INVESTMENTS - ALLOCATION
 
 

CASE STUDY:

STARTING TO MANAGE AN INVESTMENT PORTFOLIO

Background: Erik Erikson is a successful professional in his early 30s who has managed to save $37,000 over the years from his income. At this point, all of this money is in savings accounts and bank CDs. He has now made the decision to invest these assets in a portfolio of mutual funds instead of letting them languish in low-yield securities.

Currently, Erikson has few financial obligations and no debt. Eventually, however, he would like to get married and have children and a home – but not until he is better established in a new entrepreneurial business venture for which he recently agreed to work.

Analysis. Given Erikson’s current age and status, the most appropriate portfolio for him should be a moderately aggressive one. That’s because he has no anticipated short-term requirements that would force him to dip into his nestegg. Therefore, a portfolio largely invested in stocks is appropriate. And since at this point he has no stock investments – or bond investments for that matter – he starts off with a clean slate.

1. Investment Objective. Erikson realizes his primary investment goal should be long-term investment growth. He’s seen and experienced the effects of relegating money to cash vehicles and recognizes that there is danger in safety – loss of value to inflation and taxes, and loss of opportunity to experience growth that would better meet his future financial needs.

2. Investment Allocation. Erikson has decided that he wants to allocate about 85% of his portfolio to stock and partial stock funds and just 15% to bond funds. In addition, he is keeping $2,000 in a money market fund for short-term emergencies, so his total investment in stock and bond funds will be $35,000. While this allocation is aggressive, Erikson figures that if he doesn’t have to draw on his stock fund assets for many years, he should eventually come out ahead. He knows that historical figures show that money invested in stocks over the longer term far outpaces bonds. Although he is concerned that stocks are at all-time highs, he has also read studies that indicate that long-term stock investors fare well even if they invest at market peaks.

3. Identification of Appropriate Types of Investment. Erikson has selected five stock-fund categories to invest in: aggressive growth, growth/income, small company, technology, and international. In addition, he had decided also to go with a managed hybrid: an asset allocation fund. He believes that aggressive growth, along with the small company and technology funds, will do a particularly good job of providing the growth he needs. He is attracted to the growth/income fund category for its investment stability, and the international fund category for its worldwide diversification. Finally, an asset allocation fund would counterbalance these investments by providing more cautious growth, along with some exposure to bonds.

As for bonds, Erikson decided on concentrating on only one category: muni bond funds. He believes a tax-free bond fund, even though it has a lower yield than a corporate or government bond fund, will provide higher after-tax returns.

Erikson also decided to take the more simple, straightforward approach to investing in these seven categories. He decided to put equal portions of his money in all seven funds, which gives him roughly his target allocation: 85% in stock funds and 15% in a bond fund.

4. Selection of Specific Investments. Although Erikson understands the fundamentals of investing, he is not especially familiar with individual funds and fund families. In addition, he is not one to invest his money based on hunches, or on tips printed in magazines. Therefore, he made the decision to go with funds ranked highly by the Value Line Mutual Fund Survey.

For equity funds, the data provide each fund’s investment objectives; overall rank as a measurement of the performance of the fund based on a variety of criteria, including risk; and risk ranking as a measurement of how risky a fund is compared with other funds in its category. To gauge long-term consistency of performance, Erikson consulted the 5-year growth persistence ranking.

In addition, Erikson referred to the total return statistics, including figures indicating how each fund performed during the most recent bull and bear markets. And although he recognizes that yields are quite low at this point, he also was interested in each fund’s yield percentage. The remainder of the categories – providing information such as the largest sector held in the fund – filled in the picture for him.

For tax-free bond funds, the data provided similar ranking, return, and yield information for Erikson to use to judge his funds. However, they also provide information such as average maturity in years, average duration, and average quality.

In terms of aggressive growth funds, Erikson chose Salomon Brothers Opportunity for its overall rank of 1 while maintaining an average risk of 3, and its hearty total-return record. He then went with the Mutual Shares Fund for growth/income, being strongly attracted to its lower-than-average risk (2) while maintaining an overall ranking of 1.

For small company, Erikson chose T. Rowe Price Small-Cap Value – again for factors such as its superior rankings and return. Then for technology, he chose T. Rowe Price Science & Technology despite its high-risk ranking. Erikson decided such risk was a small price to pay in the face of the fund’s record of soaring growth. He also noted that most technology funds sported high-risk rankings.

