Part 1: Portfolio Monitoring

Once a portfolio is fully implemented, it is extremely important to monitor the portfolio structure to ensure it stays within the guidelines stated within the client’s Investment Policy Statement (IPS).

I recently wrote a four-part series about portfolio implementation and the steps involved to properly implement a portfolio for an affluent family. If you are interested in learning more about this process feel free to click here.

Over a three-part series my colleague Dan Hallett and I will be discussing what we do after cash has been deployed as per the client’s tailored IPS. Specifically, we are ultimately monitoring for three key things:

1. The portfolio structure at a point in time relative to the IPS’ targets
2. The performance of each investment mandate, the individual managers that make up each mandate including the monitoring of each segregated manager’s model.
3. The performance of the overall portfolio in absolute terms as it relates to the client’s stated rate of return objectives, which is reported on a quarterly basis.

In this blog post I will focus on the first bullet – monitoring the portfolio structure. Before we dive in I think the best way to frame “portfolio monitoring” is by thinking of your portfolio as having layers similar to an onion. As you peel back the layers the deeper you go until you reach the individual securities that ultimately make up your entire portfolio.

3 Layers of Portfolio Monitoring

We think of our client portfolio structures as having 3 layers:

• First layer = Asset Class
  • Equities, Cash & Fixed Income, Alternatives/Private Investments

• Second layer = Investment Mandates
  • Canadian Equities, Global Equities, Canadian Bond, Commercial Real Estate, etc.
  • These investment mandates are the “building blocks” that make up the respective asset classes (first layer).
  • Canadian + Global Equities belong to the “Equities” asset class, etc.

• Third Layer = Individual Securities
  • Pooled funds and individual stocks/bonds
  • Rogers Communications Inc. (third layer) is a stock that belongs to Canadian Equities Investment Mandate (second layer), which belongs to the Equities Asset Class (first layer).

On a regular basis we are actively monitoring our client portfolios for the following things:

1. Portfolio Structure – Asset Classes (first layer) & Investment Mandates (second layer)

The saying, “if you can’t measure it, you can’t manage it” is especially true in the investment industry when it comes to portfolio monitoring.

In our case, we need broad asset mix targets along with “goal posts” or minimum/maximum ranges for each asset class (first layer). These “goal posts” essentially tell us how far each asset class is allowed to drift from it’s original target before an action is required.

We try not to disrupt client portfolios unnecessarily, but as capital markets move on a daily basis the market value of the client positions change ($) and the relative weights of the positions (%) drift from their original targets. Sometimes, the portfolio can shift beyond our min/max “goal posts” where some action is then required to bring the portfolio back onside/within range.

As discretionary portfolio managers we have the authority to make any necessary portfolio changes in a timely manner. This includes placing any trades to rebalance the Investment Mandates (second layer) within the portfolio so that we can bring some or all client accounts back to their respective policy guideline targets.

Before we do any rebalancing, here are the 5 factors we consider prior to placing any trades:

• Tax Consequences
• Materiality & Transaction Costs
• Capital Market Conditions
• Contributions & Withdrawals
• Cash Balances

Tax Consequences:

We typically try to assess the tax implications prior to rebalancing. To limit the tax implications when rebalancing the portfolio we will try to adjust the investment mandate weights within registered accounts first (ie. Tax-deferred or tax-exempt accounts), but sometimes we need to place trades in taxable accounts and incur a taxable consequence – we do our best to minimize the tax impact when realizing taxable gains.

Materiality & Transaction Costs

Sometimes clients have a preference to have a relatively low target to a specific asset class (ie. 10% Cash and Fixed Income). Let’s say you have a +/- 20% threshold relative to your asset class target. Because the relative goal posts are narrower with a 10% target when compared to an asset class with a 40% target you need to consider the materiality of the asset class weight. For instance, portfolio size also plays a key role. A 20% shift on a $250,00 portfolio is obviously a lot less in absolute dollar terms when compared to a $2 million portfolio.

Materiality and transaction costs typically go hand in hand. Sometimes you need to consider whether or not the transaction costs are worth the effort to rebalance on relatively smaller accounts. We need to assess whether or not it is worth rebalancing all client accounts or just the ones that would have the greatest impact on the portfolio.

Capital Market Conditions

Just because an asset class breaches a min/max tolerance threshold doesn’t necessarily mean we are in a rush to place trades to rebalance the portfolio. For instance, when we are experiencing some portfolio volatility we need to assess whether or not it’s worthwhile to rebalance. For example, if a client portfolio is overweight Equities by 20% relative to their target we understand that a capital market pullback could naturally bring the portfolio back onside without the need to place trades, incur transaction costs, and possibly trigger taxable consequences.

Additionally, some clients prefer to phase in their deployments of cash during uncertain times. We could be overweight Cash & Fixed Income as we deploy the cash to target in stages, which will eventually bring the portfolio onside once all cash has been deployed as per IPS guidelines.

Contributions & Withdrawals

We have a number of clients that make regular and recurring portfolio contributions and the portfolio could be flagged as being overweight Cash & Fixed Income as we are waiting to deploy the cash into various investment mandates.

In contrast, as clients take recurring withdrawals from their portfolio while having an allocation to a relatively illiquid asset class such as Alternative Investments we need to be prepared to take action with the anticipation that the Equities and Alternative Investment asset classes are going to get larger and larger over time.

Cash Balance:

Many of our affluent families require regular and recurring portfolio withdrawals to help fund a lifestyle, legacy or philanthropic goal – almost like a “HighView paycheque”.

Given that “Cash” is one of our investment mandates it is important that we monitor each client account to ensure we have sufficient cash available to make these recurring payments. Sometimes a client portfolio could be flagged as being “overweight” Cash & Fixed Income, but it is a direct result of floating select accounts with cash in anticipation of future/upcoming withdrawals.

2. Individual Securities (third layer)

The investment managers we hire typically use a pooled fund as an investment vehicle, but some of our managers can get direct access to client accounts and manage the account on a segregated basis (ie. holding individual securities directly in the client account instead of the pooled fund). We monitor each of our segregated manager’s models on a periodic basis to ensure they stay within the Statement of Investment Policy & Goals we define for the manager.

To recap, like many investment decisions, portfolio rebalancing has it’s pros and cons and some challenge whether or not it’s even worthwhile. I will not get into the debate, but the advantages of practicing this discipline speaks to who we are as a firm.

We at HighView firmly believe that portfolio monitoring paired with necessary rebalancing allows us to:

1. Prioritize adherence to the client’s IPS guidelines
2. Mitigate risk for the client to create a portfolio behaviour that the client can stomach
3. Increase the probability that we achieve/exceed the client’s stated goals and objectives

In Part 2 of this series my colleague Dan Hallett will discuss how we monitor the performance of each investment mandate and individual manager against their respective benchmarks. Additionally, he will speak to how we monitor each of our segregated investment managers against their Statement of Investment Policy & Goals.