• Low Interest Rates. In a normal interest rate environment, insurers were able to build reserves for pay-outs through investment income generally derived from high-quality bonds. As bond yields have hit a 50-year low and an aging population requires higher benefit payouts, many big name providers have dropped the service.[1] For example, Unum Group announced in February 2012 that it will be no longer selling LTC to corporate customers.[2]

• Low Surrender Rates. The surrender rate is a provider’s estimation of the percentage of policyholders who will forgo their benefits. This estimation includes policyholders who drop their coverage or die without reaching their policy ceiling. As the population ages, surrender rates have dramatically decreased and therefore, many providers are paying far more in benefits than their originally estimated. 

These implications could make LTC an unreasonable investment for you in the very near future. Consider the following:

• Low returns have caused LTC providers to heighten scrutiny of applicants and policyholders alike. It is no secret that insurance companies do an exhaustive investigation before paying claims; however, as LTC becomes a losing game for providers, this scrutiny will likely become more intensive and less forgiving.
• Due to dwindling profits in the LTC sector, providers are beginning to lobby regulators for permission to raise rates for existing policyholders.[3] For example, John Hancock has succeeded in raising rates in 30 states. No states have flat out denied their request.

While a dialogue about your insurance needs must be within the context of your overall financial strategy, the diminishing returns of the LTC industry certainly call for careful consideration.

[2] Leslie Scism, “Prudential Pares Long-Term Care” The Wall Street Journal. 08 March 2012.

[3] Greene

As a result, we are pleased to announce that Campion Wealth Management is now Campion Asset Management. Our new name best describes Campion’s full range of services for both individuals and organizations. “Asset Management” represents the exact nature of who we are and what we do.

Although our name has changed, our promise to you remains the same. We are committed to serving you through our focus on independence, integrity and innovation. Whether it is your family’s long-term legacy or your organization’s long-term reserve, as Campion Asset Management, we will continue to provide objective investment advice and the highest level of client service.

Please feel free to contact us if you have any questions regarding our name change. We look forward to serving you for years to come as Campion Asset Management.

1. Consider a Roth IRA conversion. A Roth IRA conversion allows you to enjoy tax-free income from your retirement assets. Additionally, it can serve as an estate planning tool because your heir’s withdrawals would not be not subject to income tax. Roth conversion has not always been an option for high-income individuals.  With tax revenue at the forefront of every Congressional debate, this opportunity for high-income individuals is most likely fleeting.

2. Give year-end gifts to children and grandchildren. If you have not already maxed out your potential tax-free gift for 2011, you should do so before 2012. In 2011, you can give each of your children and grandchildren $13,000 as a tax-free gift.  Additionally, it is important to note, that tax law exempts gifts that are made for educational or medical expenses. Such expenditures must meet certain requirements and must be paid directly to the educational or medical institution. However, this presents yet another opportunity for tax-free asset transition.

3. Make an extra mortgage payment. Making an extra mortgage payment at the end of every year can reap a two-fold benefit. First, you can increase your home mortgage interest deduction by making your January 2012 payment before December 31^st. By doing so, you are allowed to use your January interest deduction for 2011. Second, if you make an extra payment towards your principle, you shorten the life of your loan. These payments will come off the back end of the loan and therefore, will not change your monthly payment. However, by paying off your principal early, you will decrease your total mortgage expenditure over the life of the loan.

4. Record your charitable donations. As the holiday season inspires your inner-philanthropist, be sure to keep ample records. The tax benefits for charitable contributions are only available if you itemize your deductions. Keep in mind, for any gift of $250 or more, you must have a written acknowledgement from the charity. Additionally, if you are donating property valued at more than $5,000 you must obtain a qualified written appraisal.

5. Contemplate delaying your RMD. If you turned 70 ½ in 2011, you have the opportunity to strategically delay your first RMD to 2012. By doing so, you would be able to withdraw both your 2011 and 2012 RMDs next year. This would be beneficial if you’re expecting to be in a lower tax bracket in in 2012.