Erikson’s international fund pick was managers International Equity Fund. He was impressed that despite its average overall rank and risk rank, Managers had turned in a performance in 1995 that far exceeded its foreign equity peers. And finally, for asset allocation, Erikson selected the Vanguard Asset Allocation Fund, again for its strong rankings and strong returns.

Getting his vote for the muni bond fund was the Vanguard Municipal Intermediate-Term Fund on the basis of high ranking and solid returns.

One of the advantages of investing in mutual funds, Erikson now recognizes, is that funds provide investors with the ability to invest exact allocations in particular investment categories. Of course, within these funds not all investments exactly match their categories. Even the most aggressive stock fund, for example, must keep a certain amount of money in cash to allow for redemptions.

Erikson now has his money fully invested and must wait to see how his funds will perform. In about six months he should review his portfolio to see if he needs to reallocate in order to maintain his target allocation – but until then he can relax knowing that he has selected good funds within each category.
 
 

Erik Erikson’s Mutual Fund Portfolio
 

Fund	Category	Amount
STOCK FUNDS:
Salomon Brothers Opportunity	Aggressive Growth	$5,000
Mutual Shares Fund	Growth/Income	5,000
T. Rowe Price Small-Cap Value	Small Company	5,000
T. Rowe Price Science & Technology	Technology	5,000
Managers International Equity	International	5,000
Vanguard Asset Allocation	Asset Allocation	5,000
Subtotal		30,000
BOND FUND:
Vanguard Municipal Intermediate-Term	Muni Bond	5,000
Total		$35,000

CASE STUDY:

CHANGING FROM AN AGGRESSIVE TO A BETTER-DIVERSIFIED INVESTMENT PORTFOLIO

Background. Joan Lee is in her early 30s, unmarried, and has a successful professional career. She started investing in mutual funds soon after finishing college. Thanks to her early start, her continuous investing through an automatic investment program, and the recent market runup, she now has a sizable portfolio. Most of her holdings are in aggressive-growth stock funds. Joan considers herself a long-term investor. Although she normally spends a few minutes a day reading financial and business news and she checks her portfolio once in a while, she follows a buy-and-hold strategy and doesn’t trade often; rather, she is content to reinvest her dividends and capital gains into the same aggressive-growth stock funds that have rewarded her in the past.

Lately, however, Joan has become a little concerned about the market. The market’s recent tumults seem to signal that the rally is near its peak. There is talk, some from high-profile market analysts, that U.S. stocks are grossly overvalued. Furthermore, a string of economic data continues to produce a picture of growing strength in the economy, and she is particularly concerned by the strong conviction, shared by several leading economists, that a recession is just around the corner. Joan understands that predicting the stock market and interest rates is always treacherous, so she is not prepared to make a precipitous change in her investment strategy. Nevertheless, she feels the need to adjust her portfolio and get into some more-defensive vehicles before a possible market downturn. She feels, quite correctly, that her portfolio could be very badly hit if the U.S. stock market experienced even a relatively mild correction. What should she do?

Analysis. Joan’s current portfolio, 60% in aggressive growth funds and 20% in small-cap funds, with the rest in growth and income and long-term bond funds (see table below), is indeed aggressively allocated. Such a portfolio may perform very well in a bull market, but tends to be hard hit when a market correction arrives. In the recent market correction, funds that suffered the most were the small-cap and aggressive stock funds. As market conditions are apparently changing, it is prudent for Joan to rethink her portfolio.

Diversify within the U.S. stock market. One weakness of Joan’s portfolio is its insufficient diversification. It will provide very little downside protection in the event of a market correction. Joan might want to consider reducing her holdings in aggressive-growth and small-company funds and increasing her holdings in growth and income funds, or consider other more conservative fund categories such as equity income. Most growth and income funds and equity-income funds invest primarily in large-cap, dividend-paying stocks, which tend to hold up better in a market downturn compared with aggressive-growth and small-cap funds.

