The four stages of an annual review

A top-down approach to assembling, analyzing and acting on portfolio data is advisable

Investment News
By Blaine F. Aikin
December 6, 2009
As the year draws to a close, fiduciaries should be turning their attention to one of their most important responsibilities: the annual portfolio review. This is a prime event conducted in the process of fulfilling the continuing fiduciary duty to monitor. It is the time when the fiduciary undertakes a comprehensive assessment of whether the investment objectives of the investors they serve are being met.
Monitoring involves four stages: gathering material information, analyzing the implications of the information, acting appropriately on the findings of the analysis and documenting the basis for actions considered and actions taken. Effective monitoring hinges on deciding at the outset what information is relevant to determining whether the current portfolio management process is meeting investor objectives and is likely to continue to do so. A top-down approach is generally recommended to assemble, analyze and act upon this information.
Start by addressing what has changed at a level above portfolio composition and holdings. Most importantly, consider whether the investor's objectives have changed, in which case there is a direct effect on what information is material, as well as on the decisions that will bring the portfolio management process into alignment with the new objectives.
Change in laws or regulations, the economy and the financial markets is also relevant to most portfolios. For example, 22 states this year introduced or enacted the Uniform Prudent Management of Institutional Funds Act. This should be a major discussion topic in the annual portfolio review process of most endowments and foundations in those states.
Similarly, the implications of historically high unemployment, unprecedented government stimulus spending and extraordinary market volatility have profound implications for domestic investments. While no one can say with certainty the precise nature and magnitude of these implications, the annual review process should demonstrate thoughtful deliberations of these matters and how they influenced investment decisions.
Next, examine portfolio composition and asset allocation issues. Performance of the broad asset classes over the past year and longer time periods is generally the focus of attention, but unusual volatility within certain asset classes and apparent changes in the correlation among asset classes are important factors for analysis. Even if certain asset classes are not represented in the investment portfolio being reviewed, it is advisable to consider a wide range of accessible asset classes for potential introduction to the portfolio.
Simply by improving the asset allocation of the portfolio, it may be possible to achieve higher-than-expected returns for the level of risk the investors are prepared to take. To make this determination, Monte Carlo simulation, mean-variance or re-sampled efficiency optimization, or a comparable analytical tool may be applied. Model portfolios supported by sound research and analysis may serve as the basis for decision making.
For participant-directed plans, changes in the available asset classes may be warranted, based upon findings from this stage of review.
If tactical asset allocation (a form of market timing) is employed in managing the portfolio, the value added by asset allocation moves should be carefully analyzed at this stage. The value of this approach can be assessed by comparing the results of tactical decisions against what would have been achieved by using a strategic benchmark allocation.
Finally, revisit the due-diligence criteria used to select the specific investments held in the portfolio and evaluate each position for shortfalls that may have developed. With respect to performance, each portfolio holding should be compared with an appropriate index and peer group benchmark. While manager performance is often the focus of attention during quarterly portfolio reviews, the annual review should be more comprehensive and balanced. In rough order of priority, an effective annual review process should result in sound decisions with respect to: current investor objectives and investment policy provisions, investment philosophy and strategy, asset allocation, re-balancing activities, and investment manager watch listing and replacement.
The annual review will be incomplete until the deliberations and decisions of the process have been recorded. These records help ensure that planned actions are taken and subsequent moves planned with the benefit of information previously considered, and demonstrate that a prudent process has been followed. That is especially important at a time such as the present, when an extraordinary investment environment lends itself to rampant second-guessing.
Blaine F. Aikin is chief executive of Fiduciary360 LLC.