A Portfolio Checkup in 6 Steps

Here is the link.

published on Jul 21, 2014

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Best practice for Portfolio checkups

• infrequent: Annual, semi-annual, or quarterly at the most
• targeted: Employ a checklist to help you get in and out
• Fundamentally driven, not just focused on performance
• Progress from most important to less important variables
• Take tax and transaction costs into account if changes are needed

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6 steps in the portfolio-checkup process

• step 1: Gauge viability of current plan
• step 2: Evaluate portfolio positioning
• step 3: Check liquid reserves
• step 4: Review individual holdings
• step 5: Troubleshoot current risk factors
• step 6: Conduct a cost audit

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Step 1: Gauge viability of current plan (Accumulators)

• Thumbnail test: 15% current salary = annual savings target
• Fidelity benchmarks:
• Save 1X current salary by age 35
• Save 3X current salary by age 45
• Save 5X current salary by age 55
• 401(k) contribution limits, 2014: $17,500 ($23,000 50+)
• IRA contribution limits, 2014: $5,500 ($6,500 50+)
• Use an online calculator to gauge adequacy of current investments and savings rate. 
• Online tools include:
• T. Row Price Retirement Income Calculator
• Fidelity Retirement Quick Check
• Fidelity Retirement Income Planner

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Step 1: Gauge viability of current plan (Accumulators)

• The best tools are holistic and factor in:
• inflation
• Reasonable return expectations, variability of returns (Monte Carlo modeling)
• Taxes
• The role of other income sources, such as pensions and Social Security

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• If already retired and taking withdrawals, check viability of current withdrawal rate
• The traditional rule of thumb is that 4% with an annual inflation adjustment is a safe withdrawal rate for most
• For someone with an $800,000 portfolio:
• -- Year 1 withdrawal: $32,000
• -- Year 2 withdrawal: $32,960 (assuming 3% inflation)
• Recent research suggests an even more conservative withdrawal rate (3%) makes sense given low bond yields

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Step 2: Evaluate Portfolio Positioning

• Morningstar's X-Ray tool a good starting point
• Portfolio Manager enables you to X-Ray, as does Instant X-Ray (on Tools tab of Morningstar.com)

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Step 2: Evaluate Portfolio Positioning

• Focus on asset allocation relative to your targets (Morningstar Lifetime Allocation Indexes and target-date funds can be a starting point)
• Check sector/style positioning
• Geographic exposure
• Individual stock overload

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What should  you do if you're light on stocks?

• Stay mindful of current valuations: Average price/fair value for Morningstar's covered stocks = 1.04
• Employ a dollar-cost averaging strategy, deploying fixed amounts at regular intervals
• Make sure you have a good value-oriented manager (or two) in your portfolio
• Look to Morningstar's highly rated stocks for ideas
• Hold a bit of extra cash to meet opportunities as they arise

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Favorite Value-Learning Funds (Gold- or Silver-Rated)

• Dodge & Cox Stock (DODGX): Gold
• American Funds American Mutual (AMRMX): Gold
• American Funds Washington Mutual (AWSHX): Gold
• Artisan Value (ARTLX): Silver
• Sound Shore (SSHFX): Silver
• Tweedy, Browne Global Value (TBGVX): Silver
• Vanguard Equity-Income (VEIPX): Silver
• Vanguard value Index  (VIVAX): Silver
• Vanguard Windsor II (VWNFX): Silver

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Favorite reasonably priced stocks (4-star plus wide moat, low uncertainty)

• Baxter International (BAX)
• Colorx (CLX)
• Enbridge (ENB)
• ExxonMobil (XOM)
• Philip Morris (MO)
• Procter & Gamble (PG)
• Spectra Energy Partners (SEP)
• Wal-Mart Stores (WMT)

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What should you do if you're light on Bonds?

