Cornerstone Models-Essential Steps:

For many people, managing their investment portfolio is pure drudgery, and for some it seems nearly as dreadful as a root canal.  There are some people who truly enjoy the investing process, but this is the small minority.  As individuals, we often put more effort into buying gas at the cheapest gas station or maximizing our coupons at the grocery store than we do managing our money.  This is human nature.  We also feel inadequate in how to proceed.  The reality is that diligence related to our portfolios is orders of magnitude more impactful than our savings at the gas station or grocery store.

To help manage the investment process, Cornerstone provides a list of some key decisions that need to be made.  To start, Investors need to determine the mix of active and passive levels within their portfolios.  This determination involves many levels.

First, a decision needs to be made regarding whether you will utilize an adviser or whether you decide to be a DIY investor.  You may not need an advisor at the beginning if you are diligent about determining your Investment Objective and then buying an appropriate Asset Allocation fund.  However, a good adviser can provide comprehensive investment and planning services that can add significant value and can help meet your overall needs.  These services come at a cost, and the investment portfolio often includes a high level of expensive active investment management.  Advisers often charge 1%/year for investment assets, and they may have another 1% of active investment fund expenses.  If you are committed to a DIY approach, you will save costs (no 1% for the adviser and perhaps only 0.1% for passive index fund expenses), but you might make a number of bad choices.  You may have the wrong risk/reward investment objective, and you may make inappropriate financial planning and tax decisions.  These adverse actions (or lack of action) can significantly hurt your current and future financial well- being, so it is important to get a good solution.  Paying the costs for a good adviser is better for many people than paying a much higher cost of getting it wrong.  This is especially true as you build wealth and have more financial complexity.

Assuming that you decide to be a DIY investor, then a number of decisions need to be considered:

-The Investment Objective which can range all the way from Aggressive Growth to Capital Preservation.

-The asset class weights for the portfolio.  For example, what weights are assigned to US Large Cap, Mid Cap, and Small Cap.  Do you want any tactical adjustments between Growth and Value?  What is the mix between Domestic and Foreign.  For foreign, what is the mix between Developed countries and Developing countries.  Real Estate, Commodities and Hedge Funds.  Similar decisions need to be made for the Fixed Income weights.

-The passive index approach is recommended, but this requires decisions as well.

To be a DIY investor, you can consider using a Robo Adviser services, the Cornerstone models, or your own methodology.  Both the Robo Adviser service and the Cornerstone Models provide the structure for diversification, active/passive weights, asset class weights and security selection.  For example, most robo adviser services rely heavily on passive securities but they still make many active decisions, and there may be a range of fees for these services.  The Cornerstone Models also rely heavily on the passive index approach, but there are elements of active management as well.  Regardless of your approach, investing has many nuances and some key considerations are as follows:

-The first passive index funds were based on the market capitalizations of the index.  This meant that the larger stocks had a proportionately larger weight than the smaller stocks in the index.  This market cap weighting methodology means you will get an investment return that is very close to the index less the embedded fund expenses.

-An alternative to market cap weighting is to equal-weight the index.  With equal weighting, the investment performance is based on an equal weight.  This method gives the portfolio performance a tilt to smaller cap holdings and a tilt to the value investment style.

-There are dividend investment strategies.

-Another alternative is to use Fundamental Indexing.  The criteria for this methodology involves structuring an index based on company “fundamentals”.  These fundamentals often include a proprietary mix of revenue, cash flow, dividends and valuation (Price/Book).  Fundamental Indexing avoids the momentum effect that occurred most strikingly during the internet frenzy at the end of the 1990’s.  During that time, the technology sector soared until it peaked in March 2000.  The ensuing “tech-wreck” decimated portfolios, and especially market-based portfolios which kept buying over-valued assets that ultimately crashed.  Meanwhile, the fundamental indexes were constructed more broadly (revenue, cash flow, dividends and valuation), and did not keep overweighting the most expensive assets.  As a result, fundamental indexes did not rise as high, but they also did not plummet as far.  In general, fundamental indexes have more of a value tilt and they have been less volatile.  Fundamental indexes are sometimes referred to as “smart beta”.  There is no assurance that future fundamental performance will exceed market-based strategies.  Moreover, anything that gets labeled as “smart” after the fact is not as beneficial as a strategy that is called smart before it performs strongly.

Factor investing represents another strategy.  This strategy is based on historical analysis that shows persistent outperformance related to several “factors”:

Size:  Relative historic outperformance of small-cap stocks compared to large-cap stocks.

Valuation:  Relative historic outperformance of the value style compared to the growth style.

Quality:  Consistently profitable companies with lower debt have outperformed.

Momentum:  Positive price momentum outperforms in the short-term and negative momentum underperforms.

Low Volatility:  Assets with lower price volatility have outperformed.

Dividend Yield:  Companies with steadily growing dividends have outperformed.

