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Welcome to the June 2009 edition of the Brighton Bulletin. This month I'll address a commonly asked question - "What is it that you do?", re-examine the value of an investment policy statement and remind everyone why asset allocation is not dead.
It's been a rather sanguine month in the equity markets with the S&P 500 up just under 4% month-to-date. As we entered 2009, I thought the index would finish the year at 950 which would be a roughly 5% calendar year return. As of today, we're at 912 so 950 still looks possible. We've recovered substantially from the bottom at 666 but have moved mostly sideways for the last 4 to 5 weeks. The news continues to be what pundits have referred to as "second derivative", that is, still bad but not as bad as last year. For example, GDP growth in the first quarter of 2009 was (5.7%), terrible, but better than the fourth quarter (6.1%). The markets price in expected news so what matters is the unexpected news - is it better or worse than expected? For the last 2 months, it's been predominantly better and the markets have responded. We still have strong headwinds however, so continued skepticism is warranted. I'd be thrilled to see the S&P above 950 at the close on 12/31 but still think 950 is a reasonable expectation.
Fixed income markets have also performed well over the last 8 weeks. However, there are a few concerns here. First, Treasury auctions in recent weeks have become very challenging as investors have forced yields up rather significantly. Higher yields will make current issues which have lower coupons less attractive to investors. Thus, prices will fall. This suggests avoiding longer term bonds. Higher yielding issues have been strong performers as well as investors are attracted to these high yields. However, default risk remains high as the economy struggles to recover. It's been said that investors should avoid reaching too far for yield. I think that's very true now. I'm more interested in short to intermediate term high quality issues, both corporate and sovereign (bonds issued by governments of other countries).
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What Is It That You Do?
Financial Advisor Primer
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I've been asked frequently recently what exactly I do. I know that "financial advisor" is a vague term. It can cover a host of services, some of which I can provide and some I can't. I don't typically "sell" in this newsletter but thought an overview of my services would be useful. I will return to "non-sales" topics for the rest of the newsletter. Here is what I can do for you:
1) Financial planning - this covers analyzing your current income, spending and assets to determine if you will have enough savings to support retirement. It includes analyzing insurance coverage as well. The purpose is to help you plan for a healthy retirement by identifying strengths which can be fortified and weaknesses which can be rectified.
2) Estate Planning - if you are fortunate enough to have enough assets now or expect to in the near future such that your net worth exceeds certain limits, you will likely benefit from estate planning. The purpose is to ensure that your intentions with regard to the disposition of these assets are met while reducing, to the extent possible, the tax liability at death.
For these services, I will provide an estimated flat fee after our first meeting and before the process begins. The fee will not increase but will be reduced if the planning process does not require as much time as I estimated.
3) College and College Financial Aid Planning - this is very similar to the financial planning service but, obviously, is focused on helping you maximize your ability to finance your children's (or grandchildren's) college educations. This can be done on an hourly fee basis.
4) Financial Well-being Assessment - this is essentially a second opinion and involves reviewing your current financial situation and providing advice as to potential changes to your plan, if any are needed. This can also be done on an hourly basis.
5) Discretionary Investment Management - this involves managing your assets (taxable investment accounts or IRAs) on your behalf. This process involves developing an investment policy statement, constructing an asset allocation, building and implementing a portfolio and ongoing monitoring and reporting on performance. Fees are based on assets under management.
6) Retirement Plan Implementation and Management - this involves small business retirement planning. I help small business owners (plan sponsor) establish a new retirement plan (401k plan typically) for employees. I also work with existing plans to review the investment options, recommend changes, report to employees, etc. Many small business owners assume this responsibility themselves and often find they don't have time to manage it effectively. Fees for this are also based on assets under management.
This is not exhaustive but does provide a good overview of the services I can provide to clients. I'm also happy to help clients with other finance related questions such as 401k asset allocation, mortgage refinancing, etc. Hopefully this provides a better understanding of what I can do and how compensation works for these services. Now back to our regularly scheduled programming!
