Increasing Portfolio Efficiency with Strategic Asset Allocation
Each investor’s asset allocation mix should be a unique reflection of an entirely unique situation. By allocating assets in a manner that accounts for time horizons, goals, and risk tolerance, an investor can take a large step forward in solidifying a long-term financial
plan. Along the way, strategic asset allocation can help achieve efficient portfolios that balance risk and return based on the investor’s profile.
A Look Back in Time
The modern theory of portfolio management was born in the 1950s with the publication of Portfolio Selection, by Harry Markowitz. According to Markowitz, most investors preferred higher returns, but did not want to experience any major declines in portfolio performance. Markowitz theorized that investors could create an efficient portfolio mix in the sense that the portfolio could produce desired earnings with the least amount of variation in actual returns.
One of the keys to Markowitz’s efficient portfolio theory is the concept of covariance.
Covariance is the statistical measure of the correlation in the movement of two variables, either positively or negatively. Although it is difficult to find variables that move in exactly the same or opposite directions, the major asset classes of equities and fixed-income securities tend to be a good fit, since the value of investments in the two categories rarely move in the same direction at the same time. For instance, when the equity market is experiencing strong performance, fixed income yields tend to be lower. Conversely, when the equity market is experiencing poor performance, fixed-income yields tend to be higher. By the same token, equity investments tend to have greater risk associated with
them, while fixed-income securities generally tend to be less volatile. Therefore, diversifying across asset classes can result in a relatively efficient portfolio.
Setting the Record Straight
To most investors, asset allocation usually is described as the division of investment holdings among the three major asset categories—equities, fixedincome securities, and
cash. However, in actuality, the term “asset allocation” encompasses a number of
different investment strategies. Technically speaking, here are the most common forms of asset allocation: Strategic asset allocation is a passive strategy that divides a portfolio
among the major asset classes in proportions consistent with an investor’s longterm
financial goals and objectives. Generally, the investor maintains the asset allocation mix unless a change in goals or objectives requires a different allocation.
Dynamic asset allocation, also considered a passive strategy, establishes several predetermined assetshifting mechanisms to limit risk. The idea is to continually monitor investment performance and make strategic adjustments to the asset allocation mix in order to protect against loss.
Tactical asset allocation is an active strategy that is more commonly called “investment
timing.” Generally, this investment philosophy attempts to outperform the market by timing investments based on market trends or projections. One of the challenges of strategic asset allocation is determining how much of a portfolio should go into each asset class. This decision must be made while recognizing that asset allocation is a personal process rather than a strategy based on a set formula. Although guidelines and models do
exist to help establish the general framework, building a portfolio involves matching the risk/return tradeoffs of various asset classes to the unique investment profile of an investor with the end result being an “efficient” portfolio.
Generally speaking, investors with shorter time horizons or those who wish to preserve capital, may choose a more conservative asset allocation mix that favors fixed-income securities. On the other hand, aggressive investors seeking maximum capital appreciation
may benefit from an equityheavy asset allocation mix. Oftentimes, portfolio efficiency
falls somewhere between conservative and aggressive allocations.
A Balancing Act
When one segment of the market performs exceptionally well, it is often tempting for some investors to become preoccupied with investments earning returns well beyond reasonable expectations. All too often, however, after a significant rise in the stock market, a portfolio’s new composition may vary considerably from its original composition.
Why should this be cause for concern? One of the reasons that investors allocate fixed percentages of investment dollars to specific asset categories is to create an efficient portfolio. As previously mentioned, portfolio efficiency is based on the maximization of returns for the given level of risk an investor can afford to tolerate. Therefore, an asset allocation mix should carefully reflect the investor’s objectives at all times. In this
sense, strategic asset allocation, though considered a passive strategy, is actually an ongoing process that requires active involvement, regardless of investment returns
Some factors that may require an investor to rethink current allocation are changes in life circumstances, time horizons, or tax liability. After making a fair and honest assessment,
many investors may find their objectives have not drastically changed. Therefore, rebalancing a portfolio (and maintaining a strategic asset allocation approach) is often a prudent step to maintain long-term portfolio efficiency.
It’s Your Decision
For many investors, strategic asset allocation is regarded as one of the cornerstones of successful portfolio management. However, when the economy is particularly good,
many investors may feel pressure to forgo traditional strategies in favor of outsized returns. For this reason, it is important to maintain perspective.
UGMA/UTMA Transfers to 529 Plans
The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) made 529 plans more attractive to investors saving for college. Earnings in a 529 plan have the potential to grow tax deferred, and withdrawals made T for qualified higher education expenses are federally tax free.* Prior to the popularity of 529 plans, many people saving for their children’s education opted for either a Uniform Gifts to Minors Act (UGMA) account or a Uniform Transfers to Minors Act (UTMA) account, depending on their state of residence.
For investors looking to enjoy the tax benefits 529 plans offer, it is possible to fund most 529 plans with assets from an UGMA or UTMA; however, the rules governing the custodial account still apply. Before an investment is made in a particular 529 plan, the rules applicable to that plan should be reviewed.