Reduce risk with international funds. Picking a good, international fund is one of the easiest ways to put an umbrella over the portfolio. For someone like Joan who hasn’t yet owned any international stock funds, now is an excellent time to buy them. Even those who already own international funds may now consider increasing their percentage of non-U.S.-stock-fund holdings. The suggested percentage of non-U.S. assets in a portfolio is 15% - 30%, depending on the individual’s goals and appetite for risk. Studies show that global diversification can improve returns and reduce risk. Though it’s true that a decline in U.S. stocks will spread to many other world markets, some won’t fall as much, and a few may not drop at all. U.S. and most foreign markets aren’t perfectly correlated, and the correlation that occurs tends to be over the short term.

Increase bond holdings. Typically, a well-diversified portfolio maintains a mix of stocks and bonds, with the percentage in each asset depending on each individual case. Bonds, particularly Treasury securities, have not been Wall Street darlings recently. But now, at a time when the stock market is at an all-time high, it may not be a bad time for Joan to consider shifting a portion of her stock holdings into bonds. Indeed, many promotional money managers, whose investment mandate calls for them to invest in both stocks and bonds, have recently increased their bond allocation. Joan should consider adding short- and intermediate-term bond funds to her current long-term bond holdings. Just as she is seeking better diversification in the stock portion of her portfolio, by investing in bond funds of varying maturities, she is also improving her fixed-income diversification.

Timetable and tax considerations. In reallocating her portfolio, Joan needs to keep in mind that such moves may have tax consequences. Nevertheless, there usually aren’t too many unrealized capital gains in actively managed funds because realized capital gains are distributed to shareholders each year. Since Joan does not want to make a sudden change in her investment allocation, but is still intent on eventually putting together a portfolio that will, in her words, "let me sleep better," the following table provides a timetable for gradually redeploying her investments over the next year.
 
 

Timetable for a Shift from an Aggressive to a More-Diversified Portfolio
 

Investment Category (Funds)	Current Allocation (%)	3 Months Hence  (%)	6 Months Hence  (%)	Target 9-12 Months Hence (%)
Aggressive Growth	60	40	25	15
Growth & Income	10	20	20	20
Small-Cap Funds	20	15	15	15
International Stock		10	20	20
Subtotal (stocks)	90	85	80	70
Long-Term Bond	10	10	10	10
Intermediate-Term Bond			5	10
Short-Term Bond		5	5	10
Subtotal (bonds)	10	15	20	30
Total	100%	100%	100%	100%

CASE STUDY:

LATE STARTERS

How One Middle-Aged Couple Is Using Mutual Funds to Begin a Retirement Savings Program

Background. Laura and Scott Albright are a couple in their early 50s. They’ve got seven more years of mortgage payments, but their two cars are paid for and running well at the moment. Both work as allied health professionals, although for different employers; Laura has worked full time only during the past five years. Their youngest child has just begun his freshman year – fortunately on full scholarship – at a college two states away, and the Albrights are feeling both sad and excited about being empty nesters at least. They’re also somewhat worried. Because they’ve had to raise four children largely on the earnings from Scott’s middle-income job, they haven’t been able to start a retirement savings program, and they’re concerned it may be too late.

Scott’s employer doesn’t offer a 401(k) plan, but Laura’s does. Laura’s 401(k) allows her to contribute $6,000 a year, and both she and Scott are doing $2,000 IRAs. That’s the tax-deferred portion of their portfolio. On top of that, they’re going to try to save another $5,000 a year outside their IRAs. And they do have about $25,000, an inheritance from Scott’s grandmother, in a taxable brokerage account.

Analysis. Although this may not be especially comforting knowledge for the Albrights, a lot of other people are in the same boat. A growing number of singles and couples are reaching middle age without having been able to start a retirement savings plan for a variety of reasons – including children still at home or in college. This is true even in two-income families. But Scott and Laura are willing to offset their more limited time horizon with a very aggressive portfolio allocation of 80% stocks and stock funds, so they’re off to a good start.

They’re certainly not too far behind to catch up – with the right investment strategy. Twenty years of dedicated saving for retirement is usually sufficient, so people who expect to retire in their 60s typically need to start saving in their early 40s. The Albrights are only 10 years behind, and neither wants to retire as early as 65. They love their work, and they’re both in excellent health. Their companies don’t have mandatory retirement ages, but if their employers decided to phase them out before they are ready, they feel pretty confident about the market for their skills, either as employees somewhere else or as independent consultants.

