Conduct a Midyear Checkup Christine Benz July 2014

Best Practices for Portfolio Checkups

•  Infrequent: Annual, semi-annual, or quarterly at the most •  Targeted: Employ a checklist to help you get in and out •  Fundamentally driven, not just focused on performance •  Progress from most important to less important variables •  Take tax and transaction costs into account if changes are needed

6 Steps in the Portfolio-Checkup Process

•  Step 1: Gauge viability of current plan •  Step 2: Evaluate portfolio positioning •  Step 3: Check liquid reserves •  Step 4: Review individual holdings •  Step 5: Troubleshoot current risk factors •  Step 6: Conduct a cost audit

Step 1: Gauge Viability of Current Plan (Accumulators)

•  Thumbnail test: 15% current salary = annual savings target •  Fidelity benchmarks:

•  Save 1X current salary by age 35 •  Save 3X current salary by age 45 •  Save 5X current salary by age 55

•  401(k) contribution limits, 2014: $17,500 ($23,000 50+) •  IRA contribution limits, 2014: $5,500 ($6,500 50+)

Step 1: Gauge Viability of Current Plan (Accumulators)

•  Use an online calculator to gauge adequacy of current investments and savings rate.

•  Online tools include: •  T. Rowe Price Retirement Income Calculator •  Fidelity Retirement Quick Check •  Fidelity Retirement Income Planner

Step 1: Gauge Viability of Current Plan (Accumulators)

•  The best tools are holistic and factor in: •  Inflation •  Reasonable return expectations, variability of returns (Monte

Carlo modeling) •  Taxes •  The role of other income sources, such as pensions and

Social Security

Step 1: Gauge Viability of Current Plan (Retirees and Pre-Retirees)

•  If already retired and taking withdrawals, check viability of current withdrawal rate

•  The traditional rule of thumb is that 4% with an annual inflation adjustment is a safe withdrawal rate for most

•  For someone with an $800,000 portfolio: -- Year 1 Withdrawal: $32,000 -- Year 2 Withdrawal: $32,960 (assuming 3% inflation)

•  Recent research suggests an even more conservative withdrawal rate (3%) makes sense given low bond yields

Step 2: Evaluate Portfolio Positioning

•  Morningstar’s X-Ray tool a good starting point •  Portfolio Manager enables you to X-Ray, as does Instant X-Ray (on

Tools tab of Morningstar.com)

Step 2: Evaluate Portfolio Positioning

Step 2: Evaluate Portfolio Positioning

•  Focus on asset allocation relative to your targets (Morningstar Lifetime Allocation Indexes and target-date funds can be a starting point)

•  Check sector/style positioning •  Geographic exposure •  Individual stock overload

What Should You Do if You’re Light on Stocks?

•  Stay mindful of current valuations: Average price/fair value for Morningstar’s covered stocks = 1.04

•  Employ a dollar-cost averaging strategy, deploying fixed amounts at regular intervals

•  Make sure you have a good value-oriented manager (or two) in your portfolio

•  Look to Morningstar’s highly rated stocks for ideas •  Hold a bit of extra cash to meet opportunities as they arise

Favorite Value-Leaning Funds (Gold- or Silver-Rated)

•  Dodge & Cox Stock (DODGX): Gold •  American Funds American Mutual (AMRMX): Gold •  American Funds Washington Mutual (AWSHX): Gold •  Artisan Value (ARTLX): Silver •  Sound Shore (SSHFX): Silver •  Tweedy, Browne Global Value (TBGVX): Silver •  Vanguard Equity-Income (VEIPX): Silver •  Vanguard Value Index (VIVAX): Silver •  Vanguard Windsor II (VWNFX): Silver

Favorite Reasonably Priced Stocks (4-Star Plus Wide Moat, Low Uncertainty)

•  Baxter International (BAX) •  Clorox (CLX) •  Enbridge (ENB) •  ExxonMobil (XOM) •  Philip Morris (MO) •  Procter & Gamble (PG) •  Spectra Energy Partners (SEP) •  Wal-Mart Stores (WMT)

What Should You Do if You’re Light on Bonds?

