Repositioning Your Portfolio In Seven Steps

We believe the United States economy is in the mid-cycle phase of a long economic expansion. Alongside this expansion, equity markets have rallied and, after a long period of being undervalued, appear to be near fair value. Even as the U.S. economy transitions to the next leg of the expansion, economies across the world are still struggling to find growth, moderating output on a global level, and leading to extraordinary monetary policies being employed. As a consequence, we expect to see frequent periods of volatility in asset markets. While returns may be lower and more volatile than expected, inflation is also lower, leaving after-inflation real returns less impacted than nominal returns. Given this background of tepid global economic growth, unconventional monetary policy measures, and near fair market valuation, we think it is prudent for investors to look at ways to position and rebalance their portfolios for the second half of 2016 and beyond.

Checking Up On Your Portfolio

In terms of overall portfolio weightings, as of this writing, we have largely moved to neutral in equities. We maintain a small underweight in fixed income and maintain exposure to alterna­tive investments to improve return potential and hedge volatil­ity. We also hold some cash with a view to deploying it when the opportunity arises. Further, we suggest that rather than using a “set it and forget it” approach, typically associated with a buy-and-hold strategy, clients should thoughtfully manage different sources of return while seeking to achieve their investment goals. Here are seven steps to consider in managing your portfolio, through the second half and later:

1. Review investment goals to ensure that they are still relevant. And, equally important, review those goals alongside an asset allocation policy to ensure that they are aligned, improving the probability of being able to fund those goals in the future.

2. Take periods of volatility in the second half as opportunities to rebalance a portfolio by trimming winners and adding assets that have temporarily lost value.

3. Evaluate concentrated positions of individual securities and asset classes, especially when financial asset prices are high and a period of lower growth is beginning. Carefully examine if there are any remaining marginal benefits in maintaining such a position. If not, consider diversifying to protect against significant portfolio drawdown driven by the large concentrated position. Generally: You concentrate to create wealth. You diversify to maintain wealth.

4. Consider an increase in the role of active investing across and within asset classes as market conditions favorable to active management improve. For some time now, passive funds, such as exchange-traded funds, or ETFs, have been popular with investors. Inter-asset class correlations, having been elevated, are now declining relative to historical averages, meaning passive investing may become less effective. This, coupled with higher dispersion in returns across stocks, could be an opportunity for active managers to add meaningful value to portfolios.

5. When investing for yield, be aware that many yield-generating investments — including long-dated bonds, Treasury and agency securities, and certain real estate investment trusts (REITs) — can be particularly sensitive to the impact of rising interest rates. We encourage investors to think about a broader total-return approach, with a focus on appreciation potential, depreciation risk and yield.

6. Manage portfolios for tax efficiency. As we often say, “It’s not what you make, it’s what you keep.” With top effective federal marginal rates at over 40% — net of certain phase-outs and the enactment of the healthcare surcharge — tax-efficient investing and tax-loss harvesting can be effective strategies to defer, minimize and offset income tax liabilities. Therefore, consider the following:

• Think about placing tax-inefficient asset classes and strategies in tax-advantaged accounts.
• Evaluate the potential tax benefits of certain investments such as ETFs, master limited partnerships, REITS, common stocks and qualified preferred stocks, as well as the tax efficiency of certain managed solutions.
• With periods of episodic volatility, think about tax-loss harvesting — using losses to offset taxes on both gains and income — throughout the year.

Remember, tax-advantaged investment management strategies can still provide potential benchmark return exposure while also providing attractive systematic tax-loss-harvesting opportunities and potentially better after-tax returns.

7. Use the natural liquidity of a portfolio to meet spending needs. A diversified portfolio can generate cash flow from stock dividends, bond coupons and other income flows, which can be augmented by rules-based rebalancing where winners are trimmed to generate cash flow while maintaining asset allocation goals.

Considering Nonprofits

Many of these recommendations apply to nonprofit organizations (NPOs) as well. In addition, NPOs should review spending rates and smoothing formulas, particularly when they need consistency in spending. They should also review their spending policies to ensure that they are aligned with their asset allocation policy to meet and provide the cash flow they need to sustain programs and/or meet operating needs.