Fixed-Income

Shorten Portfolio Duration. U.S. Treasury yields declined noticeably last week. As global equity markets slide, bond yields are likely to rise as the market reacts to the U.S. credit rating. Portfolio duration is a measure of a bond portfolio’s sensitivity to changes in interest rates. In order to reduce the impact of rising bond yields, we recommend reducing the duration of your fixed-income portfolio. The best way to take advantage of rising bond yields is to invest in short-term bonds using an exchange-traded fund such as the Vanguard Short-Term Bond ETF.

Reduce exposure to mortgage backed securities (MBS). Given that Fannie Mae and Freddie Mac are controlled by the U.S. government, the downgrade will have a negative impact on MBS. MBS comprise a significant percentage of the Barclay’s Capital Aggregate Bond Index. We recommend reducing exposure to this index by selling exchange traded funds that replicate the performance of this index.

Increase exposure to investment-grade corporate bonds. Despite the poor financial health of the U.S. government, many US corporations still have strong balance sheets. We recommend taking advantage of investment-grade corporate bonds by increasing exposure to exchange traded funds that replicate the performance of investment-grade corporate bonds.

Maintain 3–5 percent exposure to high-yield debt instruments. Another way of shortening portfolio duration is to invest in high coupon bonds. It is important to note that high-yield bond returns are almost twice as volatile (measured by the standard deviation of index returns) as investment-grade corporate bonds. High-yield bonds will experience greater price declines than investment-grade corporate bonds if the economy continues to slowdown. Rather than taking the risk of investing in specific high-yield bonds, the best way to achieve exposure to high-yield bonds is to allocate an appropriate percentage of your portfolio to an exchange traded fund designed to replicate the performance of high-yield debt instruments.

Equities

Reduce equity allocation by 5–10 percent. We recommend a tactical reduction in your equity allocation. Equities with highest volatility (measured by the standard deviation of index returns) include emerging markets (+/- 28.61 %), small-cap U.S. equities (+/- 21.2%), REITs (+/- 22.24%), and mid-cap U.S. (+/- 19.68%).

Reduce portfolio beta. We recommend reducing your portfolio’s risk by increasing exposure to sectors that are less sensitive to overall market movements. These sectors include: consumer staples, energy, health care, industrials, basic materials, utilities, and telecommunications. Excluding telecommunications, sectors that are less sensitive to overall market movement have provided consistent returns above the S&P 500 Index over various time horizons.

Source: Standard and Poor’s as of 06/30/11.

Additionally, we recommend reducing exposure to sectors that are more sensitive to overall market events. These sectors include: consumer discretionary, financials, and technology.

Shorten portfolio duration. Portfolio duration is affected by cash flows (i.e., interest payments and dividends) received over the life of a security. The higher the cash flows, the shorter the duration of the security. This indicates lower sensitivity to rising interest rates or market events. Therefore, stocks with high dividend yields will be less sensitive to market events than stocks with a low dividend yield.

Individual stocks with above-average dividend yields are often in the following sectors: consumer staples, energy, health care, industrials, basic materials, utilities, and telecommunications.

Reduce exposure to financials. Financials are likely to experience the brunt of the impact of the downgrade. This news will impact capital requirements and returns on fixed-income securities. Additionally, asset backed securities issued by Fannie Mae/ Freddie Mac and held by insurance companies will likely take a hit.

As a firm, we remain cautiously optimistic that recent market events provide a platform for our clients to take advantage of the tactical opportunities we have outlined. A long-term investment time horizon and a moderate risk tolerance will provide buying opportunities for patient investors.

Please feel free to call us if you have any question or would like to set up a meeting to review your portfolio. As always, thank you for the privilege of serving your investment management needs.

Two years ago, world financial markets were just starting to work themselves out of a huge hole and the worst experience in recent memory. Annual returns on various equity market indices have come full circle. Just to see how far we have come, consider that the S&P 500 Index declined -37.0 percent in 2008 and rebounded completely and then gained 26.46 percent in 2009, another 15.06 percent in 2010, and still banged out another 5.92 percent in the first quarter of 2011. Though not bad, the picture is even better for mid-cap equities. After diving 36.23 percent in 2008, the S&P 400 Mid-cap index returned a handsome 37.38 percent in 2009 and then another 26.64 and 9.36 percent respectively in 2010 and 1Q2011. If you like real estate, the Dow Jones equity REIT index didn’t disappoint either. After tanking -37.54 percent in 2008, it gave back 28.47 percent, 27.70 percent, and another 6.76 percent respectively in 2009, 2010, and 1Q2011.

