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By Jason Stipp | 04-04-2012 01:00 PM

Spring Clean Your Portfolio

Morningstar's Christine Benz says investors should clean up excessive interest rate risk, overexposure to high-flying sectors, pricey funds, and unnecessary overlap.

Jason Stipp: I'm Jason Stipp for Morningstar. The first quarter has come to a close, and trees are blooming here in Chicago. So, it could be a good time to do some portfolio spring cleaning. Here with me to offer some cleaning tips is Morningstar's director of personal finance, Christine Benz.

Christine, thanks for joining me.

Christine Benz: Thanks for having me, Jason.

Stipp: So, you have a list of a few things here, ways that you might be able to brush up your portfolio.

The first one is one that has been on investors' minds for quite a while, but it came to a head in the first quarter when we saw interest rates creep up a little bit during certain parts of the first quarter, especially near the end. It's that interest rate sensitivity in your fixed-income portfolio. If I'm looking at my bond portion, what do I really need to keep in mind at this point in time?

Benz: It's a great point, Jason. Actually, the market may be taking care of this for some investors in that longer-duration bonds and bond funds are really getting smacked down recently; we have seen yields jump up.

But I think you do want to take a look at your holdings. If you have bond funds, you want to focus on a statistic called duration as a rough gauge of interest rate sensitivity, and the rule of thumb that we've been sharing, which is one that was originally conveyed to us by Vanguard's Ken Volpert, is to look at that duration statistic, subtract the fund's SEC yield--which, if you can't find it on Morningstar.com, go to the fund company's website and look for it--so you subtract the SEC yield from duration, and the amount that's left over is the amount that you might expect to see a fund lose if interest rates were to jump up, and you'd expect to see the fund lose that much over a one-year period.

So, if the fund has a duration of 6 and an SEC yield of 2%, and interest rates were to jump up 1 percentage point, you might expect to see that fund lose 4% during that time. So, just keep your eyes on that statistic, go holding by holding, and get a sense of interest rate sensitivity. I think given that, at least until very recently, long-term bonds had had a very good run of performance, I think you probably want to be stripping back those long duration bonds and bond funds from your portfolio at this juncture.

Stipp: So, if you're holding those expecting that great rally to continue, it might be time to maybe come back in a little bit on the duration, but definitely you wouldn't suggest getting rid of all of your fixed income or anything like that given the uncertain environment.

Benz: Absolutely not, but I do think that you need to be mindful that you're not taking too much interest rate sensitivity.

I [also] think some investors have said, "well, why not just go to cash until these rate worries blow over?" And I think you might really have an opportunity cost there, because even as bond yields go up and that might hurt your principal on your bond fund, you are able to partake of those higher-yielding bonds as they become available. So, I don't think you want to starve yourself of bonds entirely.

Stipp: Another place that your portfolio may actually have increased in the percentage of assets are some of the defensive sectors. So we know dividend payers, for example, have been very popular and certain of the consumer defensive and other defensive sectors have had a pretty nice rally in the recent past. What kind of cleaning might you need to do there?

Benz: I think the overarching theme with the equity portion of your portfolio as well as fixed income is, you just want to make sure that your portfolio isn't fighting the last war. So, as you mentioned, Jason, some of the dividend payers and very high-quality wide-moat names that we liked and have liked for the past several years are approaching fair value based on our analysts' estimates.

So, I think you want to look through your portfolio, make sure that you aren't overdosing and that your portfolio isn't disproportionately skewed toward some of those defensive sectors. A couple of sectors that our analysts think are fairly valued, if not overvalued, currently would be consumer defensive stocks as well as utilities, and even the health-care names, which our analysts thought were very, very cheap even a year ago, are now getting pretty close to fair value.

On the flipside, our analysts are finding more to like in the more cyclically oriented sectors such as basic materials and energy.

Stipp: Certainly there are worse things than being fairly valued; you would probably still get a fair return in some of those sectors. But if you're really loaded up there, you might want to scale back a little bit if you're expecting that strong run of performance to continue.

Benz: Just to make sure that you have balanced sector exposure.

Stipp: Christine, another thing that's more about the actual investment vehicle that could maybe use some cleaning up are the expenses that you're paying on your investments. We talk about expenses a lot. They are very important, though, but it seems like especially so in this day and age?

Benz: I think so, and one thing that I would look at is that no one is that excited about return expectations for the next several years. No matter what information source you look to, no one is calling for 15% equity market returns and certainly given where our bond yields are currently, it's hard to get excited about that asset class, too.

So given that, it's all the more important to really be careful about what you're paying for fund management fees or any other fees that you're paying to manage your portfolio. The rule of thumb that I usually throw out there for equity funds is 1% or less, certainly much less if you're going with some sort of an index product. And for bond funds, you would want to set the threshold even lower, 0.75% or ideally much less than that given the muted bond market returns that I think we can reasonably expect.

Stipp: Christine, sometimes investors will see opportunity in an area of the market, or they'll hear about opportunity somewhere, maybe emerging markets, and so they will buy a dedicated fund because they want to capture that opportunity. But these niche funds sometimes actually can be good to clear out because maybe you don't even need them when you look at your portfolio as a whole?

Benz: I think that's a great point, Jason. So, part of a spring cleaning effort that I would envision is looking for redundancies, and I think oftentimes those sector or region-specific funds can be areas of redundancy if you've already got well diversified holdings in your portfolio.

I think it's a good idea to go through and look specifically for some of those and see whether your diversified funds might be accomplishing exposure to some of those areas for you.

And the other point I would make on sector and region-specific funds is that when we look at investor behavior and how it intersects with the timing of their purchases and sales of these funds, it's not so great. So, investors tend to buy and sell those funds at inopportune times.

My thought is that by embedding some of those risky assets classes within the context of broadly diversified holdings, that you will reduce your susceptibility to some of those behavioral mistakes that we all run into.

Stipp: Those diversified funds can just be easier to hold as investors over the longer term.

Last thing, Christine, we know that a lot of investors have several funds they have accumulated over time, maybe they rolled over one account into another account, or maybe they have two funds they've had for a while that are very similar, maybe they are from the same category or they are both core funds. There could be opportunity for some cleaning there?

Benz: I think there could be. I think there is a natural tendency if you've got this pull money here and this one here that you tend to want to run them as well-diversified portfolios unto themselves, and it's not illogical, but I think you can streamline your number of holdings if you take a "best-of" approach to each of those portfolios.

So, if your spouse has maybe some great bond funds available, and your bond funds aren't so great, you can use a best-of-breed approach within each portfolio, streamline and concentrate within those highest-conviction holdings. I think Morningstar research reports can really help you determine which are those funds in your portfolio are best of breed and which are maybe not so great. You could use the concentrated approach within the truly good funds.

Stipp: So, keep it simple?

Benz: Exactly.

Stipp: All right, Christine thanks so much for your tips on spring cleaning your portfolio and for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.

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