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Implementation of Your Portfolio


Now that we've covered the elements of portfolio design, we'll move onto implementation, which is done in three phases: 1) custodian selection, 2) product selection, and 3) selection of asset location.

Last week we discussed designing a portfolio, which involves developing the best mix of different asset classes to best meet your financial needs. The next phase of the portfolio management process is to implement your design, which is done in three phases: 1. Select a custodian; 2. Select your products; and 3. Select your asset location.

With regard to custodians, some investors choose to leave their assets in the custody of each of the fund families they own, sometimes leaving them with five or more custodians. The problem with this is that trading to implement and rebalance the portfolio becomes extremely difficult and time consuming. We’ll further discuss rebalancing in the next blog, but it is certainly more cost efficient to rebalance with fewer custodians. While it may be most cost effective to have only one custodian, we recommend keeping your assets with two. In this day and age, with Bear Stearns and Lehman Brothers now bankrupt, it is a good idea to diversify where your money is held as well as how it’s invested.

The next implementation phase is product selection, which is the criteria for how you choose your products and how you diversify within each of your designated asset classes. We recommend choosing low-cost, style-specific products that tightly adhere to your desired asset class. For example, index funds like the S&P 500 Index Fund invest exclusively in that particular index, so you can be assured that all of your investment would be in U.S. stocks in this instance.

On the other hand, some actively managed funds may identify themselves as a U.S. growth stock fund, but may have a small stake in bonds to boost yield. Our philosophy is you should know exactly how your money is invested. If you want bonds, look into a bond fund. You don’t need a bond holding in your stock funds. That is one of the reasons why we recommend style-specific funds and Exchange Traded Funds (ETFs). Another reason is that historically the vast majority of active traders fail to beat index returns over the long-term.

After you have selected your products, the last step is to decide where to locate them. Will they be housed in a tax-deferred or tax-exempt vehicle such as an IRA or 401(k), or will they be in a taxable account? In today’s tax environment, you want your tax efficient investments in a taxable account and your tax inefficient investments in a tax-sheltered account. Junk bonds and other high-yield investments should be in tax-sheltered accounts to avoid current federal income taxes which can be as high as 35%. By contrast, because of the preferential capital gains tax (currently 15% for long-term holdings), growth stocks should be in a taxable account. Should the tax code dramatically change, remember, you can always change your allocation within a tax-sheltered account at any time without tax consequences.

To help you locate your assets properly, rank your asset classes in order from low-tax to high-tax, and plug them in to the most appropriate account. Don’t be concerned that your assets may grow disproportionately. Think of your money collectively as one big pot of gold. Proper asset location will produce savings with regard to both expenses and taxes and facilitate the most efficient growth of your assets over time.

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Victor J. Dzau, MD, gives expert advice
Victor J. Dzau, MD, gives expert advice