Pretty impressive, but where do we go from here? GDP growth has rebounded as well from some pretty dark times too, but can it continue? Although things have improved, Thursday’s child has far to go and so does the economy.

Despite avoiding another significant depression and experiencing an incredible turnaround, significant uncertainty still remains. I believe that economic scenarios for the 2011-2013 investment time horizon will likely follow one of three paths:

• a slow but steady acceleration of economic growth and declining unemployment (45 percent);
• an economy that muddles along with unemployment elevated well above comfortable historical average (45 percent); or unfortunately
• a sudden deceleration of economic growth (10 percent).

Noticeably absent is the possibility of a strong economic recovery and a steady decline in unemployment. That is pretty remote at this point in time for the following reasons:

• Uncertainty on the part of businesses and consumers due to future tax policy.
• Increased awareness that government spending (and borrowing) is “crowding out” private investment.
• Growing concern to cut government spending and reduce the mounting federal deficit.
• Lingering doubts over whether the major causes of the 2008 financial crisis have ever been addressed.
• Growing evidence of a double-dip scenario in the housing market.

Although U.S. corporations (except U.S. banks) are in good financial health, I believe that global macroeconomic factors will drive market sentiment and trump strong fundamentals in the short-term. Despite negative “macro” factors, corporate profits remain strong. Although that may seem scary to some, it also represents investment opportunities for patient investors.

Leading and coincident economic indicators continue their upward trends as the recovery slowly continues, but the question remains how will the recovery and GDP growth continue? From where will sustained growth in aggregate demand come?

As the Federal Reserve’s Quantitative Easing Program (QE2) comes to an end in June 2011, it is likely that the Federal Reserve will “coast” in 2011 and into 2012 despite growing pressure to increase interest rates and put an end to “easy money” policy.

Despite numerous exogenous shocks including the recent earthquake in Japan, ongoing chaos in the Middle East, the spike in oil prices, rising food prices, the resurrection of the Greek and now Euroland debt crisis, equity markets have been quite resilient in 2011.

Investment Opportunities and Pitfalls in the Years Ahead

Despite current market uncertainty, investment opportunities exist and potential pitfalls are out there. Before touching on new opportunities, I would like to touch on a few things to keep in mind.

Don’t forget September 2008 when Lehman Brothers collapsed. Every day that September 2008 (or the market nadir in March 2009) fades further into the distant rear view mirror, the next financial crisis is one day closer. Financial crises occur with greater regularity than one thinks or wants. So, the key is to prepare one’s portfolio to weather the next storm. Here are a few things to keep in mind:

• Cash is still king. Make sure you have enough to weather a one-year storm or that investment income generates half or even two-thirds of your annual spending.
• Keep investing simple and focus on transparency. If you do not understand the nature of any investment and its cash flows, then do not invest in it. If you do not feel there is adequate transparency about an investment, then do not invest in it. Alternative investments (i.e., hedge funds and private equity investments) and many financial “innovations” are often nothing more than compensation schemes for a few at the expense of many. They remain an ideal strategy to separate you from your money. Besides, if everyone is doing it, what will the risks and returns be? Avoid them to your own benefit!
• Asset allocation is not dead; its importance is often misrepresented as explaining return instead of the variation in return. The key is to incorporate suitable and appropriate asset classes into your portfolio that meet your needs.
• Keeping up with the market is hard enough; therefore, a portion of every portfolio should be indexed to appropriate asset classes.
• Rebalancing a portfolio can enhance returns and reduce portfolio risk. Regardless of the methodology, just do it.

Equities Investment Themes

Disciplined and balanced portfolio allocation with diversified exposure to suitable and appropriate asset classes.

Dividends still matter. Over a very long investment, horizon dividends can account for a significant source of total return. So, it pays to focus on high-quality, high-dividend companies that consistently generate positive free cash flow and that have little or no debt or less debt than their competitors.