Cornerstone is monitoring factor investing, but this strategy is not a significant part of our current model portfolios.

Some (like Vanguard) argue that anything beyond market cap weighting is a form of active management.  Others say indexing has simply evolved.  Regardless of your interpretation, Cornerstone supports a mix of market cap and fundamental investing.

CORNERSTONE MODELS AND SERVICES:

Cornerstone maintains the investment models based on our Investment Philosophy.  The models posted in this website include a Focused Model for smaller portfolios, or for single accounts.  The Base Model applies to larger portfolios.  Finally, a more comprehensive model is available upon request for more complex portfolios.  You can use these models for guidance related to your own investment process.  These models can be used for your whole portfolio, or in conjunction with other strategies and approaches.

Cornerstone models and services include sophisticated asset allocation and tactical advice based on valuation and other fundamentals.  The models have a long-term focus, but they incorporate short-term tactical adjustments.  For example I maintained an underweight risk profile during the precipitous market decline in 2008 and early 2009 and then over-weighted equities eleven days after the March 9, 2009 market bottom.  During this time most advisers panicked on the way down and didn’t get back in for years.  These advisers experienced major portfolio losses when the market was down, and then minimal recovery as the market rebounded upward.

The models can also be used as a basis for a second opinion related to existing portfolios and adviser recommendations.

Cornerstone Model Portfolios:

Although the tables are “busy’ and could use more “white space”, they do delineate the following:

-Weights by overall Investment Objective from Aggressive Growth to Capital Preservation.

-Weights for domestic equities (70% of total equities) and international equities (30%).

-Weights for International Developed (85% of international) and Developing Emerging Markets (15%).  So Developed international = 25.5% of total equities (30% X 85%) and Emerging Markets = 4.5%.

-Weights for alternative asset classes for Real Estate and Commodities.

-Weights for the Fixed Income categories.  Taxable fixed income weights should include municipal bonds.

-Weights for specific securities for all of the asset classes.

Using the Cornerstone Models:  To use the models you need to decide if you want the Focused Model or the Base Model.  Then select the column for your Investment Objective.  Finally, use the securities and weights for each asset class.  For example, the Focused Model with the Growth With Income Investment Objective specifies holding a 18.0% weight of the Vanguard Total International Stock Index fund-VXUS.  You then purchase 18.0% of your portfolio for the VXUS fund.  Then follow this procedure for the other recommended securities for your Investment Objective.

It is important to remember that volatile markets will cause some holdings in your portfolio to perform better than other holdings.  Therefore, your investment portfolio will need to be rebalanced back to the model levels over the course of time or during particularly volatile market moves.

Cornerstone Model Assumptions and Expected Returns:  The Cornerstone Models are constructed based on historic relationships and assumptions regarding future performance and risk.  The table below shows various Investment Objectives and the historic investment return based on the time period from 1990 through 2015.  The table also shows the Cornerstone long-term future Expected Return.  The Cornerstone Expected Return is lower than the historic return for several reasons.  First, current equity valuation levels are relatively high and are expected to revert back to the mean (average) return as we look to the future.  Second, historic fixed income returns were higher due to bond price increases as interest rates declined.  Interest rates are currently low and future bond prices may be negatively impacted by increasing interest rates.

Direct Personal Investment Analysis and Recommendations:  Cornerstone also offers direct face-to-face investment (limited by time availability) consulting primarily within the Twin Cities metro area.

Advice includes:

1. Determination of current and future income, spending and investment priorities.

2. Establishment of Investment Objectives for short-term, mid-term and long-term investment portfolios.

3. Asset allocation, diversification and security recommendations.

4. The basics of rebalancing and constructing portfolios using low-cost, low turnover, no-load passive/index portfolios.

5. Advice related to DIY activities and types of accounts.

6. Risk Analysis and risk assessment worksheet.

7. Advice related to help from financial advisors/planners (both fee and commission), the new robo-advisors, wealth management firms, and family offices.

8. Provide a stock selection/monitoring methodology, and stock research sources. I would not maintain a stock list because it takes too much time.

9. Second opinion. Advice regarding types of investment products (like should you do a Variable Annuity, and if so, then which one), the advisers you are considering, (I am knowledgeable of local advisors and wealth management firms and could make recommendations

10. Maintain credible, objective analysis and recommendations on 529s, Variable Annuities, and other investment products.

Although I enjoy stocks and hold stocks in my portfolio, I do not maintain a stock list.  I believe there are reasons for holding stocks in portfolios, but they require a solid rationale and disciplined process.  Cornerstone maintains criteria for holding stocks and more information is available from Jeff Johnson.

Institutional Consulting:  Finally, Cornerstone offers in-depth institutional-level research that includes data and forecast methodologies, proprietary econometric analysis, and capital market ssumptions.  Contact Jeff Johnson directly.