Investors use different management styles to maintain their investment portfolios. This chapter covers:
Investment advisers typically use one of two asset management approaches: strategic or tactical.
Strategic asset management means setting a long-term asset allocation based on the investor’s goals, time horizon, and risk tolerance.
For example, here’s a possible allocation for a 40-year-old investor saving for retirement:
| Asset | Allocation |
|---|---|
| Common stock | 60% |
| Preferred stock | 10% |
| Long-term bonds | 25% |
| Money markets | 5% |
This is a typical allocation for an average 40-year-old (it matches the rule of 100). A strategic asset allocation is in place if the adviser recommends keeping this structure for the foreseeable future.
Once the investor accepts the recommendation, the adviser adjusts the portfolio to match the target allocation. That may require selling securities the investor already owns. For example, if the investor is currently 100% invested in common stock, 40% would be sold and reallocated to preferred stock, long-term bonds, and money markets.
Over time, market performance will naturally push the portfolio away from its target. If common stocks outperform fixed income, the common stock percentage rises while the others fall. After several months, the allocation might look like this:
| Asset | Allocation |
|---|---|
| Common stock | 75% |
| Preferred stock | 5% |
| Long term bonds | 17% |
| Money markets | 3% |
When the portfolio drifts too far from the original strategic allocation, the adviser should recommend rebalancing. In this example, 15% of the common stock would be sold, and the proceeds would be invested in preferred stock, long-term bonds, and money markets to move back toward the original target.
Tactical asset management means temporarily deviating from the long-term strategic allocation. Advisers do this to take advantage of short-term opportunities or to reduce short-term risk.
To see how this works, start with the original strategic allocation for the 40-year-old investor:
| Asset | Allocation |
|---|---|
| Common stock | 60% |
| Preferred stock | 10% |
| Long term bonds | 25% |
| Money markets | 5% |
If the adviser shifts away from this long-term plan for a short period, that’s tactical asset management. For example, suppose the adviser expects fixed-income markets to significantly outperform common stocks over the next six months. The adviser might shift the portfolio to:
| Asset | Allocation |
|---|---|
| Common stock | 45% |
| Preferred stock | 15% |
| Long term bonds | 35% |
| Money markets | 5% |
The portfolio stays at this tactical allocation for six months because the adviser believes preferred stock and long-term bonds offer better return potential than common stocks during that period. After six months, the adviser sells the “extra” fixed-income positions and reinvests the proceeds into common stock to return to the original strategic allocation.
Strategic and tactical asset management both focus on building a suitable asset allocation based on the investor’s situation and goals:
We discussed active and passive management styles in the exchange traded funds (ETFs) chapter. Here’s a refresher, with a focus on how these styles relate to suitability.
Active portfolio management involves selecting individual securities with the goal of “beating the market.” Here, “the market” means the broad market for a given asset class.
For example, an actively managed large-cap common stock portfolio would try to outperform the S&P 500, a broad stock index that tracks 500 large U.S.-based companies.
In an active strategy, the manager looks for the “best” investments. For instance, a manager might choose 50 of the 500 stocks in the S&P 500 in hopes that the portfolio outperforms the index. In practice, consistently selecting outperforming securities is difficult. 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 trying to identify the best individual securities.
Buying every security in an index (such as all 500 stocks in the S&P 500) is difficult for most investors. That’s why index funds and ETFs exist.
Investors often prefer passive management for two main reasons:
First, actively managed portfolios often underperform their benchmark indexes (as shown above). The idea is simple: if it’s hard to beat the market consistently, investing in the market itself may be more reliable.
Second, passive management typically costs less. Active management requires ongoing research and trading, which increases costs. Passive managers generally track an index rather than selecting securities.
Expense ratios of passively managed funds are typically significantly lower than those of 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 create a large gap in results over long periods.
To illustrate, assume an actively managed fund and a passively managed fund both earn a 10% annual return over 30 years. The chart below shows the cost of each fund using the average expense ratios and a $100,000 investment in each:
| Fund | Expense ratio | Total cost over 30 years |
|---|---|---|
| Actively managed | 0.60% | $264,061 |
| Passively managed | 0.12% | $56,213 |
Expense ratios can be easy to overlook because investors don’t pay them directly out of pocket. Instead, the fund deducts expenses from its assets, which reduces the investor’s return. Over long periods, a lower expense ratio can save hundreds of thousands of dollars (and even more for larger positions). To justify the higher costs of active management, returns must consistently outperform the benchmark.
Investors who prefer passive management often try to hold investments that mirror index movements, sometimes called indexing. Index funds, ETFs, and even index options can be used to do this.
Investors who want bonds as part of a long-term portfolio strategy may use one of several bond approaches. The most popular are:
A bond ladder is easy to picture if you think of the rungs of a ladder. The strategy spreads investments across many maturity dates.
For example, suppose an investor wants to buy $10,000 of bonds with varying maturities. If each bond is purchased at its $1,000 par value, the portfolio could include:
This creates “maturity diversification” by spacing maturities evenly (every three years in this example). Longer-term bonds are more exposed to interest rate and inflation risk, while shorter-term bonds are less exposed. Because longer-term bonds generally carry more risk, they typically offer higher yields than shorter-term bonds.
Bond investors who use ladders often follow a “revolving door” approach. When a bond matures, the proceeds are reinvested into a new long-term bond. Using the example above, after three years the 3-year bond matures, and the redemption proceeds could be used to buy a new 30-year bond. One rung matures, and a new rung is added at the long end.
A barbell has weight on both ends and a thin bar in the middle. A bond barbell follows the same idea: the investor buys short-term and long-term bonds, but avoids intermediate maturities.
For example, suppose an investor wants to buy $10,000 of bonds with varying maturities. If each bond is purchased at its $1,000 par value, the portfolio could include:
This strategy combines features of both ends of the maturity spectrum:
Short-term bonds provide more liquidity and typically have less interest rate and inflation risk. When a short-term bond matures, the investor can make a choice based on current rates. If interest rates have risen, the investor can buy a long-term bond and lock in a higher yield for longer. If interest rates have declined, the investor can buy another short-term bond and wait for rates to rise.
Long-term bonds typically offer higher yields, but they also carry more risk. In a barbell, that risk is balanced by the short-term side of the portfolio.
A bond bullet is named after a bullseye. The idea is to target a specific future date when the investor needs a large payout.
For example, suppose an investor is saving for a dream home over ten years. Each year, the investor buys $100,000 of bonds that will all mature at the 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 mature that year.
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