Mid-cap and small-cap U.S. equities. Even though mid- and small-cap U.S. equities experienced similar largest one-year declines as large-cap U.S. equities over the latest 10 years, the returns are noticeably higher than large-cap equities. Therefore, one may want to consider increasing the allocation to mid- and small-cap equities.

Equity REITs focused on data storage and living care facilities. There is a growing demand for offsite data storage and providing quality care for an increasing older population.

Healthcare and Pharmaceuticals. Regardless of who ultimately pays for healthcare equipment and pharmaceuticals, demographics indicate this will remain a good long-term investment, especially U.S. healthcare equipment providers and non-U.S. pharmaceuticals.

Financials. Canadian banks provide attractive dividends and an interesting alternative to large U.S. banks. Relatively young local community banks also provide interesting long-term opportunities without all the baggage of large U.S. banks weighed down with toxic mortgage assets still on their balance sheets.

Regional mid-cap utilities. Everyone needs electricity. High dividends, reasonable debt levels, low dividend payout ratios, and positive free cash flow are all attractive, but focus on regional natural gas utilities outside of those areas hardest hit by the housing bubble.

Publicly traded energy Master Limited Partnerships (MLPs). Despite the additional tax work for your accountant, MLPs are a great diversifier for a portfolio in that they have a low correlation with both equities and bonds. Add in the high dividend yields and double-digit returns over the last 10 years and a 5 to 10 percent allocation to MLPs looks even better.

Fixed-Income Investment Ideas

Treasury Inflation Protected Securities (TIPS). Given the incredible expansion of the U.S. money supply over the last two years, inflation is a distinct possibility. Taking into consideration the low volatility and low correlation of TIPS with virtually all equity asset classes, one may want to consider including at least a 10 percent allocation to TIPS in one’s portfolio.

Emerging market debt. Although debt as a percentage of GDP may be approaching 100 percent or more for developed or advanced countries within 5 to 10 years, the same is not true for emerging markets. The emerging economies are in relatively stronger financial shape than advanced economies, even though their current debt yields are higher. Rather than try to cherry pick a specific country or issue, consider allocating 3 to 5 percent of your portfolio to emerging market debt using exchange-traded funds for maximum diversification.

Although dividends are one useful measure of cash flow, another good measure is a firm’s free cash flow (FCF). FCF attempts to derive the expected after-tax cash flows available for distribution to both shareholders and creditors, discounted at an appropriate, risk-adjusted rate of return on capital.

Thus, FCF reflects the amount of cash that the company has available after incurring all of its operating expenses, including necessary investments in working capital and in property, plant, and equipment (PPE). All of the financial information needed to calculate FCF is available in the firm’s financial statements and is calculated as follows:

EBIT x (1 – t) + Depreciation – Investment

Where,

• EBIT equals earnings before interest and taxes,
• t equals the firm’s tax rate, and
• Investment is broadly defined as all PPE as well as any increase in working capital.

FCF provides incredible insight because it ignores how a company’s activities are financed and focuses on what is important: generating cash from core operations, not by managing earnings from quarter to quarter. Frankly, if a firm cannot generate free cash flow from operations, one might question whether the company should be in business!

The table below highlights FCF per share for ten companies. Companies that generated FCF above their respective industry average achieved favorable returns during the subsequent 12-month period while the laggards’ performance was quite disappointing.

Two questions remain: First, what do the “overachievers” do with all that cash? The answer is, reduce outstanding debt, repurchase outstanding common stock, pay dividends, or even acquire other companies, although allowing cash to accumulate for any length of time might make the firm a takeover target.

Second, what happens to the “laggards?” The answer depends. Transitory industry events or “headline news” may create negative sentiment within an industry and drive the stock price down. That may represent a buying opportunity. True laggards often become acquisition targets of well run competitors with additional capacity or private equity firms that may wrestle control from existing management, focus on maximizing FCF from key operations, and jettison non-core business segments. Investors should keep in mind that FCF is only one indicator of relative value.

Information Processing Errors. Sometimes investors incorrectly process information about investments, which leads them to misestimate the likelihood of certain events or possible returns on select investments. Common information processing errors include forecasting errors, overconfidence, conservatism, and sample-size neglect.