The Albrights are fortunate in another way, as well: They agree on their retirement objectives. Their children don’t expect to inherit much money, if any, from their parents. Each of the four, in fact, has told Laura and Scott directly that they want to make their own way and would be happiest if their parents would start putting themselves first for a change. So the senior Albrights are comfortable with their goal of investing to achieve a comfortable retirement lifestyle that will allow them to keep their home, entertain friends, pursue cultural interests, and travel moderately.

Investment strategy. Besides agreeing on an 80%/20% ratio of stock to bond holdings to offset their condensed time frame with higher than average growth, Laura and Scott have moderated their risk by choosing investments with differing but compatible objectives.

Retirement portfolios. As the following table shows, the Albrights have chosen to put 30% of their retirement mutual fund money in growth and growth and income funds, whose large-cap, dividend-paying companies offer generally strong returns plus stability. For higher expected returns over the long term, they’ll be investing 25% in international stock funds, a good choice for their long-term growth orientation. The 20% invested in corporate bond funds provides some balance in a volatile stock market.

Taxable account investments. Laura and Scott are also investing directly in some blue-chip growth and dividend-paying stocks outside their IRAs (see the following table), taking advantage of tax-deferred growth by buying and holding individual stocks. They’ve minimized the risk associated with individual stocks by staying with high-quality companies that should weather market fluctuations nicely and perform well over the long haul. The muni bond fund augments their tax-deferral advantage, and the 10% money market position gives them a cash reserve.

This is a very tax-friendly overall portfolio: The most heavily taxed investments are in the least heavily taxed (retirement) accounts. And the least heavily taxed investments, the individual stocks and muni bond fund, are in the most heavily taxed accounts.

And even though stocks are at all-time highs, the Albrights aren’t concerned about current high valuations because by investing steadily, they’re receiving the advantage of dollar-cost averaging, one of the best ways there is to minimize investment risk. (In dollar-cost averaging, you simply invest the same amount of money periodically in the same investment categories. The money buys more shares (or more bond principal) when prices are down, fewer when they’re up. It’s a long-term investing strategy that lowers your exposure to market fluctuations, and it’s virtually painless.)

While the Albrights are late starters, their investment program, combined with the $25,000 they now have, if it averages an eight percent return over the next 15 years, will provide them with a retirement nest egg of almost $500,000. Of course, if they can gradually increase the amount they save as their income increases, they will accumulate even more.
 
 

The Albrights’s Retirement Portfolio
 

STOCK FUNDS	% ASSET ALLOCATION
Growth	15
Growth/income	15
Small company	25
International	25
Subtotal stock funds	80
BOND FUNDS
Corporate	20
Total	100

 

Taxable Portfolio
 

INDIVIDUAL STOCKS	% ASSET ALLOCATION
Growth	40
Growth/income	40
Subtotal	80
MUNICIPAL BOND FUND	10
MONEY MARKET FUND	10
Total	100

CASE STUDY:

PUTTING TOGETHER A TAX-EFFICIENT MUTUAL FUND PORTFOLIO

Background. George Bassett is an investor whose job as chief operating officer at a large medical center places him in the 3% federal income-tax bracket. After the passage of the Taxpayer Relief Act of 1997, he became concerned that the new tax rules reward long-term stock investors with the 20% maximum capital gains tax rate, but penalize investors who take gains on investments held less than 18 months.

George has a substantial taxable portfolio - $200,000 invested 80% in stock funds and 20% in U.S. government bond funds. He was horrified to learn that most of his stock funds generate primarily short-term capital gains (for stocks held one year or less) taxed at his ordinary income-tax rate of 36%. The funds do generate some mid-term gains (for stocks held more than one year but not more than 18 months), which are taxed at 28%, but his funds produce few long-term gains (for stocks held more than 18 months) that qualify for the new 20% rate. In George’s opinion, "18 months isn’t a very long time to hold onto a stock, but judging from the capital-gains taxes I paid last year, my fund managers must think it’s an eternity." What’s more, he’s paying a 36% federal tax on the income from his government bond funds.

"It wasn’t so bad before the new tax rules came along. Most of my capital gains were taxed at 28%. But the new 20% rate means I can keep a lot more of my gains – but not with the current roster of funds I own. I could buy individual stocks, of course, and hold onto them for at least 18 months. But I don’t have time to ride herd on a bunch of stocks. I’ve always been more comfortable with funds, but I would like a more tax-friendly portfolio than I’ve now got."

