In the hierarchy of institutional investors, pension plans get picked on the most. Endowments and foundations are the mean girls of this space, generally looking down at their pension brethren because they all assume pensions are the last to the party when it comes to innovative investment ideas.
In my experience, this is often unwarranted because I’ve witnessed plenty of silly mistakes from the E&F crowd, but I’ve spilled my fair share of ink on problems in the pension world (see here, here, and here).
So it’s only fair to point out a pension that seems to be on the right track. The San Bernadino County Employees’ Retirement Association (SBCERA) made a decision in 2006 to change the way they rebalance their portfolio and it’s added nearly $1 billion to their $10 billion fund since it was implemented. They estimate that’s an increase in annual returns of around 1.25%.
The CIO of the fund and some of his colleagues wrote a research paper with a mouthful of a title called How Knowledge Management Can Capture Untapped Alpha: A Case Study of Informed Rebalancing at the San Bernardino County Employees’ Retirement Association to explain how they did it:
Asset allocation decisions contribute 80-90% to total fund risk and good governance requires that they should be actively measured, monitored and managed. SBCERA called this approach “Informed Rebalancing”, different from “Traditional Rebalancing”, requiring the staff member to source the best ideas (or source knowledge) so that the rebalancing decisions were not arbitrarily triggered, but rather provided staff’s best estimate of which assets were over/undervalued and in turn, over/underweighted within the Board approved ranges.
Obviously, making rebalancing decisions like this that add so much value is no small feat but I love the fact that this fund used one of the simpler investment decisions to add value to the portfolio management process.
Instead of trying to find money managers that will knock the cover off the ball like many of their peers, they’ve instead chosen to focus their attention on an intelligent rebalancing process.
Rebalancing is an often overlooked investment decision people seem to take for granted but it can play an integral role in the portfolio management process when done prudently. Here are three more investment decisions which are often overlooked:
Asset Allocation. Diversification doesn’t work as well if you don’t understand asset allocation and asset allocation doesn’t work as well if you don’t understand rebalancing. So this one goes hand-in-hand with rebalancing but it’s amazing how much time and energy Wall Street puts into individual stock analysis and investment strategies while mostly ignoring the simple building blocks of portfolio construction.
I know why this is the case — asset allocation is boring while stock-picking is sexy. But the asset allocation decision, and any changes to that asset allocation over time, vastly outweigh the sexier topics.
Asset allocation is how you can define and shape the risk profile of your portfolio to balance your many competing needs and goals.
Asset Location. Asset allocation is the cornerstone of the portfolio management process but where you place your assets in terms of how you utilize the various types of accounts at your disposal can have an impact on the tax efficiency of your portfolio and your overall finances. Comprehensive portfolio management requires not only understanding which asset classes and investments you choose but also where you choose to hold those assets.
For young people that means taking advantage of tax-deferred investment vehicles and diversifying your tax exposure (since there’s no way to tell what your tax rates will be in the future). For people with more financial assets that means being thoughtful about which types of investment strategies and asset classes you segregate by taxable and tax-deferred accounts.
This can be something of a balancing act because you have to consider not only the tax efficiency of the investment but also the expected return and the turnover involved in the strategy.
Asset location is not going to add tons of value to your overall portfolio but the idea is to create slight edges that can compound over time.
Your Investment Filters. There’s never been a better time to be an individual investor because of the access we now have to different investment products, fee structures, geographies, and strategies. But these benefits come with a cost in the form of increased choice and temptation to make portfolio changes.
Low expense ratios, decreased trading costs and more liquid ETFs do you no good if you simply churn your portfolio every time a shiny new object comes to market. Behavioral mistakes can eat up those cost savings in a hurry.
Those who have filters in place in the information age have a leg up on those who don’t because the firehose of information grows by the day. The same is true of placing intelligent filters on your portfolio. Figuring out what you won’t invest in — types of securities, strategies, fee structures, etc. — is far more important in today’s world than figuring out what you will invest in.
If you’re able to filter out the majority of the bad stuff that’s going to cause you emotional strain or behavioral challenges, whatever is left over should be easier to manage.
Investing is never a precise endeavor because there will always be an element of uncertainty involved.
Each decision you make in the portfolio management process may not add value in and of itself, but when taken together, a handful of decisions that offer you slight edges over the long haul can add up.
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