When investors assign higher probabilities to recent experience than to historical experience — while forecasting, say, future earnings of a company — forecasting errors occur. These forecasts may turn out to be too rosy, given that nothing is certain and stock returns tend to revert to historical averages.

How many of us think we are excellent drivers? Overconfidence occurs when investors (much like politicians running for office) overestimate the accuracy of their beliefs, forecasts, or even abilities.

Investors often are slow to incorporate recent events into their beliefs, resulting in conservatism. For example, and investor might focus on a corporate scandal from five years ago instead of considering remedial steps since taken by the company to improve its governance.

How many of us thought that the stock market returns of 1998-1999 would continue well into the future? How many people thought the housing boom of the last decade would continue unchecked like “tulip mania” during the Dutch Golden Age of the 1630s? When investors extrapolate good news about a company, an investment style, a sector, or an asset class far into the future, sample-size neglect results.

Behavioral Biases. Investors don’t always make entirely rational decisions with regard to their Total Portfolio. Instead, they are swayed unknowingly by behavioral biases, which have a major impact on how investors frame discussions about risk, asset allocation, and portfolio tax-efficiency. Common behavioral biases that creep into investment decisions are mental accounting, framing, and regret avoidance.

Mental accounting explains how investors segregate certain decisions. For example, an investor may have a balanced (say, 50 percent stocks and 50 percent bonds) $1.0 million investment portfolio, but also have a home equity loan with a $300,00 balance, In reality, this investor has a $700,000 portfolio with about 70 percent equities and 30 percent bonds with at least 20 percent more risk!

An equally dangerous practice is to take additional risk as one’s portfolio increases in market value. In this situation, investors are more willing to take risk because they “frame” the decision like a gambler: they view incremental market returns as “winnings” and are willing to continue taking risks instead of correctly rebalancing their portfolios. This essentially throws the most important portfolio management decision — asset allocation — out of the window.

Regret avoidance demonstrates investors’ tendency to ride stocks with negative returns for far too long when they could use such losses to offset gains on stocks that have performed well. For these investors, selling losing stocks realizes the pain of regret.

Here are some steps you can take to help counteract behavioral biases:

• Incorporate both assets and liabilities, as well as all cash inflows and outflows, when evaluating the asset allocation of your Total Portfolio.
• Periodically rebalance your Total Portfolio in accordance with your investment objective, which will add value over a long investment horizon and reduce risk.
• Realizing losses on investments that did not work out as planned can offset realized gains on securities that were real “home runs.” The result will reduce your tax bill and reduce the risk associated with concentrated stock positions.
• Don’t be afraid to admit that you made a mistake or a suboptimal decision. The key is to learn from it and to avoid the same pitfall going forward.

It is important to select appropriate benchmarks against which to compare the performance of your actual portfolio. An ideal benchmark demonstrates the following characteristics:

• Measurable. A valid benchmark can be easily calculated on a regular basis such as daily, monthly, quarterly, or annually and since inception of the account.
• Appropriate. A valid benchmark is representative of the portfolio manager’s investment style, expertise, or strategy.
• Reflective of current investment opinions. The benchmark incorporates the portfolio manager’s knowledge of the security and factor exposures in the benchmark itself.
• Investable. An ideal benchmark is a passive alternative to active management.
• Specified in advance. Ideal benchmarks are specified in advance within each client’s Investment Policy Statement to avoid “gaming” performance by changing benchmarks depending on actual results.
• Unambiguous. Ideal benchmarks provide the names, weights, and factor exposures of all securities within the benchmark.

The table below highlights broad market indexes that are commonly used as benchmarks for select asset classes. Each of these benchmarks is well known, easy to comprehend, widely available, and meets most of the criteria for an ideal benchmark. In some cases it may be useful to further break down these benchmarks to reflect the investment manager’s style (i.e., growth versus value).

Common Broad Market Indexes Used As Benchmarks

One can also create customized benchmarks that reflect the long-term asset allocation target, for example, a 60% equity/40% bond allocation. After comparing portfolio performance against the agreed upon benchmarks or customized benchmark, you can examine other key drivers of investment performance, including sector and individual security exposure. The extent to which these factors affect performance is driven primarily by the relative sector and individual security weights in your portfolio compared to the index.