Analysis. It’s no secret that tax efficiency is not a big selling point for most mutual funds, since most fund managers make trading decisions regardless of the tax consequences to individual shareholders. Under the new tax rules, however, an increasing number of investors in all tax brackets are interested in taking advantage of the reduced capital-gains tax rate for their investments. So-called "tax-efficient" funds either have a history of minimizing, or are designed to minimize, heavily taxed capital-gains distributions.

What makes a fund "tax efficient?" A look at the annual turnover rate – the percentage of holdings a fund sells each year – is one quick measure. High turnover can mean that the fund distributes a high percentage of short-term gains taxed at investors’ ordinary-income tax rates. According to the American Association of Individual Investors, research indicates that turnover of 10% or less is needed for true tax efficiency. Yet the average mutual fund has a turnover rate of 80 to 90 percent. (In contrast, an index fund that sells stocks only when the composition of its index changes may have a turnover rate of about five percent.) Turnover doesn’t tell the whole story, though.

A low-turnover fund holding stocks that pay high dividends, such as a growth-and-income, equity-income, or balanced fund, may still be tax inefficient, because the dividends are taxed at ordinary-income rates. And a low-turnover fund that has accumulated substantial unrealized gains could create significant tax liabilities for investors, even at the lower capital-gains rate. (The fund manager might have to liquidate holdings and distribute the gains in order to meet massive redemptions by investors during a bear market, for example. Or a change in the fund’s investment objectives or manager could result in a similar sell-off, with similar results.) Such a fund could of course minimize the taxes passed on to investors through strategies such as accumulating loss carryforwards, just as a high-turnover fund could achieve tax efficiency through a strategy of offsetting capital gains with capital losses, or selling the shares with the highest cost basis first.

Investors leery of capital-gains exposure are often attracted to funds that have substantial inflows of new cash, especially new funds run by experienced managers. But it’s easy for a fund to disguise tax inefficiency, particularly in a bull market, by spreading distributions among an increasing number of investors – with unfortunate consequences if performance declines. One of the best ways to judge a fund’s tax efficiency is to compare its pre-tax returns with its tax-adjusted returns, information that can be calculated from data contained in the Value Line Mutual Fund Survey. As the following hypothetical example illustrates, tax efficiency has a significant impact on real return, and a tax-managed fund with less impressive pre-tax returns can offer more after-tax income than a "regular" mutual fund with higher pre-tax returns.

 
 

	Pre-tax	Tax-adjusted	Efficiency	Lost to Taxes
Growth fund	23.3%	23.2%	82%	18%
Tax-managed growth fund	24.6%	23.9%	97%	3%

 
Investment strategy. George has decided not to limit his portfolio to the relatively small number of available funds that are specifically managed to minimize taxes, but also to select funds that meet his investment objectives while considering the following criteria as selection guidelines:

A track record of above-average performance relative to a fund’s peer group.

An expense ratio that is below average for a fund’s peer group.

A manager who has performed well on a risk-adjusted basis, compared to asset-class peers, according to Value Line’s overall rank, and/or direct peers, according to Manager Rating.

Low turnover rate, unless specific strategies are in place to minimize short- and mid-term capital gains.

Readily available information that enables investors to identify and sell shares with the highest cost basis first ("highest in, first out").

A consistently high tax-efficiency rate.

Over the next two years, George wants to put together a moderately aggressive portfolio with a long-term horizon that will provide both growth and tax efficiency (see table below). It will include municipal bond funds because he has determined that these funds, historically, at least, have provided greater after-tax returns than the government bond funds he currently holds. But because he realizes that even a tax-managed fund cannot guarantee continuous tax efficiency, particularly in a bear market, he will not select funds solely on the basis of their current tax efficiency, but will focus on buying – and holding – above-average funds within each asset class.
 
 

George Bassett’s Tax-Efficient Portfolio
 

STOCK FUNDS%	ALLOCATION
Tax-efficient growth	25
Tax-managed growth and income index	20
Tax-efficient small company	15
Tax-managed international index	20
Subtotal	80
BOND FUNDS%
Single-state municipal	10
Multi-state municipal	10
Subtotal	20
Total	100

CASE STUDY:

ASSEMBLING A FUND PORTFOLIO GEARED TOWARD MAXIMUM CAPITAL APPRECIATION

Background. With all of their own investment accounts well managed, David and Joan Smith, a retired couple, now have the opportunity to do something for their children. They want to gift $20,000 annually to each of their children. Since they don’t expect their children, who are now in their late 20s and early 30s and professionally employed, to need the money any time soon, the Smiths have decided to assemble and manage an investment portfolio under their children’s names.