•  Rebalance into bonds, but limit interest-rate sensitivity and keep credit quality high

•  Invest with flexible core fixed-income funds such as Dodge & Cox Income, Metropolitan West Total Return

•  If retirement is close at hand and you’re notably underweight bonds, de-risk immediately

•  Move bond money to cash •  Dollar-cost average during a period of months

Step 2: Evaluate Portfolio Positioning: Some Benchmarks

Total U.S. market style Price/fair value by style

Step 2: Evaluate Portfolio Positioning: Some Benchmarks

Global market-cap distribution U.S.: 48% Rest of world: 52% Developed markets: 90.9% Developing markets: 9.1%

Step 3: Check Liquid Reserves

Baseline amount if retired: 6 months’ to 2 years’ worth of living expenses Baseline amount if working: 3 to 6 months’ worth of living expenses Do not count: Residual cash in mutual funds, short-term bonds (manually calculate; don’t use X-Ray tools)

Step 4: Review Individual Holdings

•  Morningstar Ratings and Analyst Reports enable you to quickly review the status of current holdings.

•  For funds, red flags include: •  Ratings, manager, strategy changes •  Persistent underperformance vs. cheap index fund •  Dramatically heavy stock, sector bets

•  For stocks, red flags include: •  High price/fair value, low star rating •  Negative moat trend

Step 5: Troubleshoot Potential Risk Factors

•  Risk Factor 1: Tricky times for bond investors

•  Risk Factor 2: Complacency about inflation

•  Risk Factor 3: Overvaluation in small and mid-caps

Risk Factor 1: Tricky Times for Bond Investors

•  Investors have been buying high-yield bonds: ~ $7 billion in new flows during past year

•  But the yield differential (or “spread”) between high-yield bonds and Treasuries is just 3.4 percentage points

•  Spreads have only been this low 9% of the time since 1996 •  Fed chair Janet Yellen: “High-yield bonds have certainly caught our

attention. There is some evidence of reach-for-yield behavior.”

High-quality bonds carry risks of their own: greater interest-rate sensitivity •  Consider the following “duration stress test” for your high-quality

holdings •  The fund’s duration minus fund’s SEC yield = expected loss over one-

year period if interest rates rose by 1 percentage point •  Stress test most useful for high-quality bond types, less useful for

junk bonds, international bonds, etc.

Stress Test Examples

•  Vanguard Total Bond Market Index •  Duration of 5.6 years minus SEC yield of 2% = ~3.6% loss if rates

rose by 1 percentage point •  Vanguard Long-Term Bond Index •  Duration of 14.2 minus SEC yield of 4.1% = ~10% loss if rates rose

by 1 percentage point

Risk Factor 2: Complacency About Inflation

•  Investors have been selling inflation-protected bond funds; $26 billion in outflows during the past year

•  Motivations included high interest-rate sensitivity, benign CPI •  But even though CPI is mild, investors’ actual inflation experiences

might be different •  Food prices increased by 0.7% in May 2014; energy prices increased

by 0.9%

Risk Factor 2: Complacency About Inflation

•  Best sources of inflation protection include the following: •  TIPS (Vanguard Short-Term Inflation-Protected Securities a

favorite—VTIP or VTIPX) •  Stocks, especially wide moats with pricing power •  Real estate, commodities, gold •  Bank-loan investments

Risk Factor 3: Overvaluation Among Small and Mid-Caps

•  Median price/fair value for all stocks in our coverage universe = 1.04 •  Median price/fair value for small- and mid-cap stocks in our coverage

universe = 1.06 •  If peeling back on stocks as part of rebalancing program, concentrate

reductions here

Step 6: Conduct a Cost Audit

•  Total portfolio cost audit: Compare your portfolio’s expense ratio (in X-Ray) to that of a good target-date fund for your age range.

•  Expense ratio for T. Rowe Price Retirement 2025: 0.72% •  Expense ratio for Vanguard Target 2025: 0.17%

Step 6: Conduct a Cost Audit

•  Holdings-level cost audit for index funds, ETFs. •  ETF price wars have been good for consumers •  Are your holdings as cheap as the cheapest funds available to retail

investors in each asset class? •  U.S. Stock: 0.04% •  International Stock: 0.09% •  Bond: 0.05%

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