Beyond sector and individual security weights, you can then delve into specific portfolio characteristics that provide additional clues about the risks inherent in your portfolio. For equity portfolios, you may want to evaluate dividend yield and price-to-book ratios. For bond portfolios, you may want to look at the effective duration and credit ratings.

In order to compare investment performance among managers, investors should review performance results using net-of-fee time-weighted returns with geometric linking from each manager and read all the footnotes that accompany any performance information.

For a thoughtful discussion about performance attribution analysis or your investment management needs, contact Terence E. Burns, CFA at 703-848-0344.

Equity REITs usually offer a great deal of geographic diversification, but they often specialize in certain types of properties such as warehouses, multi-family (apartment buildings), mixed use, office, retail, and even living care properties. REITs also come in different sizes as defined by market capitalization and how much they use leverage to finance their purchase of properties.

REITs are exempt from taxes as long as at least 95 percent of their taxable income is distributed to shareholders. Their dividends are taxable to shareholders as personal income, however.

In addition to generating current income in a portfolio, an appropriate allocation to REITs helps reduce fluctuations in portfolio returns because REITs’ returns are not highly correlated with the overall stock market. That is, the return of REITs and the S&P 500 Index generally do not follow the same patterns.

Table 1 highlights the returns of the S&P 500 Index and the Dow Jones Equity All REIT Index. Despite negative returns in 2008 and 2009, REITs have positive returns over one-, three-, and five-year periods. Although unique characteristics affect the performance of individual REITs, their returns are driven by the following factors:

♦ Changes in the 10-year Treasury yield
♦ Inflation (both expected and actual)
♦ Replacement costs of properties
♦ Funds from operations (FFO)
♦ Market capitalization rates
♦ Supply and demand for specific property types
♦ Vacancy rates
♦ Demographic trends

REITs and Rebalancing

Even when it’s appropriate to include REITs in a specific portfolio, investors should evaluate their exposure to REITs within the context of their Strategic Asset Allocation and an investment management framework.

Given the impressive returns in 2009 and 2010 of 28.47% and 27.70%, it may be time to rebalance your exposure to REITs. These impressive returns and increase in market value look great, but don’t forget the lesson of the late 1990s, when growth stocks had phenomenal returns before returning sharply to more appropriate valuations. What goes up can and does come down. Statisticians call this phenomenon the mean reversion of stock prices. Sooner or later, all asset class returns revert to their long-term historical average.

No one ever knows how quickly mean reversion can happen, but trends can change faster than our Virginia weather! Consider that the Dow Jones Equity All REIT Index declined 15.59 percent in 2007 based on the perception that interest rates would rise. Consider also that the yield on the 10-year Treasury note rose above 5% in mid-2007 before falling below 4% by year-end. Furthermore, consider that the yield on the 10-year Treasury note rose from about 2.4% in mid-October 2010 to around 3.4% by mid-January 2011.

So, unless your portfolio is rebalanced, you could give up all of your gains during a downturn for REITs or any other asset class.

Portfolio management is a dynamic process that requires both a solid framework and the discipline to manage a portfolio within that structure. Investment professionals who consistently apply a sound investment management framework will keep their clients from abandoning a well-conceived Investment Strategy during both “the best of times and the worst of times,” to borrow from Charles Dickens. Our framework consists of the following key elements:

♦ Investment Policy Statement. This document lists a client’s investment objectives, risk tolerance, liquidity requirements, investment horizon, tax situation, and any unique needs and circumstances. An Investment Policy Statement guides all investment actions taken on behalf of a client and establishes appropriate benchmarks for evaluating performance. If any investment’s appropriateness is ever questioned, the first item to check is the Investment Policy Statement—the roadmap for achieving a client’s investment objectives.

♦ Strategic Asset Allocation. One of the most frequently misrepresented statements in investment research concerns a portfolio’s asset allocation. Many financial planners and advisers mistakenly tell clients that asset allocation drives (or in statistical terms, “explains”) the return on a client’s portfolio. Or they might say that allocation is the key driver of investment performance.

