1. 1 Personal Finance: a Gospel Perspective Investments 9: Portfolio Reporting and Rebalancing

2. 2 Objectives A. Understand the uses and types of benchmarks B. Understand the importance of portfolio management and performance evaluation C. Understand portfolio rebalancing D. Understand how to perform attribution analysis E. Know how to read the WSJ Monthly Performance Tables

3. 3 Application #1 Steve and Suzie are both 45, are aggressive investors, and have an investment portfolio of over $250,000. Their target asset allocation is 60% equities and 40% bonds and cash which they have invested in 10 mutual funds. Their actual asset class weights are different from their targets due to the out-performance of the equity part of their portfolio. Asset Class Actual Wgt. Target Wgt. Difference Equity 70% 60% 10% Bonds 20% 30% -10% Cash 10% 10% 0% When should they rebalance their portfolio and how should they do it?

4. 4 What are benchmarks? Benchmarks are measuring devices which give the performance of a specific set of securities for comparison purposes. Benchmarks may be built on published indexes or may be customized to suit a specific investment strategy Why are benchmarks important? Benchmarks are the standard from which your portfolio should be judged. You cannot know how your are performing without a benchmark A. Understand the Uses and Types of Benchmarks

5. 5 Uses of Benchmarks (continued) What are the uses of benchmarks? 1. Tracks average returns for a specific asset class 2. Used to compare performance of mutual fund managers in similar asset classes and to check broker’s recommendations 3. Use as a base to build portfolios Key Questions in choosing or using an Index: Is it representative of the performance of assets desired? How broad is the benchmark, i.e. number securities? How is it constructed, i.e. price, total return index? How is it weighted, i.e. market cap, equal weighted?

6. 6 Uses of Benchmarks (continued) How are benchmarks differentiated? Type: Stocks: Large capitalization (cap), small cap, mid cap, international, emerging markets, etc. Bonds: Long-term, short-term, corporate bonds, government bonds, convertible bonds, etc. Other Asset Classes: Real estate, REITs, currencies, commodities, derivatives, gold, hedge funds, etc.

7. 7 Uses of Benchmarks (continued) Geography: Global: Follows performance of a set of assets from a specific set of countries including the US, i.e., MSCI World, MSCI AC Free. International includes only countries outside the US Regional: Follows performance of a set of assets from a specific region of the world, i.e., MSCI EAFE, DJ Asia, Latin America Country: Follows performance of a set of assets from a specific country, i.e., MSCI Argentina, S&P/IFC Chile, Japan TOPIX, etc.

8. 8 Uses of Benchmarks (continued) Asset Size: Market Capitalization Follows the performance of a set of assets with a specific market capitalization range, i.e. large- cap, mid-cap, small-cap, micro-cap, etc. Industry: Follows the performance of a set of assets from a specific industry, whether global, regional, or country, i.e. Telecomm, Financial, Retail, Automotive, Consumer Durable, etc.

9. 9 Uses of Benchmarks (continued) Investment Style: Value These follow stocks that are perceived to be undervalued by the market, i.e. their PE and P/BV ratios are lower than the market. Blend These follow a portfolio of stocks that include both value and growth in their portfolio. Growth These follow stocks that are expected to achieve accelerated growth, whether due to increased earnings, dominant market position, or other factors

10. 10 Benchmarks Types Types of Return Benchmarks: Price Return: Includes only price appreciation or capital gains Total Return with Gross Dividends (or gross dividends reinvested): Includes both price appreciation and dividends. It does not take into account the impact of withholding taxes on dividends (international) Total Return with Net Dividends: Includes both price appreciation and dividends. It also takes into account the impact of withholding taxes on dividends, hence dividends received internationally will be less than paid

11. 11 Benchmark Construction How are stocks weighted in various benchmarks? Market-value weighted (S&P 500, NASDAQ) Weight is based on market capitalization Stocks are weighted according to their market capitalization. This assumes market capitalization (price * shares) is a good proxy for size Price weighted (DJIA, Nikkei, Japan) Weight is based on the price of the stock Stocks with a higher price are weighted more in the index. This assumes a higher priced stock is more valuable than a lower priced stock

12. 12 Benchmark Construction (continued) Equally weighted (Value Line) All stocks are weighted the same Stocks are equally weighted. This assumes all stocks are equal and hence gives a higher weighting to smaller stocks Float weighted (MSCI Emerging Markets Free) Weight is based on market cap and available float outstanding, i.e. what investors can really purchase Stocks are weighted according to available shares outstanding. This gives greater preference to companies whose shares can be purchased (i.e., are not held by a few individuals) and who do not have foreign ownership limits

13. 13 Finding Data on Indexes Where do you find these benchmarks or indexes? Internet: Any of the many financial sites available: CNN Money, YahooFinance, etc. Generally these free Benchmarks are without dividends (make sure you check) Proprietary Data Providers: Bloomberg, Reuters, etc. They will also produce special indexes for a fee ( i.e. MSCI EM Free ex-Malaysia) Data Suppliers: Standard and Poors, Morgan Stanley Capital International, NASDAQ, Bloomberg, etc.