Should we design this portfolio any differently than if it were for ourselves? the Smiths asked their financial advisor. While dividends, interest income, and relative lower risk may make sense for you, you should look for maximum capital appreciation for your children. That means assembling an aggressive investment portfolio where the action is primarily in stocks. Their advisor also noted that although stocks are at all time highs, history has shown that an aggressive portfolio wins out over the long run. Since the mid-1940s, stocks have enjoyed average annual returns of approximately 10%, while fixed-income investments have returned about 7.5% during the same period. That 2.5% historical advantage for stocks over bonds may seem small, but over time it can generate a lot more money.

Investment decisions. Considering the very long-term nature of these investments, the Smiths have assembled a mutual fund portfolio geared toward maximum capital appreciation. The following is a description of the portfolio components.

Aggressive growth funds (15%). Aimed at maximum capital appreciation, these funds are arguably the most aggressive and the riskiest of all fund categories. They may rapidly shift between sectors, asset classes, and investment styles, frequently resulting in a very high portfolio turnover. They may use derivatives (such as call and put options on stocks); they may buy stocks with borrowed money or to purchase unregistered securities. In the quest for the hottest worldwide opportunities, furthermore, they may load up on bonds to exploit currency exchange issues, or storm into emerging markets. Aggressive growth funds’ investment returns tend to be volatile: Their net asset value often moves twice as fast as the Standard & Poor’s 500 Index, both on the way up and on the way down.

Growth funds (15%). Striving also for capital appreciation, growth funds invest in companies with the potential of rapid growth, such as companies in developing industries, companies that offer innovative products, services or technologies, or fast-growing companies. They attempt to discover these companies before they are recognized by the rest of the market. Some aggressive growth funds use several investment strategies, including options and futures, in an effort to achieve superior returns. But in general, they are less aggressive and less risky than aggressive growth funds.

U.S. small company stock funds (10%). Small-cap stock funds have similar investment goals and guidelines as aggressive growth funds. The major difference between the two fund categories is that aggressive growth funds may invest in companies of any size (although many of them concentrate on small-cap stocks); whereas small-cap stock funds invest exclusively in companies with a small total market capitalization, normally under $500 million. Both aggressive growth funds and small-cap stock funds usually favor the growth investing approach rather than the value approach.

International small company stock funds and emerging market funds (20%). These are designed to take advantage of specific investment opportunities in the world’s developed and emerging countries. Emerging market funds, which concentrate on the world’s fast growing regions or countries, offer substantial earnings potential for aggressive portfolios. However, due to the development nature of these economies and their political environments, the great potential of investing in these markets comes with above-average ups and downs over the short term. International small-cap stock funds offer similar growth opportunities by concentrating on smaller, rapidly growing foreign companies.

Sector funds (20%). Sector funds focus on the equities of either a single industry (such as technology, financial services, or retail), or a single commodity (such as gold, or oil and gas). Sector funds can help investors cash in on an industry’s rise, thus producing strong returns over a relatively short period of time. But because of their narrow focus, these funds can be highly volatile. Sector fund investing lies between broadly-based mutual fund investing and individual stock investing. It provides an opportunity to concentrate on a particular industry of interest to an investor.

High-yield bond funds and emerging market debt funds(20%). High-yield bonds, also called junk bonds, are those municipal or corporate bonds rated below investment grade. These bonds promise to pay high interest in exchange for higher-than-average risk.

Most emerging market bonds offer even higher yields, sometimes up to 20%. Investing in individual high-yield bonds can be very risky; much of the risk, however, can be reduced by the diversification and professional management offered by bond funds specializing in these areas.

All of the fund categories in the portfolio offer increased investment opportunity – and increased investment risk. They can be very volatile in the short term; but in the long run, they tend to outperform the market and deliver superior returns to their shareholders. The portfolio is suitable for long-term investors who are comfortable with investment risk and who have a time horizon of at least 10 to 15 years.