With most of 2013 still ahead, investors should not overlook the opportunity to review their portfolios to make sure they are still aligned with their short- and long-term goals. While it is easy to get wrapped up in other priorities, the beginning of a year is an ideal time for investors and their advisors to spend some time going over current holdings and possible future allocations. Although most fund investors are focused on long-term investing, a year or several without such a review can create disconnects in a portfolio's positioning versus the expectations of the investor.
But before we start to think about what has changed in our lives, it may be good to review what has taken place in the markets over the past year or so. For many, an understanding of the markets and their trends most often comes from what is reported in the news or talked about in investment-based media. And, while much of the information presented in these sources can be useful, it can also be narrowly focused and/or based on short-term events. This focus often results in a fragmentation of the larger investment picture and creates noise that can distract people as they make important investment decisions.
It would not be surprising if many investors felt 2012 was a tough year. With much of the news over the past year focusing on the debt issues in Europe, high unemployment at home, polarized politics and natural disasters, many would expect a market environment characterized by high volatility and low total returns-in short, a situation similar to 2011, when most market indices ended the period flat or down and when volatility as measured by the VIX spiked during the second half of the year.
In reality, the performance in 2012 was quite the opposite. Many equity markets finished the year with double-digit gains, while volatility stayed around the levels that existed before the 2008 crisis. Fund investors also benefited; equity, bond and mixed-asset products all ended the year with strong gainswith average total returns of roughly 14.5%, 6.2% and 11.2%, respectively (see table for a fund performance summary).
Should a single year of performance influence investors to make significant changes to their portfolios? Probably not, but the review does show that the markets have not recently been as bad as they are often perceived.
Another important element to these decisions should be the events that have taken place in the investor's life since the last portfolio review. Although one year may seem like an insignificant period relative to one's entire investment time line, a lot can happen in 12 months. Marriage, divorce, children, college, a new job, a pay raise, unemployment or simply being one year closer to retirement can all be reasons to re-examine a portfolio.
So what topics are investors, advisors and fund management companies focusing on in their conversations? Most likely, the discussion will be framed around proper asset allocation and the types of funds that can be used to fill specific investment buckets.
Well before the financial crisis of 2008, investors and advisors focused on risk diversification through the proper mix of asset exposure within a portfolio. While much of this remains true today, the general increase in cross-asset correlations over the years has created a scenario in which traditional diversification is not enough. When even conservative portfolios may have lost roughly 20% or more in 2008, we saw a general shift in investors' perception of risk and their reaction to such events.
Most asset allocation models base an investor's fund selection on two main factors: age (investment horizon) and risk tolerance (aggressive, moderate, conservative or some other variation). In general, these two factors work in tandem with each other; as one's investment horizon shortens, so should the risk profile.
Of course, this can vary according to an individual's needs. Risk has traditionally been measured by how much and what type of equity exposure an investor has. In most cases, analysts agree that until retirementand often throughout retirementinvestors should maintain a healthy portion of their portfolio in equity to help promote growth. But with the huge stock losses of 2008 and an ever-rallying bond market since, some investors may have shifted or, in extreme cases, cashed out their equity exposure in preference for bonds or cash.
Looking at mutual fund and exchange-traded fund flows in the periods before and after 2008 (see table), a drastic shift in asset allocation is obvious. While investment in equity funds dominated the landscape in the five years leading up to 2008, net inflows into bond funds have easily outpaced those into equity funds over the past five years and have increased roughly 160% compared with the net inflows of the earlier time frame. Combine those figures with the performance numbers outlined in the table, and it seems the "conservative" move to fixed income may have come at a cost compared with the returns of investors who stayed the course. This is not to say that bond exposure does not have its place, but it is something to think about going forward.
Outside of traditional long-only allocations, many advisors are now making a stronger case for the use of alternative funds within investors' portfolios. Lipper defines alternative funds as investments that generate correlation benefits to traditional long-only constructed investments and that implement a hedge fund-like strategy, often incorporating leverage, derivatives, short positions and/or multiple asset classes. Some examples of these types of products are long/short, equity market-neutral, global macro, arbitrage and commodities. The goal of allocating to these types of funds is often to enhance risk-adjusted returns and to lower volatility.
There are varying recommendations on the types of funds to use and the extent to which they should be used. These decisions should be based on an individual investor's needs and should be made with a strong understanding of how the alternative funds may interact with other investments within a portfolio.
Aside from analyzing securities allocation and selection, there are other important issues for regular portfolio maintenance. Contribution amounts, rebalancing and taxes also play a role. As with the issues outlined above, many of these topics should be reviewed on a timely basis in order to best serve each investor's evolving needs.
Matthew Lemieux is a senior research analyst for Lipper.
He specializes in performance analysis, methodology management
and fund flows and also contributes to Lipper FundFlows Insight Reports.