14. 14 Vanguard Sends Notice of Index Changes From a Vanguard e-mail: We believe that the new indexes will reflect the performance of the funds' targeted market segments more accurately than any other available indexes. We believe stock indexes should: Be constructed according to objective rules, not subjective judgment. Weight their holdings to reflect only "floating" shares, meaning those that are available and freely traded in the open market. Feature overlapping buffer zones around the breakpoints between large-, mid-, and small-capitalization segments. Assess a variety of factors to identify a stock as "growth" or "value." Rebalance their holdings to reflect market changes in a gradual and orderly fashion. From Vanguard Website on 5/6/03: http://flagship.vanguard.com/VGApp/hnw/web/corpcontent/vanguardviews/js p/VanViewsNCArticle.jsp?chunk=/freshness/News_and_Views/ALL_benchc hange_04032003.html

15. 15 Key Benchmarks Examples of benchmarks: Domestic equities: Large cap stocks S&P 500 (SPX) Small-cap stocks Russell 5000 (RTY) Micro-cap stocksWilshire Micro-cap International equities: GlobalS&P Global 1200, MSCI World, DJ World International MSCI EAFE (Europe, Australia and the Far East) Emerging MarketsS&P/IFCI and MSCI Emerging Markets Free

16. 16 Key Benchmarks (continued) Corporate Bonds Short-term DJ Corporate Bond Index IntermediateLehman Brothers Intermediate High YieldSalomon Smith Barney High Yield Mortgage backed Lehman Brothers MBS Index Yankee Merrill Lynch Yankee Index Treasury Securities IntermediateLehman Intermediate Treasury Long-termLehman Long-term Treasury Real Estate REITStandard & Poors REIT

17. 17 Questions Do we understand the uses and types of Benchmarks to an investor?

18. 18 B. Understand the Importance of Portfolio Management and Evaluation What is portfolio management? The development, construction, and management of a portfolio of financial assets to attain an investor’s specific goals What is performance evaluation? The process of evaluating a portfolio’s performance with the goal of understanding the key sources of return Why are these two topics so important? Both are complicated subjects and both are critical to investing

19. 19 Portfolio Management and Evaluation (continued) What is Active Portfolio Management? The process of using publicly available data to actively manage a portfolio in an effort to: Beat the benchmark after all transactions costs, taxes, management, and other fees However, you must do this consistently year-after-year, and not just from luck Why is Active Management such a hot topic? Management fees for mutual funds which can consistently outperform their benchmarks are 5-25 times higher than those on passive management (19 basis points versus 250 basis points)

20. 20 Portfolio Management and Evaluation (continued) What is passive management? The process of buying a diversified portfolio which represents a broad market index (or benchmark) without any attempt to outperform the market Why is passive management such a hot topic? Most active managers fail to outperform their benchmarks, especially after costs and taxes Investors have realized that if you can’t beat them, join them, so they buy low-cost passive funds which meet their benchmarks consistently and minimize taxes

21. 21 Portfolio Management and Evaluation (continued) What factors lead to above-benchmark or excess returns? 1. Superior asset allocation Shifting assets between a poor-performing asset class and a better performing asset class 2. Superior stock selection Picking sectors, industries, or companies within a specified benchmark which, as a whole, outperform the return on the specified benchmark

22. 22 Portfolio Management and Evaluation (continued) What is superior asset allocation? The process where the investor gains a higher return than the benchmark from adjusting the investment portfolio for movements in the market The investor shifts among stocks, bonds and other asset classes based on their expectations for returns from each of the asset classes What are the results? Done well, superior asset allocation yields higher returns with lower risk. Done poorly, it yields lower returns, higher transactions costs, and higher taxes

23. 23 Portfolio Management and Evaluation (continued) What is superior stock selection? The process where the investor builds an investment portfolio which earns returns in excess of the benchmark through buying or selling undervalued stocks, sectors or industries The investor shifts among the various securities of the index in an attempt to buy the securities with the highest growth potential What are the results? Done well, superior selection yields higher returns with lower risk. Done poorly, it yields lower returns, high transactions costs, and high taxes

24. 24 Portfolio Management and Evaluation (continued) What is portfolio evaluation? The process of monitoring financial asset performance, comparing asset performance to the relevant benchmarks, and determining how well the fund is meeting its objectives. If the assets are underperforming benchmarks, the investor may sell underperforming assets and purchase other assets which would more closely align asset performance with benchmarks

