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Four Questions Investors Should Ask in the New Year

February 2020

By Matt Kelley
Portfolio Strategy Manager, ESL Federal Credit Union

The tools and information available to investors has increased significantly in recent years, most likely due to a combination of improving technology and increased access to low- or no-cost investment research. Today, there is more information readily available than ever before. Yet, despite all of the new tools and information, there has not necessarily been an improvement in investor behavior.

Investors continue to underperform their own investments—as measured by cash flows in and out of mutual funds and exchange traded funds (ETFs)—relative to the performance of those same funds.

One potential way to avoid this issue is for investors to gain a better understanding of what they own and why they own it—each investment should have a purpose. When reviewing your portfolio or meeting with a financial professional, there are several key questions investors can ask to evaluate their own holdings and improve in the year ahead.

Is there a lack of diversification among my investments?

It has been difficult to be a diversified investor since the Great Financial Crisis. U.S. Equities have outperformed international; large cap stocks have outperformed small cap stocks; growth has outperformed value; and high yield bonds have outperformed higher quality issues. Investors should make sure that performance chasing does not cause them to trim their underperforming investments that are meant to serve a purpose down the road. Of course, we never hear anyone bragging about his or her poor performing investments, which can lead to insecurity and investment envy. Nothing will be more meaningless to your success as an investor than the performance of someone else’s portfolio. Instead, investors should ask themselves this question: is there something in my portfolio that I hate? If the answer is no, then your portfolio is probably not as diversified as you think it is.

Do I have too much diversification (Am I experiencing “DiWORSification”?)

Counter to the above, another issue is too much diversification. We see many portfolios that look like “mutual fund salad.” Envision a portfolio with 40 names, many of which have 1–2% allocations. Realistically, it is likely that these small allocations are not actually moving the needle, and could instead be combined into one diversified investment that achieves very similar exposure (often at a lower cost).

Am I reaching too much for yield?

Many investors think they need yield in order to earn money from their portfolio, or that receiving cash from a security is a sign of quality. This often is not the case. The highest yielding securities, both equities and bonds, are often of the lowest quality. This can sacrifice total return (yield + price appreciation). Unfortunately, in order to receive the yields investors may be accustomed to historically, they may be taking on more risk than they realize due to the recent interest rate environment.

For example, investors should determine whether the bonds in their portfolio are meant to be a safe haven or risk reducer—it is important to not over expose your portfolio to lower quality bonds to reach for a desired yield. Credit spreads (the increase in yield of a lower quality bond over a treasury) tend to correlate to equities in a downturn; when those spreads widen as stocks fall, it means both parts of your portfolio could drop. What is often most important to investors is focusing on total portfolio return.

Should I focus on Active vs. Passive?

There has been much debate over whether to be active vs. passive when it comes to managing your own investments, and about the value of paying someone to manage them for you. At the end of the day, the answer lies in what you are paying vs. the exposure you get. What you want to be sure of is that you are not paying someone an active management fee to look like an index. Investors can verify this by looking at the active share of the portfolio (a number showing the percentage of holdings that differ from its benchmark); if that number is low, you’ll want to make sure your management fees are low, as well. Ultimately, your asset allocation decisions and tax management (turnover, asset location, and tax harvesting, if applicable) are going to be much greater contributors to your success over time.

In short, effective management is the key to success when it comes to investing. The four questions I have outlined make for important conversation with your experienced financial professional. In 2016, Vanguard introduced a study quantifying the value financial professionals can add for their clients, in which they estimate that financial professionals can add as much as 1.5-2% to net returns through rebalancing and behavioral coaching, helping investors to not chase performance or bail out of a strategy when they hit the inevitable bump in the road. Vanguard also estimated that financial professionals could add another 1.5-2% to net returns through effective tax management. This includes strategies like asset location, spending/withdrawal strategy, and tax-loss harvesting, among others. If you are not an expert in these fields, it makes sense to work with a professional. The beauty of effective tax management of your investments is that it provides a definite improvement in net (after tax returns) investment returns, all else equal.

In summary, investors should consider reviewing their portfolio periodically to ensure their allocation and holdings match their investment purpose. When reviewing your investments, keep in mind factors like diversification, yield preference, exposure, and effective tax management (if applicable) within your overall portfolio. Investors should focus on having a purpose behind each of their investments, and manage those investments effectively, in order to drive their success.

Matt Kelley is a Portfolio Strategy Manager with ESL Federal Credit Union. In his role, Matt oversees ESL’s portfolio strategy team and is responsible for the investment philosophy, approach, and overall performance of ESL’s internal and external investment portfolios.