• Rebalance into bonds, but limit interest-rate sensitivity and keep credit quality high
• Invest with flexible core fixed-income funds such as Dodge & Cox income, Metropolitan West Total Return
• If retirement is close at hand and you're notably underweight bonds, de-risk immediately
• Move bond money to cash
• Dollar-cost average during a period of months

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Step 2: Evaluate portfolio positioning: Some benchmarks

Global market-cap distribution
U.S.: 48%
Rest of world: 52%
Developed markets: 90.9%
Developed markets: 9.1%

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Step 3: check liquid reserves

Baseline amount if retired:
6 months' to 2 years' worth of living expenses

Baseline amount if working:
3 to 6 months' worth of living expenses

Do not count:
Residual cash in mutual funds, short-term bonds ( manually calculate; don't use X-Ray tools)

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Step 4: Review individual holdings

• Morningstar ratings analyst report enable you to quickly review the status of current holdings. 
• For funds, red flags include:
• Ratings, manager, strategy changes
• Persistent underperformance vs. cheap index fund
• Dramatically heavy stock, sector bets
• For stocks, red flags include:
• High price/fair value, low star rating
• Negative moat trend

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Step 5: Troubleshoot potential risk factors

• Risk Factor 1: Tricky times for bond investors
• Risk Factor 2: Complacency about inflation
• Risk Factor 3: Overvaluation in small and mid-caps

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Risk Factor 1: Tricky times for bond investors

• Investors have been high-yield bonds: ~ $7 billion in new flows during past year
• But the yield differential (or "spread") between high-yield bonds and Treasures is just 3.4 percentage points
• Spreads have only this low 9% of the time since 1996
• Fed chair Janet Yellen: "High-yield bonds have certainly caught our attention. There is some evidence of reach-for-yield behavior."

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High-quality bonds carry risks of their own: greater interest-rate sensitivity

• Consider the following "duration stress test" for your high-quality holdings
• The fund's duration minus fund's SEC yield = expected loss over one-year period if interest rates rose by 1 percentage point
• Stress test most useful for high-quality bond types, less useful for junk bonds, international bonds, etc. 

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Stress test examples

• Vanguard Total Bond Market Index
• Duration of 5.6 years minus SEC yield of 2% = ~3.6% loss if rates rose by 1 percent point
• Vanguard Long-Term Bond Index
• Duration of 14.2 minus SEC yield of 4.1% = ~10% loss if rates rose by 1 percentage point

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Risk Factor 2: Complacency about inflation

• Investors have been selling inflation-protected bond funds; $26 billion in outflows during the past year
• Motivations included high interest-rate sensitivity, benign CPI
• But even though CPI is mild, investors' actual inflation experiences might be different
• Food prices increased by 0.7% in May 2014; energy prices increased by 0.9%

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Risk Factor 2: Complacency about inflation

• Best sources of inflation protection include the following:
• TIPS (Vanguard Short-Term Inflation-Protected Securities a favorite - VTIP or VTIPX)
• Stocks, especially wide moats with pricing power
• Real estate, commodities, gold
• Bank-loan investments

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Risk factor 3: overvaluation among small and Mid-caps

• Median price/fair value for all stocks in our coverage universe = 1.04
• Median price/fair value for small- and mid-cap stocks in our coverage universe = 1.06
• If peeling back on stocks as part of rebalancing program, concentrate reductions here

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Step 6: Conduct a cost audit

• Total portfolio cost audit: Compare your porfolio's expense ratio (in X-Ray) to that of a good target-date fund for your age range. 
• Expense ratio for T. Rowe Price Retirement 2025: 0.72%
• Expense ratio for Vanguard Target 2015: 0.17%

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Step 6: Conduct a cost audit

• Holdings-level cost audit for index funds, ETFs
• ETF price wars have been good for consumers
• Are your holdings as cheap as the cheapest funds available to retail investors in each asset class?
• U.S. Stock: 0.04%
• International Stock: 0.09%
• Bond: 0.05%