Portfolio Construction Considerations

June 26, 2024

“How will my account be invested?”

At The Fiduciary Group, we believe a thoughtful response to this question begins with the creation and implementation of an Investment Policy Statement (IPS) for the client. The IPS serves as a framework for how the portfolio will be managed and takes into consideration the client's goals, needs, concerns, and priorities. Through conversations and discovery meetings, we are better able to gauge a client's return objectives, risk tolerance, time horizon, liquidity needs, tax situation, and other unique circumstances.

While developing the IPS, we often request information about current investment accounts and financial assets. Many prospects and clients have multiple accounts and account types. Assets to review can include those managed by The Fiduciary Group, accounts managed by other advisors, self-managed accounts, and retirement accounts. Reviewing all investments on a consolidated basis allows us to understand portfolio risk and identify overexposures or duplication. In a perfect world, all accounts and assets should be working in concert to fulfill the needs of a financial plan.

When reviewing portfolios, several factors are under consideration. We start with a holdings analysis to understand the current asset allocation and portfolio characteristics. We evaluate stock concentration risk, geographic exposure, market cap, style diversity, liquidity, credit, and interest rate risk. In addition, we look at security types, income generated, tax considerations, and expenses.

Asset allocation is the most helpful tool in managing risk. Proper asset allocation balances investments across equities, bonds, and other asset classes. Clients often own mutual funds, exchange-traded funds (ETFs), and individual stocks and bonds across their accounts. We evaluate each asset and analyze underlying fund holdings to determine a consolidated household allocation.

After reviewing the overall asset allocation, we drill down further into the underlying characteristics of those asset classes. On the equity side, we review geographic exposure, style (growth vs. value), size (large cap, mid cap, small cap), and sector weightings. Proper diversification across the equity spectrum helps access more potential return drivers while limiting risk to any single segment of the market.

Single-stock concentration is a recurring theme when reviewing portfolios. A portfolio heavily invested in a single stock or just a few stocks increases vulnerability to company-specific issues. Clients are often not interested in selling stocks with significant gains due to taxes. Also, these stocks have provided a positive experience and sometimes carry sentimental value. We prefer to have conversations about trimming the security over time to reduce risk; however, at the very least, we will be mindful of the large holding and typically refrain from purchasing securities vulnerable to similar risk factors.

On the fixed income side, we review current yields, credit risk, interest rate risk, and sectors. Fixed income comes in many shapes and sizes, with varying risk profiles. We view fixed income as the safer portion of a portfolio to preserve capital while generating income. However, occasionally, we see accounts with large portions of their fixed income in high-yield credit, long-duration holdings. Those holdings tend to be more volatile than high-quality bonds in periods of market stress.

Costs and Taxes

Investment costs and tax efficiency are wise to consider when assessing a portfolio. Investment costs include advisory fees, trading commissions, and expense ratios. We review statements to ensure fees are reasonable and have no unnecessary costs. Occasionally, we discover opportunities to reduce costs by transitioning away from expensive products. For example, if there is a high-cost mutual fund, we can convert it to a lower-cost share class or find an appropriate replacement.

Investing for after-tax returns through asset location, choosing tax-advantaged investments, and tax loss harvesting are ways to improve the efficacy of a portfolio. Asset location can include owning high-income-producing assets and mutual funds in tax-advantaged accounts while owning ETFs and growth stocks in taxable accounts. A relevant topic of note is mutual fund distributions. Many mutual funds that were popular years ago are now facing yearly redemptions as investors transition to more tax-efficient ETFs or as those assets are transferred to beneficiaries and sold upon receipt. In an article on March 21, 2024, The mutual fund at 100: is it becoming obsolete?, The Financial Times reported, "US mutual funds suffered more than $1 trillion in net outflows from January 2021 to December 2023." Meanwhile, ETFs have received more than $2 trillion in inflows in the US since January 2021. To fund redemptions, mutual fund managers must sell stocks to generate cash. If the fund manager realizes capital gains, those gains are then distributed to the remaining shareholders. We recommend monitoring fund redemptions and developing strategies to reduce positions in funds facing outflows. Lastly, tax loss harvesting can reduce a capital gains bill. As part of our portfolio management process, we look for tax loss harvesting opportunities throughout the year, emphasizing harvesting losses before year-end to offset capital gains.

An in-depth asset review is part of our value proposition as advisors, and we encourage you to contact us anytime to discuss your investment portfolio, progress toward your financial goals, and any questions or concerns you may have.