A COMMON SENSE APPROACH TO LOW FEE INDEXING

Time is the most valuable asset we all have. And navigating time is the essential component of any good financial plan. But the financial services industry does a terrible job of communicating time horizons to investors. Traditional portfolio managers charge high fees while trying to pick the optimal set of assets per unit of risk without giving investors any understanding of how their portfolios match certain time horizons. This old model is broken as the evidence shows over 80% of active managers underperform the market year in and year out. The result is that investors chase performance not knowing they’re usually chasing risk all the while flipping from failed active portfolio to failed active portfolio. The traditional asset management process fails in large part because it doesn’t give investors any understanding of time horizons within their portfolio. The Defined Duration strategy adds the element of time by quantifying how much risk an investor is taking per unit of return across time.

This innovative approach to asset allocation helps improve the probability of meeting your financial goals by helping you better understand your expenses and liabilities and the way specific assets align with those expenses and liabilities. This not only establishes a financial planning based foundation, but it applies a behaviorally robust solution to the problems that exist in Modern Portfolio Theory.

Traditional portfolio construction uses what’s called “mean variance optimization” or Modern Portfolio Theory. This means the portfolio manager plugs in a certain risk profile and then spits out an “efficient” asset allocation such as a 60/40 stock/bond portfolio. This approach is usually sold to investors as generating the optimal return per unit of risk in exchange for high fees. But this process is backwards and fails to provide the investor with an understanding of how much risk they’re taking per unit of return across time. This is because the portfolio manager or advisor is trying to optimize the collection of assets without any understanding of the customer’s specific liabilities.

The Defined Duration strategy flips this entire process around and starts by first quantifying the investor’s expenses/liabilities. We then apply the proper assets based on liability needs, not based on asset performance wants. This financial planning based foundation gives the investor a better understanding of how much money they’ll have at certain times in their life thereby creating a diversified and behaviorally robust asset allocation.

We build custom portfolios to meet your planning needs, but as a general overview the Defined Duration portfolio has three specific buckets:

1. Nominal stability bucket
2. Growth bucket
3. Insurance bucket

The specific portfolio will be implemented using low cost and tax efficient bonds and ETFs.

The nominal stability bucket is comprised of instruments that are designed to give you short-term principal stability and income to help you meet short-term and medium-term liability needs. This could include money market funds, Treasury Bills and bond ETFs and will generally comprise 10-30% of the portfolio depending on planning needs.

The growth bucket is comprised of diversified stock ETFs, REITs, corporate bond ETFs and multi-asset ETFs. This is the core of the portfolio and will be implemented in a tax efficient and diversified manner comprising 30-60% of the portfolio.

The insurance bucket is dynamic and changes across time to meet your portfolio’s insurance needs. The insurance bucket is optional and contingent on your financial plan. It’s implemented only in very specific high risk environments and for investors who need it as part of their broader financial plan. In most environments cash/T-Bills are a good insurance hedge that gives you optionality and certainty. But for the right investor and in unusual environments the insurance bucket could include gold, options, commodities and other instruments that have low expected real returns and high potential asymmetric payoffs to help protect you from inflation and other uncertainties. It will fluctuate from 0-15% of the portfolio depending on personal needs and macroeconomic conditions.

If you want your own customized Defined Duration portfolio you can contact us here. We’ll customize your financial plan and then assign the corresponding assets to that plan. If you want to manage it on your own then great. Don’t hesitate to reach out and ask for help. But if you prefer for us to manage it on your behalf then we will rebalance the portfolio, tax loss harvest, optimize cash holdings and help you navigate the twists and turns of the markets over your ever-changing financial life.

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