As a portfolio manager who follows the passive management strategy, I’ve never really liked the term “passive management.”  It just seems to elicit thoughts that we aren’t really managing the portfolios we oversee.  Nothing could be further from the truth.  While we follow the passive management strategy, we are anything but passive in our approach to make sure our client portfolios are the best they can be.

The passive management strategy means that we don’t do any forecasting of the financial markets.  We truly believe that no one can accurately predict what will happen in the markets.  We do not believe in market timing, or trying to determine when to be in or out of the markets, an asset class, or an individual investment.  We also don’t believe in stock picking, which involves trying to determine whether we should own Coke or Pepsi, Apple or Microsoft, or Exxon Mobil or Chevron. 

With a passive management approach, we focus on building a portfolio that is structured properly for each client.  We own all of the market and are invested at all times.  Then, when market moves change the mix of our portfolio, we rebalance, which makes sure our level of risk doesn’t change.  We are also always working to review the model portfolios we use to make sure they are providing the diversification we desire.  And that’s where we are making some changes.

The purpose of diversification is to reduce risk in the portfolio by investing in a variety of asset classes.  We want asset classes that do not move up and down in tandem.  The technical term is correlation.  We want to build our portfolio with asset classes that are not highly correlated.  A good example can be seen in the broad asset classes of stocks and bonds.  As we have seen over the years, and especially this summer, stocks can be highly volatile, moving up and down in large amounts.  We add bonds to the portfolio because bonds tend to go up when stocks go down and vice versa…and usually to a lot lesser degree.  So, they help to smooth out the ride, or lower the risk, of the overall portfolio.

For the last several years, our portfolio models have been made up of the following asset classes: US large stocks, US small stocks, International large and small stocks (developed countries), emerging market stocks (developing countries), real estate, commodities and short-term and intermediate-term bonds.  So, what about those changes I mentioned earlier?

We are living in a world that is becoming more and more a global economy.  In fact, I read recently that 52% of the earnings of the S&P 500 companies come from overseas.  From an investment standpoint, recent research has indicated that several asset classes have become more highly correlated and are not providing the diversification we need.  For example, over the last two years, US stocks and the stocks of international developed countries have had a correlation of between 85-95%, meaning they are moving up and down almost in lockstep.

I won’t turn this into a technical paper by going over all the correlations; I just want to convey the updates to the portfolios we manage.  We will be, in a broad sense, combining our domestic and international stock holdings.  We will keep emerging markets as a separate asset class because stocks from the emerging countries, while moderately correlated with US and international stocks, still provide some diversification benefits.  We are also folding our real estate asset class into our domestic small stock class because many of the real estate companies are included in the small cap index.

There are a few other small changes, but basically, our new models will consist of four stock indexes (large, small, emerging markets and commodities) and our three bond indexes.  There will be no changes to our bond mix.

We do not take changes to our models lightly and a lot of time and research went into the process that resulted in these changes.  And, we will not be implementing the changes all at once.  We will make them as opportunities present themselves based upon the unique situation in each client portfolio.  The implementation decisions will be based on rebalancing needs, liquidity needs, and any potential tax consequences with an eye toward keeping transaction costs to a bare minimum.