25. 25 Portfolio Management and Evaluation (continued) Why monitor performance? Unless you monitor performance, you will not know how you are doing in working toward accomplishing your objectives You need to know how every asset you own is performing, and performing versus its benchmark, so you can determine how well you are moving toward your goals

26. 26 Portfolio Management and Evaluation (continued) How do you evaluate performance? Calculate: 1. The period return on each owned asset 2. The period index return for each benchmark 3. The difference between the asset return and benchmark return 4. The weight of each asset or portfolio in the overall portfolio 5. The overall portfolio return With this information, you can know how each of your funds or assets is performing versus its benchmark, and how well the portfolio is moving toward its objectives

27. 27 Portfolio Management and Evaluation (continued) What is portfolio reporting? The process of reviewing portfolio performance with the necessary participants, i.e. your spouse If you are managing your portfolio, you should report performance to your spouse at least monthly or quarterly If others are helping you manage your portfolio, they should report performance to you and your spouse at least quarterly as well. Be careful not to do too much buying and selling, as these incur transactions costs and taxes

28. 28 Questions Any questions on the importance of portfolio management and evaluation?

29. 29 C. Understand Portfolio Rebalancing What is portfolio rebalancing? The process of bringing portfolios back into given target asset allocation ratios. What causes the need to rebalance portfolios? Changes occur due to: Changes in asset class performance Changes in investor objectives or risk Introduction of new capital Introduction of new asset classes

30. 30 Portfolio Rebalancing (continued) Why is this rebalancing so critical? You must balance competing principles of keeping both transactions costs and tracking error low What is tracking error? That is the return that is lost from your portfolio being different from your target weight What are the different ways of rebalancing? Periodic-based (or calendar-based) Percent-range-based (or volatility-based) Equal-probability-based Active risk-based

31. 31 Portfolio Rebalancing (continued) What is periodic-based rebalancing? Specify a time period, i.e. quarterly, annually, etc. After each time period, rebalance the portfolio back to your original asset allocation targets Advantages Most simple of the methods Longer periods have lower transactions costs (but higher tracking error costs) Disadvantages Independent of market performance Performance will depend on relative timing of large market moves and rebalancings

32. 32 Portfolio Rebalancing (continued) What is percent-range-based rebalancing? Rebalance the portfolio every time your actual holdings are +/-5% (or 10%) from your target ratios. Rebalance whenever any weight is outside this range Advantages Easy to implement Wider ranges will reduce transactions costs (at the expense of higher tracking error) Asset performance will trigger rebalancing Disadvantages Setting an effective range is difficult Assets with higher target ranges and volatility will generate most rebalances

33. 33 Portfolio Rebalancing (continued) Are there other methods? Equal probability rebalancing Allow a “no-trade” region around each assets allocation target so each asset is equally likely to trigger rebalancing. Rebalance to target ratios whenever any asset is outside this region Active risk rebalancing Allow a “no-trade” region around each asset based on transactions costs, risk aversion, correlation, and volatility. Rebalance only when active risk (defined as the standard deviation of active return) is above a specified threshold. When this happens, rebalance only back to target threshold, not back to target ratios

34. 34 Portfolio Rebalancing (continued) Which are the best methods? Generally, for most investors with fewer investable assets, the easiest is likely to be most useable Generally, a combination of periodic-based and percent-range based is useful Remember, the goal is to minimize your transactions costs, your taxes, and your tracking error costs

35. 35 Questions Any questions on portfolio rebalancing?

36. 36 Application #2 You are 40 years old, married, and have a portfolio with three asset classes. Last quarter your had the following performance. The equity benchmark is the S&P 500, bonds the Salomon Brothers Intermediate, and cash is the Lehman Cash Index. Benchmark weights are your target asset allocation, and actual weights are different from your target since you have not rebalanced lately. You like your current asset class weights. Asset Class Actual Actual Benchmark Benchmark Return Weight Weight Return Equity 2.0%.70.60 2.5% Bonds 1.0%.20.30 1.2% Cash 0.5%.10.10 0.5% How did you do for the quarter? What was your over or underperformance? What was your contribution to security selection and to asset allocation?

