I create mutual fund-based and exchange traded fund-based investment portfolios that include these asset classes:

Quality Domestic Bonds International Stocks Cash and Cash Equivalents
Large US Company Growth Stocks Commodities High Yield Bonds
Large US Company Value Stocks Real Estate Investment Trusts Emerging Markets Stocks
Small US Company Growth Stocks Small US Company Value Stocks Municipal Bonds
International Bonds Emerging Markets Bonds Emerging Markets Local Currency Bonds

I believe it is very important to select mutual funds that concentrate on securities from each of these asset classes. For instance, I would consider using the Acme Large Cap Growth fund for the Large US Company Growth Stocks asset class if Morningstar (or other reputable securities analysts) indicates that this mutual fund is composed of 95% (or more) of this type of stock.

I also use domestic stocks of varying market capitalization even to the extent of use of micro-cap stocks. 

Asset Class Discipline and Allocation

I want to know if the fund manager exercises discipline to keep that asset class of securities in the fund regardless of current market conditions. When I select mutual funds for client portfolios I also select funds with a minimum Morningstar rating of “three stars.” Most of the mutual funds in my portfolios are four- and five-star funds.

I emphasize fund asset class discipline and asset allocation because I adhere to “Modern Portfolio Theory.” This theory was recognized by the 1990 Nobel Prize in Economics, which went to Harry M. Markowitz of the University of California-San Diego.

In addition to Nobel Laureate Markowitz’s work, researchers Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower studied the effect of asset allocation on 91 large pension funds during 1974-83. They found that it accounted for more than 96% of a portfolio’s performance. Their study, Determinants of Portfolio Performance, was published in 1986.

I recommend one of the following six portfolios to my clients:

  1. Capital Preservation
  2. Moderate
  3. Balanced
  4. Income
  5. Growth
  6. Aggressive Growth

They are based on how distant is their time horizon and their risk tolerance.

The Importance of Rebalancing

When it comes to client portfolios, I don’t believe in “set it and forget it.” I don’t let portfolios stand without periodic review of the mutual funds that they include.

At times, I determine that a mutual fund has lost discipline, a manager has been replaced, or I note some other factor of concern. I might find that it is desirable to replace one mutual fund with another. That fund would be replaced in all the client accounts that use that fund.

Rebalancing portfolios is the practice of returning an account portfolio to the model asset allocation. This prevents portfolios from becoming unsuitable for a client. For example, stocks can quickly increase or decrease in value. This causes the asset allocation to change.

I use my discretionary authority to sell or buy shares in the portfolio to restore the model asset allocation. This is called “strategic rebalancing.” Costs for the transactions in this practice are minimal and I receive no fees or commissions as a result.

“Tactical rebalancing” is the practice of changing a model asset allocation in the belief that one asset class or another will advance or decline in the near future. I currently don’t engage in this practice.