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Three Elements for a Benchmark Portfolio

Vern Hayden

A good portfolio of funds should have a disciplined way of being diversified. You can be invested in a number of great funds but have a lousy portfolio because it is not properly diversified.

"Asset allocation" refers to the asset classes a manager can invest in. The most recognized asset classes are stocks, bonds, cash, real estate and commodities. In addition, you need to decide how much will be in foreign and U.S. assets. You'll also need to decide if you are going to allocate certain percentages to large-, medium- and small-cap fund managers. It seems there is no end to the decisions you must make.

There are at least two more. Are you going to use active or passive (indexing) management? And, to top it off, are you a "value" or "growth" investor? If you believe in changing your allocation now and then, you are a "dynamic allocator." If not, then you're a "static" investor. All this stuff could get to you after awhile. Where would we be without all this "jargon?"

The portfolio needs to match your situation from three standpoints. First, goals; second, your timeframe; and third, your risk tolerance. When you put these three things together, you have created a benchmark to gauge your progress with the portfolio.

Each category of allocation in the portfolio represents the way the fund's managers invest. Hybrid funds can invest in all the asset classes, as well as foreign investments. We feel this category creates a layer of safety for the portfolio. The managers of these funds (and others) will decide how much money will be in a given asset class at any time. We must assume that we will not know exactly how much is in any asset class at any time. To do this, you must be absolutely convinced that the managers will capture a good percentage of the upside in a bull market and not go down too much in a bear market.

At this point, let's take a snapshot of a sample portfolio. Here is what it could look like:

Here's how fund managers are guided in their investment decisions:

• The stock fund managers invest in stocks, foreign and domestic, and sometimes cash.

• The global managers can invest anywhere in the world, including the U.S.

• The bond managers can invest in any duration or quality they see fit.

• The specialty managers invests primarily in a sector we would like to magnify over time.

We put every portfolio through a Morningstar database and obtain all the characteristics of the portfolio as though it was one fund. That enables us to see clearly a total blended historical performance record, as well as the total allocation at that time.

The assumptions behind our example portfolio are that the investor is:

• Active in making changes.

• Has a value philosophy.

• Uses managers liable to go anywhere, with a current tilt to large-cap companies.

• Has 20% to 30% in fixed income, 20% to 30% in foreign and 5% each in the energy and health care sectors.

In my next column, I will discuss each fund manager in the example and the importance of having an offense, defense and special teams.