Our Spotlight on Practices series has looked at all of the Practices in the Organize step of the fiduciary quality management system and will soon be moving into the Formalize step. In the Formalize step, the fiduciary will be expected to act as a prudent expert in establishing proper portfolio diversification and preparing an effective investment policy statement.
Beginning with the first Practice of this step, the fiduciary will be making the decisions that will eventually lead to actual investment selection. There is a hierarchy to those decisions that many investors and fiduciaries have a tendency to reverse. They tend to focus on the hot manager or fund before developing an asset allocation strategy when research has shown that the allocation of assets is the most important determinant of the variation of returns in portfolios. As a fiduciary, your priorities must be properly placed upon asset allocation issues.
The following hierarchy of investment decisions illustrates our prioritized approach to asset allocation, which leads to manager/fund selection:
The most important decision is to determine the investment time horizon, which we define as that point in time when more money is flowing out of the portfolio than what is coming in from contributions and the anticipated growth. All other decisions flow from this.
Second only to the time horizon in importance is the decision regarding what asset classes will be considered. If the time horizon is less than five years, the portfolio should be limited to fixed income and cash. If the time horizon is long (meaning five years or more), equities and other asset classes can be considered.
The next decision is to determine the proper mix among broad asset classes. For example, if our time horizon is long, we will include equities, bonds, and cash. What will be the mix between these classes? That depends upon a number of factors that we will discuss later, but for the sake of illustration, a balanced portfolio may include 60% allocated to equities, 30% to fixed income, and 10% to cash.
Next, we consider what will be the allocation to sub-asset classes and/or peer groups within the broad classes. For example, what percentage will be in large-cap stocks, versus the proportion allocated to growth, value or blend?
Finally, and the least important decision in the hierarchy, is the selection of the manager or fund.
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The Spotlight on Practices series highlights one of the Prudent Practices for Investment Fiduciaries in order each month. To learn more about the Practices, click "Spotlight on Practices" link in the categories list or visit the Practices page on fi360.com. If you have any questions or comments, leave them in the comments section below each post, or email us at blog@fi360.com.
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