of bonds (short and long-term). Short-term bonds provide more liquidity with less interest rate and inflation risk. When a short-term bond matures, the investor can make a strategic choice. If interest rates have risen, they can purchase a long-term bond and lock in a high yield for an extended period. If interest rates have declined, they can invest in another short-term security and wait for interest rates to rise.

The long-term bonds provide higher rates of return (yield), although they are riskier. However, the risk is balanced out by the other half of the portfolio.

Bond bullets

A bond bullet refers to a bullseye, resulting in investors choosing a specific target date in the future in which they require a large payout.

For example, let’s assume an investor is saving for a dream home over ten years. Every year, the investor purchases $100,000 of bonds, all of which will mature at that 10-year mark. In the first year, the investor buys $100,000 of 10-year bonds. The next year, the investor buys $100,000 of 9-year bonds. The following year, the investor buys $100,000 of 8-year bonds. And so on.

By the time the investor reaches the 10-year mark, they’ve purchased $1 million of bonds, all of which will mature that year.