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Investment Policy Statements
Your Portfolio Blueprint
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 According to a recent article in Kiplinger's Personal Finance Magazine only 36% of wealthy investors believe their advisor managed last year's crisis well. One possible explanation for this lack of confidence in their advisors is a lack of a written investment policy statement (IPS). The IPS is only mandatory for ERISA governed retirement plans but it should be mandatory for all investors. The document is your blueprint which you and your advisor will follow to construct and maintain your portfolio.
Writing the IPS requires meeting with your advisor and discussing several critical issues:
1) Return objectives - what do you expect your portfolio to earn annually? This target should be constructed carefully. Assess your current income needs and expectations about future uses of the portfolio. Your advisor can then calculate a rate of return target consistent with these needs.
2) Risk tolerance - how much risk can you bear? This is frequently the most difficult step in the process. Investors generally perceive themselves to be more tolerant of risk than they really are and the advisor must work closely with you to determine your true risk tolerance as accurately as possible. This is often done as the first step in the process because the portfolio rate of return is usually constrained by risk tolerance.
3) Time Horizon - what do you intend to do with this portfolio? Is it to be used to meet current income needs, college expenses in 5 or 10 years, retirement income needs in 15 or 20 years? Time horizon helps refine how much risk should be borne by the portfolio. You may be more tolerant of risk than your portfolio can bear because your time horizon is short.
4) Liquidity needs - this goes hand in hand with time horizon. If you need immediate liquidity, you are unlikely to invest in real estate, private equity, hedge funds, etc which don't or can't provide immediate liquidity. Instead, you'll invest in low risk, highly liquid securities such as Treasury bills.
5) Unique circumstances - this can incorporate anything. For example, you're time horizon is long, liquidity needs low, risk tolerance high, but you're planning to travel around the world next year. If you leave this out, you're advisor will likely have to make significant portfolio changes to provide you the cash you need to pay for the trip. This is the step where the advisor asks "What else do we need to consider?"
The answers to these questions define the mission statement of the IPS. The advisor will then incorporate an asset allocation, permissable investments, frequency of rebalancing, tax considerations and reporting requirements. The blueprint now clearly defines the intentions of both parties. This document should be reviewed at least annually and revised as necessary. If you don't have one, sit down with your advisor and get started on creating one. If you don't use an advisor, answer the questions above for yourself and devise your own IPS. It will serve as a useful guide and reminder as to why you made the decisions you've made for your portfolio. I can't stress enough the value of an investment policy statement.
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As always, if you find this bulletin useful please forward on to anyone else you believe may find it interesting. If there is anything I can do for you, please let me know! Don't forget to check out our website at Brighton Financial and my blog at Brighton Perspective.
Sincerely,
John P. Middleton, CFA, CAIA
Brighton Financial Planning, Inc.
john@brightonfinancial.com
908-730-7000 (office)
908-892-5958 (cell)
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I'm Not Dead, Yet!
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That's one of my favorite lines from Monty Python's "The Holy Grail"! One man is so determine to rid himself of another that he claims he's dead even while the supposedly dead man continues to insist he's not dead, yet.
Asset allocation has been written off by many pundits as dead because so many asset allocation strategies failed to produce positive returns in 2008. It is true that most did not generate positive returns, in fact, none of the 341 distinct portfolios in the Moderate Allocation Morningstar category had a positive return in 08, and only 3 of the 173 in the Conservative Allocation category had a positive return. However, I believe the argument is disingenuous. The objective of asset allocation is not to achieve a positive return in all environments, but to attempt to provide a more consistent return while reducing volatility and providing some downside protection.
I think asset allocation strategies largely achieved these objectives in 2008. 160 of 161 conservative allocation strategies and 300 of 317 moderate allocation strategies with a full 2008 track record outperformed the S&P 500 for the year.
Further, all 135 conservative allocation strategies and 264 of 272 moderate allocation strategies with a 3 year track record had lower volatility than the S&P 500.
Asset allocation does not render a portfolio immune to significant downturns but it can help to reduce the pain and shorten the recovery. Don't declare it dead just yet!
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