5 Ways to Evaluate Your Portfolio
By Ron DeLegge, Editor
December 3, 2009

SAN DIEGO (ETFguide.com) – As 2009 comes to a close all investors should conduct a thorough self-examination of their investments. Why?

The chief purpose for analyzing your investments is to see if you’re making true financial progress or not. It’s impossible to know if you never look! An honest evaluation will also help you to find what areas of your investments you need to adjust.

Here are five key parameters to help you evaluate your investments:

Performance
One way to correctly analyze your investment portfolio is to look at its aggregate performance versus major benchmarks like the Dow Jones U.S. Total Stock Market Index (NYSEArca: TMW), the S&P 500 (NYSEArca: SPY), the MSCI EAFE Index (NYSEArca: EFA) and the Barclays U.S. Aggregate Bond Index (NYSEArca: AGG).  Make sure you evaluate your portfolio’s performance over the exact same time period.  Because there are exchange-traded funds (ETFs) that follow these major benchmarks, simply comparing the performance of your performance versus these ETFs will give you a realistic perspective of whether your investments are progressing or digressing.
 
Many mutual fund investors and analysts place undue attention on mutual fund performance relative to its corresponding peer group, when the true measure of performance should be a corresponding benchmark index. "Peer group" comparisons are dangerous,” stated William F. Sharpe, Nobel Prize Winner in Economics. Because the capitalization-weighted average performance of active managers will be inferior to that of a passive alternative, the former constitutes a poor measure for decision-making purposes. And because most peer-group averages are not capitalization-weighted, they are subject to additional biases.

Risk
The significance of your portfolio’s risk goes beyond statistical numbers like standard deviation. For example, many investors are subjecting themselves to manager risk by choosing a portfolio that’s 100% actively managed. What happens if your portfolio manager leaves, retires or loses their hot hand? Will your investment portfolio implode? Manager risk is a commonly overlooked dimension of portfolio risk that can’t be measured by numbers or statistics alone.

A properly designed portfolio will exactly match your acceptable level of risk. This is sometimes referred to as “risk tolerance.” Your investment time horizon, your age, your personality and your bottom line investment goals are other factors to consider too. Your investment portfolio’s asset mix should reflect a harmonious balance to each of these areas based upon your unique goals.

Diversification
The mis-application of diversification is a common investment disorder. For example, an investor may convince themselves they’re adequately diversified by owning five mutual funds that invest in large company stocks. However, true diversification is not achieved by the quantity of funds you own, but rather the diversity of asset classes they touch.

Many poorly designed investment portfolios lack market exposure to major asset classes like U.S. real estate (NYSEArca: VNQ), international real estate (NYSEArca: RWX), commodities (NYSEArca: GSG) and the most basic of all asset classes, cash.

Under-diversified portfolios can lead to frustration and disappointing results. Conversely, an over-diversified portfolio, won’t do you much good either. Strive to get diversified market exposure to major asset classes via low-cost investment vehicles, like index mutual funds or index ETFs.

Cost
Numerous academic studies have proven that investment cost is one of the most important factors impacting investment performance. Owning mutual funds with elevated expenses usually results in market underperformance. It’s an investment truth as sure as other basic truths, like the law of gravity. While none of us can control the performance of stocks or bonds, we can control the cost of investment management. Keep your fund expenses low.

In evaluating the true cost of your investments, it’s important to consider the entire spectrum of costs, not just mutual fund expense ratios. Other fund costs to watch for are your mutual fund’s brokerage costs, which are usually reported in the fund’s semi-annual or annual report. Your mutual fund’s brokerage expenses are an additional cost not included in your fund’s expense ratio. The cost of buying and selling securities in a fund’s portfolio is passed on to you, the fund shareholder. Therefore, it’s advisable to stick with mutual funds that have low transaction volume versus funds that are running up your tab with unnecessary brokerage costs.

Tax Efficiency
A 2008 Lipper study found that buy-and-hold investors with mutual funds in a taxable account surrendered between 1.3% to 2.2% of their annual returns over the past 10 years. In 2007 alone, the tax bite to fund investors amounted to a record $33.8 billion.  Minimizing the adverse impact of taxes should be a priority for all serious investors.

One step towards minimizing your tax bill is to invest in tax-efficient investments that distribute little annual capital gains. In this regard, ETFs can help you.

Morningstar recently conducted a survey on capital gains distributions for stock ETFs across 27 broad-based indexes. The study showed only two ETFs made capital gain distributions over the past 5-years while just one ETF made distributions over the past 10-years. Popular funds like the Dow DIAMONDS (NYSEArca: DIA), iShares MSCI Emerging Markets Index Fund (NYSEArca: EEM) and Vanguard Total Stock Market ETF (NYSEArca: VTI) continue to lead the pack in low tax distributions.

By carefully analyzing your investments in these 5 key areas, you can hopefully put your money on track and keep it there!