37. 37 D. Understand How to Perform Portfolio Attribution What is portfolio attribution? The process of separating out portfolio returns into their related components, generally attributable to asset allocation and securities selection What is the importance of these components? These components are related to elements of portfolio performance, to see what you do well What are examples of some of these components? Broad asset allocationSecurity Choice IndustryCurrency

38. 38 Portfolio Attribution ( continued) How do you determine portfolio attribution? 1. Set up a weighted ‘benchmark’ which includes all your chosen asset classes Use your chosen benchmark for each asset class, and use your target asset allocation weights from your Investment Plan 2. Calculate your returns for each of your asset classes Calculated returns for each asset class Calculate a weighted return for your overall portfolio

39. 39 Portfolio Attribution (continued) 4. Compare your portfolio returns in each asset class to the benchmark returns of each index Use Teaching Tool 17: Portfolio Attribution Spreadsheet 5. Calculate your attribution and make decisions accordingly

40. 40 Application #2 Answer If you have this return: Asset Class Actual Actual Benchmark Benchmark Return Weight Weight Return Equity 2.0%.70.60 2.5% Bonds 1.0%.20.30 1.2% Cash 0.5%.10.10 0.5% a. Your quarterly return was (2.0%*.7) + (1.0*.2) + (.5*.1) or 1.65%. The index return was (2.5*.6) + (1.2*.3) + (.5*.1) or 1.91%. The difference between these two returns is your performance. In this case you underperformed your benchmark by -.26% for the quarter.

41. 41 Application #2 Answer (continued) b. Your contribution of security selection to relative performance was -.39%. This is calculated as: (1) (2) (1*2) Market Diff. Ret. Man. Port. Wgt. Contribution Equity -0.5%.70 -0.35% Bonds -0.2%.20 -0.04% Cash 0.0%.10 0.00% Contribution of Security Selection -0.39% (1) Managed fund return less index return (2.0%-2.5%) (2) Actual weight of the managed portfolio (1*2) Contribution of asset class security selection to the portfolio

42. 42 Application #2 Answer (continued) c. Your contribution from asset allocation was.13%. This is calculated as: (3) (4) (3*4) Market Excess Weight Index-BM Contribution Equity 10%.59% 0.059% Bonds -10% -.71% 0.071% Cash 0% -1.41% 0.000% Contribution of Asset Allocation 0.130% (3) Weight of actively managed fund less benchmark weight (- is underweight) (4) Asset class return less total portfolio return (equity is 2.50-1.91 or.59%, bond is 1.20-1.91=-.71) (3*4) Contribution of the asset class to the total portfolio

43. 43 Application #2 Answer (continued) Overall comments: Your actively managed portfolio under performed the benchmarks by.26% or 26 basis points (1.65%- 1.91%). This underperformance was a combination of a -.39% contribution to security selection and a.13% contribution from asset allocation. While you did well overweighting (versus your asset allocation targets) the asset classes that performed well, you didn’t do as well picking the assets in those asset classes. It this performance continued for 24-36 months, I would consider indexing the stock selection decision, i.e. buy index funds, and keep doing what your are doing with the asset class decision.

44. 44 Why is it important to attribute performance to the portfolio’s components? It can explain the difference in return based on component weights or selection It can summarize the performance differences into appropriate categories It can help you know how you are doing What happens if you don’t perform portfolio attribution? You will not know why you are performing as you are You will not know how to improve Portfolio Attribution (continued)

45. 45 Portfolio Attribution (continued) What do you do if your actively managed funds continue to underperform? Watch them carefully. Underperformance for a month or quarter is understandable, but over 12-36 months it should be positive If not, find another fund or index the asset class performance How long does it take to determine whether an active manager is good or not? Generally, 12-36 months

46. 46 Questions Any questions on portfolio attribution?

47. 47 E. Know how to read the WSJ Monthly Performance Tables What is the Wall Street Journal? It is one of the major business newspapers in the United States What are the Monthly Performance Tables? They list the performance of most of the larger mutual funds which are listed in the United States Why do we need this information? It is an easy way to check whether your mutual fund manager is beating your specified benchmark If he is not, you can invest in an index fund with a higher probability that they will meet the benchmark

48. 48 WSJ Monthly Tables (continued) What are the precautions The numbers presented are for retirement vehicles only (i.e. tax-deferred or tax-eliminated retirement vehicles) The numbers do not take into account the impact of federal, state, or local taxes on your returns As such, you need to be careful with these numbers and taxable accounts Remember to look at the after-tax returns before investing for taxable accounts

49. 49 Reading the Wall Street Journal Monthly Tables

50. 50 Reading a Chart NAV = Net Asset Value, the cost per share to buy or sell Inv Obj = Investment objective or asset class Total Returns = Return before taxes Exp Rat = Total Expense ratio

51. 51 Stock and Bond Benchmark Indexes

52. 52 Mutual Fund Yardsticks

53. 53 Review of Objectives A. Do you understand the different types and uses of indexes? B. Do you understand the Importance of Portfolio Management and Performance Evaluation? C. Do you understand portfolio rebalancing? D. Do you understand how to perform attribution analysis? E. Do you know how to read the WSJ Monthly Performance Tables?