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A big part of my job these days is assisting financial advisors in the development of portfolios for their clients and their firms. I like to say that I have 30 years of mistakes under my belt in this business and that we will do our darndest not to repeat any of them. In short, I strive to work together with advisors to design portfolios that are in line with their view of the world and yet don't go off the reservation too far in terms of overconcentration in terms of methodology, strategy or manager selection.

Yesterday, I described the initial phase of the portfolio design process. We first define the objective, then the benchmark, and finally, the time frame. From there, my team goes to work in building portfolios that incorporate a more modern approach to diversification. This is something we call Modern Portfolio Diversification - or MPD, for short - which goes beyond the traditional diversification by asset class, incorporating multiple investing methodologies (i.e. passive, strategic, tactical, equity selection, alts, etc.), multiple strategies, and multiple managers.

Getting back to yesterday's missive, recall that after several calls with an advisor, my team had been tasked with creating a series of risk-targeted, asset allocation strategies that would attempt to "be around" the benchmarks during most calendar years and then try to "lose less" when the bears went on the attack.

The question, of course, is how do you accomplish this?

Step 1: Understand Your Objective

While it may sound obvious, the first step in designing a portfolio is to truly understand the benchmark you are trying to outperform. Believe it or not, the selection of a benchmark is usually an afterthought for most advisors. But as Yogi Berra is famous for saying, "If you don't know where you are going, you might wind up someplace else."

Too many advisors allow their clients to look at an index like the S&P 500 to gauge how their portfolio performed. However, such an approach sets you up for failure. Because, unless you are running a domestic, cap-weighted, equity portfolio, the S&P is likely the wrong benchmark.

Again, while this sounds uber simplistic, the first and most important step in successful portfolio design is to correctly identify what you are trying to accomplish and what benchmark you will be measured against.

So, once you have identified the appropriate benchmark, you need to dig into that benchmark and recognize how the thing works. For example, you must understand the makeup of the index or benchmark as well as the allocations to asset classes, regions, "styles," weighting, and/or factors.

For example, a 60/40 mix tends to be the objective of a great many advisors. Yet, it is important to note that this benchmark represents only the U.S. stock and bond market. Will your portfolio invest outside the U.S.? For most, the answer is unequivocally, yes.

Granted, the majority of companies in the S&P 500 do business globally. However, recognize that the S&P and the Aggregate Bond Index are U.S. indices - and the simple fact is that most advisors like to incorporate foreign stocks and bonds, real estate, commodities, alternatives, etc. in their portfolios. So, is a benchmark using only stocks and bonds in one country really a good idea?

The recent performance of global markets and asset classes drives this point home. Generally speaking, the U.S. has been the place to be for many years now and diversification into global markets has wound up creating "diworsification" in terms of portfolio performance.

So, if you want to utilize global markets and/or asset classes other than U.S. stocks and bonds, using 60/40 as your benchmark is really kinda silly.

Times Change

Another consideration here is the reality that portfolios tend to change with the times. For example, currently a passive approach to the U.S. stock and bond market is all the rage. The money flow stats on funds and ETFs make this very clear - money is flowing into passive index ETFs at an eye-popping rate.

As such, it is important to be aware of the fact that your portfolio may start to drift toward whatever is happening on a macro basis as the years go by - this is natural. And because of this, locking yourself into an index or a specific mix of indices becomes problematic over time.

My Solution

To be sure, I have wrestled with the benchmark dilemma for a very long time. And under the category of full and fair disclosure, I've made most of the mistakes mentioned above (as well as a bunch of others!).

I've come to the conclusion that unless you are a portfolio manager working for a mutual fund or ETF company that runs a very specific type of portfolio - small cap growth, for example - using a specific index as your benchmark means that you are going to wind up changing your benchmark every couple of years. And in short, such a practice is frowned upon by the regulatory bodies.

My answer is to think about (a) the risk level a client wishes to employ and (b) the alternatives an investor would have when deciding whether or not to use my investing services.

Again, I know this sounds simplistic, but for most investors, the alternative to utilizing a professional money manager is to invest directly in mutual funds and/or ETFs. Or for the millennials, to go online and let Betterment or Schwab build a risk-targeted portfolio for them.

It is for this reason that I prefer to utilize the risk target categories created by Morningstar. In my humble opinion, Morningstar's "Target Risk Allocation" categories make very nice benchmarks as they represent what I deem to be a real-world investing approach.

For example, the Morningstar Moderate Risk Allocation is a modern-day, real-world 60/40 approach. It includes 58% equities (spread across regions, sizes, and styles), 33% bonds (including both domestic and foreign), 6% inflation hedges (commodities and TIPS), and 3% cash. Yes fans, most portfolios have some cash in them at all times - but the popular market indices do not.

So, for me, the first step in designing a portfolio for an advisor and their clients is to identify which of the Morningstar Target Risk Allocations is appropriate. By doing so, I know exactly the risk level being utilized as well as the allocations to asset classes, styles, etc.

Tomorrow, we'll explore the three ways to add alpha to your portfolio, which is really the crux of the matter at hand.

Thought For The Day:

Talent is wanting something badly enough to work for it. -Tim Cox

Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of the U.S. Economy
      2. The State of Trump Administration Policies
      3. The State of Global Central Bank Policies


Wishing you green screens and all the best for a great day,

David D. Moenning
Chief Investment Officer
Sowell Management Services

Disclosure: At the time of publication, Mr. Moenning and/or Sowell Management Services held long positions in the following securities mentioned: none. Note that positions may change at any time.

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The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.

The analysis provided is based on both technical and fundamental research and is provided "as is" without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.

David D. Moenning is an investment adviser representative of Sowell Management Services, a registered investment advisor. For a complete description of investment risks, fees and services, review the firm brochure (ADV Part 2) which is available by contacting Sowell. Sowell is not registered as a broker-dealer.

Employees and affiliates of Sowell may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Positions may change at any time.

Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.

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