Issue 31: 2016

Investment Strategy

Repositioning Your Portfolio in Seven Steps

With periods of greater volatility and lower growth expected, here’s what to consider when managing your portfolio.

Photograph of Kumar by Eric McNatt; Photograph of Curtin by Andy Ryan Dimitri Otis/Getty Images

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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:

Generally: You concentrate to create wealth. You diversify
to maintain wealth.

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.
With periods of episodic volatility, think about
tax-loss harvesting throughout the year.

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.

For more information, contact your U.S. Trust advisor.

Photograph of stones by Dimitri Otis/Getty Images

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust and its representatives nor its advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time.

Master Limited Partnerships MLPs are limited partnerships or limited liability companies that are taxed as partnerships and whose interests (limited partnership units or limited liability company units) are traded on securities exchanges like share of common stock. Currently, most MLPs operate in the energy, natural resources or real estate sectors. Investments in MLP interests are subject to the risks generally applicable to companies in the energy and natural resources sectors, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk.

Fixed Income Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Tax-exempt investing offers current tax-exempt income, but it also involves special risks. Income from investing in municipal bonds is generally exempt from federal and state taxes for residents of the issuing state. Interest income from certain tax-exempt bonds may be subject to certain state and local taxes and, if applicable, the alternative minimum tax (AMT).

Treasury bills are less volatile than longer-term fixed income securities and are guaranteed as to timely payment of principal and interest by the U.S. government.

International Investing International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Alternative Investments Alternative investments are intended for qualified and suitable investors only. Alternative investments are speculative and involve a high degree of risk. Alternative investments such as derivatives, hedge funds, private equity funds and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity and your tolerance for risk.

Real Estate Investment Trusts (REITs) REITs involve a significant degree of risk and should be regarded as speculative. They are only made available to qualified investors under the terms of a private offering memorandum. Holdings in a REIT may be highly leveraged and, therefore, more sensitive to adverse business or financial developments. REITs are long term and unlikely to produce a realized return for investors for a number of years. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties, such as rental defaults.

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:

Generally: You concentrate to create wealth. You diversify
to maintain wealth.

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.
With periods of episodic volatility, think about
tax-loss harvesting throughout the year.

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.

For more information, contact your U.S. Trust advisor.

Photograph of stones by Dimitri Otis/Getty Images

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Any information presented about tax considerations affecting client financial transactions or arrangements is not intended as tax advice and should not be relied upon for the purpose of avoiding any tax penalties. Neither U.S. Trust and its representatives nor its advisors provide tax, accounting or legal advice. Clients should review any planned financial transactions or arrangements that may have tax, accounting or legal implications with their personal professional advisors.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time.

Master Limited Partnerships MLPs are limited partnerships or limited liability companies that are taxed as partnerships and whose interests (limited partnership units or limited liability company units) are traded on securities exchanges like share of common stock. Currently, most MLPs operate in the energy, natural resources or real estate sectors. Investments in MLP interests are subject to the risks generally applicable to companies in the energy and natural resources sectors, including commodity pricing risk, supply and demand risk, depletion risk and exploration risk.

Fixed Income Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yield and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa. There may be less information available on the financial condition of issuers of municipal securities than for public corporations. The market for municipal bonds may be less liquid than for taxable bonds. Tax-exempt investing offers current tax-exempt income, but it also involves special risks. Income from investing in municipal bonds is generally exempt from federal and state taxes for residents of the issuing state. Interest income from certain tax-exempt bonds may be subject to certain state and local taxes and, if applicable, the alternative minimum tax (AMT).

Treasury bills are less volatile than longer-term fixed income securities and are guaranteed as to timely payment of principal and interest by the U.S. government.

International Investing International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Alternative Investments Alternative investments are intended for qualified and suitable investors only. Alternative investments are speculative and involve a high degree of risk. Alternative investments such as derivatives, hedge funds, private equity funds and funds of funds can result in higher return potential but also higher loss potential. Changes in economic conditions or other circumstances may adversely affect your investments. Before you invest in alternative investments, you should consider your overall financial situation, how much money you have to invest, your need for liquidity and your tolerance for risk.

Real Estate Investment Trusts (REITs) REITs involve a significant degree of risk and should be regarded as speculative. They are only made available to qualified investors under the terms of a private offering memorandum. Holdings in a REIT may be highly leveraged and, therefore, more sensitive to adverse business or financial developments. REITs are long term and unlikely to produce a realized return for investors for a number of years. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties, such as rental defaults.