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Why Have an Annual Investment Review?

Regularly reviewing the investments you use in client portfolios can be relevant even for advisors with a passive investment philosophy.

Susan Chesson, MBA, CTP and Helen Modly, CFP, CPWA, 08/14/2014

Active investment managers--no matter their investment philosophy--live and breathe their investment decisions. Tactical allocators, long-short managers--all must evaluate and re-evaluate the composition of their clients' portfolios regularly. But for managers with a passive or evidence-based investment philosophy, what type of investment review is relevant?

At our firm, we manage our clients' assets primarily using asset class funds, and for several of those asset classes, we use institutional mutual funds managed by Dimensional Fund Advisors. Our investment accounts take on no more risk than is deemed necessary, depending on the client's specific financial picture and investment goals.

We promise our clients transparency, liquidity, and broad diversification using inexpensive investment vehicles (mostly institutional mutual fund classes or exchange-traded funds) and tax-sensitive investment management. This is expressed clearly in our Investment Policy Statement, provided to each client, where we outline our philosophy:

--Markets are inherently efficient.
--Exposure to risk factors determines investment returns.
--Diversification reduces portfolio risk and increases expected returns.
--Passive portfolio management is less costly, thus increasing expected returns.

Why should a firm like ours even hold an annual investment review? The advisors are neither chasing alpha through selection of active managers, nor are they tactical allocators, adjusting exposure to various sectors depending on economic forecasts.

But even for advisors like us, an annual investment review is important. The goal is to ensure that you are delivering on your promise to your clients--to build thoughtfully constructed portfolios using the best security selections available.

Your investment committee should have at least three senior advisors. For very small practices, consider drawing in additional members from other firms that utilize a similar investment strategy and process. Assign each advisor the task of presenting on either U.S. equity, international equity, or fixed income. Depending on the software and research available to your firm, you may draw data from several sources--Morningstar, research from ETF and fund companies, comparative analysis from your custodian firms or broker-dealers, and perhaps even interviews with mutual fund portfolio managers.

The investment review process should require each committee member to collect and analyze data on available securities or funds in the assigned asset class, prepare a recommendation for keeping or replacing each security currently in use, and then present to the other committee members. In order to standardize the process, decide in advance what key data on each security should be collected and reviewed, and agree on a standardized format for all members to use.

For example, we have standardized a quantitative table for equity funds that contains:

--the relevant benchmark for the particular sub-asset class
--average market capitalization
--number of holdings
--dividend yield
--prior and expected capital gains distributions
--annual expense ratio
--any short-term redemption fees
--1-, 3- and 5-year total return performance

For fixed-income funds, you may want to collect the following data:

--the relevant benchmark for the fund's fixed-income style box
--number of holdings
--average credit quality
--average effective duration
--percentage of non-U.S. holdings
--SEC yield
--annual net expense ratio
--1-, 3-, and 5-year performance

It is important to identify tax-efficient funds for tax-sensitive accounts and other funds that may be appropriate only for tax-deferred accounts. It is also important to identify substitutes for each fund in order to maintain the desired asset allocation when harvesting tax losses during the year.

Once the security universe has been identified, proceed to developing the overall ratios of each asset class to the total portfolio for various levels of equity exposure. We start with 100% equities and move down the spectrum to 0% equities in 5% increments. We also construct three types of models for large, medium, and small accounts. Because expense management and minimizing turnover are important to our investment strategy, we control trade size and frequency by assigning smaller portfolios to less complex models, using broader asset class funds or funds of funds. It is key that each account--no matter the size--share similar characteristics as to the ratio of large equities to small, and growth to value tilts. By examining the correlation between funds, you can build consistent portfolios, no matter the size of the investment account.

Once the review is complete, store the minutes and supporting documentation in a shared directory so that analysis and records of committee discussions can easily be located and reviewed. It will also be required for compliance purposes. Once the committee has agreed on the final recommendations, make a presentation to your advisors and determine whether existing accounts will be migrated to the new models immediately, over time, or if the model will just apply to new accounts.

The annual investment review will help you to stay true to your published investment philosophy. It forces you to step back from day-to-day client interaction and portfolio management, and to more closely examine the tenets of your investment philosophy and your current method of implementation. This formal, systematic process is an opportunity to explore other fund options that you may not have considered before and to confirm that funds in your universe are still what you think they are. A committee approach encourages all advisors to openly debate the merits of the analysis and to question the results. Once you have achieved consensus, it enables your advisors to buy in to the final results and help to foster a common understanding of your investment philosophy and its implementation. 

Susan Chesson joined Focus Wealth Management after a 20-year career in corporate treasury, fixed-income investing, and banking operations. She is a wealth manager and the director of business development. 

Helen Modly, CFP, CPWA, is executive vice president of Focus Wealth Management, a fee-only registered investment advisor in Middleburg, Va. Modly has more than 25 years of experience providing wealth-management services. She is a member of NAPFA and president-elect for the National Capital Area chapter of FPA. She can be reached at info@focus-wealth.com.

The authors are freelance contributors to MorningstarAdvisor.com. The views expressed in this article may or may not reflect the views of Morningstar.

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