A Closer Look
The custodian of an UGMA or UTMA has the right to manage assets in the interest of the
child, and may choose to transfer money to a 529 plan, provided the minor is named the plan’s beneficiary. The UGMA or UTMA custodian will be considered the owner of the plan until the child, upon reaching the age of majority (legal adult age, generally 18 or 21),
becomes the owner. Until that time, the custodian makes investment decisions.
An UGMA or UTMA is irrevocable and if funds are invested in a 529 plan, when a child becomes the owner, he or she becomes entitled to make the money management decisions. 529 plans do not stipulate that funds must be used for education; however, if funds are not used to pay for qualified education expenses, earnings will be subject to a 10% federal income tax penalty, as well as ordinary income tax. It is important to note that assets in a 529 plan could impact the beneficiary’s ability to qualify for grants and student loans.
Investments in a 529 plan must be made in cash, so it may be necessary to sell UGMA/UTMA assets, such as stocks or mutual funds, and capital gains tax may be due. However, remember that future withdrawals from a 529 plan will not be federally taxed if
they are used for qualified expenses, such as eligible tuition, room, and board. In addition to college expenses, funds may be used for graduate school. For planning purposes, bear in mind that the child, upon attainment of the age of majority, will own any additional contributions to this “custodial 529.” Investors who seek more control over funds than the custodial arrangement affords could consider opening asecond 529 plan, with funds not coming from an UGMA or UTMA.
As you consider investing UGMA/UTMA assets in a 529 plan, familiarize yourself with some of the potential risks. With the assistance of your financial professional, you can develop a strategy to help achieve your long-term funding goals.
*529 plans are state sponsored investment programs. There is no guarantee by the
issuing municipality or any government agency. Under a “sunset provision,” certain federal tax benefits associated with 529 plans are scheduled to expire on December 31, 2010, in the absence of re-enactment. You should consider the potential benefits (if any) that your own state’s plan (if available) offers to residents prior to considering another state’s plan. There may be tax benefits to plans offered by your resident state. As with all tax-related decisions, consult with your tax professional.
Annual asset charges for a 529 plan may be higher thancorresponding share classes of underlying mutual funds. Municipal fund securities (529 plans) are sold by offering statements, which are available from your registered representative. Please carefully consider investment objectives, risks, charges, and expenses before investing. For this and other information about municipal fund securities, please obtain an offering statement and read it carefully before you invest. Investment return and principal value will fluctuate with changes in market conditions such that shares may be worth more or less than original cost when redeemed. Diversification cannot eliminate the risk of investment losses.
Exercising ISOs? Beware of the AMT
Compared with other forms of compensation, incentive stock options (ISOs) can provide
executives and other employees with substantial tax breaks. If held for a certain period of time, shares purchased as ISOs may escape all taxes other than the relatively low long-term gains rate of 15%. But as many “paper millionaires” discovered, exercising ISOs can be very risky, especially if the employee fails to weigh all the potential tax consequences before cashing in.
When ISOs are exercised, there are no taxes due immediately. Instead, the entire gain, including the spread and any additional appreciation, is taxed at long-term capital gains rates, provided the employee does not sell the shares until at least two years after the option was granted, and one year after the date of exercise. The gain would lose its qualified status only if these holding period requirements were not met.
Alternative Minimum Tax Implications
Sometimes, however, exercising and then holding ISOs into the next tax year can carry a very substantial hidden sting. When calculating tax liability, you must add in the spread between the grant price and the market value as a “preference item” on the Alternative
Minimum Tax (AMT) worksheet. If the amount you would pay under the AMT is higher than your regular income tax, the employee would be required to pay the AMT. Under the AMT, people are taxed at rates of 26% and 28% on the amount of their taxable income above the exemption amounts. For 2005, this is $40,250 for single filers or heads of
household, and $58,000 for joint filers. The AMT exemptions phase out gradually at higher income levels. Some employees who held onto their companies’ shares for more than a year after exercising ISOs have found themselves in the unfortunate position of owing more in AMT taxes than their shares were actually worth. You should always consult your personal tax advisor to discuss your specific situation.
Rewards and Benefits of Lifetime Gifts
Many estate plans include a program for making lifetime gifts, so, why is it sometimes better to leave assets this way than to bequeath them in a will or trust? Lifetime gifts can offer important rewards and benefits. Here are someyou may wish to consider:
- May Reduce Probate Costs and Taxes. Lifetime gifts, especially of income-producing assets, can potentially reduce the size of your estate. A smaller estate may mean decreased probate costs and may also reduce or eliminate income and estate taxes.
Lifetime gifts are a sure thing. You can rest assured the assets will go to those you intend, for instance, your children or grandchildren, and not a former spouse or creditors. In the worst cases, a will may be challenged or creditors’ claims may take precedence over your wishes.
- Protects Privacy. Lifetime gifts are private. Only you, the recipients, and possibly the tax authorities, need to know the details. In contrast, anything that goes through probate is a matter of public record.
Making gifts during your lifetime allows you to experience the pleasure of seeing your loved ones enjoy them. It may also give your heirs the benefit of the assets when they may need them most. A program of lifetime gifts may make good sense as part of your estate plan. The rewards and benefits can extend to you and your estate, as well as