Unfortunately, neither statement is accurate. An investment professional could create, for example, five different portfolios that offer the same expected return but with dramatically different levels of risk. In theory, a portfolio manager could create an infinite number of portfolios with the same expected return—but only one would have the lowest level of risk!

Correctly stated, Strategic Asset Allocation explains much of the variability in a portfolio’s returns. So, the way your portfolio is allocated predominantly explains the level of risk in your overall portfolio. As your investment adviser, it is our job to develop a Strategic Asset Allocation that positions your portfolio to achieve your stated objective(s) in accordance with your Investment Policy—without taking unnecessary risk.

Every investor wants to maximize returns with little or no risk, of course, but as with most things in life, it’s impossible to get something for nothing. For our clients, sometimes a conversation about asset allocation creates an opportunity for us to align a client’s risk and return expectations with the reality of capital market returns.

♦ Macroeconomic Outlook. Understanding the economy’s current state relative to the overall business cycle helps to distinguish between short- and long-term trends within countries, asset classes, sectors, and individual securities. Seeing the larger economic picture also allows an investment professional to identify tactical opportunities to enhance portfolio returns. Here are a few trends that we consider for portfolio construction:

• How demographics may influence the demand for goods and services, and thus portfolio returns in the next 10 to 20 years.
• The way that many Americans’ low savings rates and high installment debt balances affect asset allocation and portfolio returns.
• The impact of an increased equilibrium price of oil on inflation, the gross domestic product of various countries, and capital market returns.
• The extent to which globalization and market integration may influence how closely the world’s equity market returns are correlated.
• The impact of ballooning federal deficits on aggregate demand and the allocation of capital.

♦ Portfolio Construction. Creating a well-diversified portfolio in accordance with Investment Policy involves analyzing the optimal way to implement the recommended Strategic Asset Allocation. Our portfolio construction process recognizes the value of passive investing and incorporates the following:

• Addresses unique needs and circumstances that may influence how a portfolio should be invested.
• Evaluates the long-term benefits of complementing active portfolio management with passive investing.
• Implements the recommended asset allocation using active management and exchange-traded funds (ETFs).
• Determines the best mix of value versus growth-oriented investments to improve tax efficiency.
• Establishes limits on portfolio turnover to maximize portfolio returns and minimize taxes.

♦ Portfolio Monitoring & Rebalancing. Both of these steps are an integral part of enhancing portfolio returns and controlling risk. Disciplined rebalancing reinforces the strategy of selling high and buying low—in other words, reducing exposure to outperforming asset classes and increasing exposure to underperforming asset classes. Depending on the investment strategy, disciplined rebalancing can reduce a portfolio’s risk and add incremental annual portfolio returns from an additional 0.25 to 0.65 percent.

An additional yearly return of 25 to 65 basis points seems trivial. But those pennies multiply dramatically in the long run. Over a 25-year investment horizon, an extra 0.65 percent return

• Allows the investor to achieve a targetlevel of wealth about three and a half years sooner, and
• Contributes an additional $1,637 for every $100,000 invested!

In this regard, clients must understand clearly the potential impact in terms of risk and return of deliberate departures (i.e., tactical asset allocation) from the agreed-upon Strategic Asset Allocation—especially as retirement approaches.

♦ Performance Measurement and Evaluation. Measuring and evaluating performance provide an opportunity to compare the relative success of a client’s investment strategy with stated objectives and relevant benchmarks. Performance attribution indicates how significantly asset class, sector, individual security, currency, and country exposure contribute to fluctuations in a portfolio’s market value. Comprehensive analysis of a client’s total portfolio provides all relevant information used to evaluate the achievement of a client’s investment objectives and make informed decisions.

Investment performance should be calculated in accordance with industry standards and should represent the results fairly, accurately, and completely. Portfolio managers should select performance benchmarks that are measurable, appropriate, reflective of investment style, investable, and unambiguous.

This dynamic process does not end here, and it is for this reason that periodic meetings with your investment professional are so important. Quarterly or semiannual meetings are obviously a time to focus attention on the value added by disciplined rebalancing and risk management, but they also present an ideal time to discuss whether your needs or circumstances have changed, document changes in Investment Policy, and adjust the overall asset allocation as necessary.