60/40 Strategic Allocation Portfolio, 3rd Quarter 2012 Series
Investors have long recognized the importance of balancing risk and creating diversification by dividing assets among major asset categories such as stocks and bonds. Finding the right mix of investments is a key factor to successful investing. Because different investments often react differently to economic and market changes, diversifying among investments that focus on different areas of the market primarily helps to reduce volatility and also has the potential to enhance your returns. We believe there are three hallmarks to a successful long-term investment plan-asset allocation, diversification, and rebalancing.
The 60/40 Strategic Allocation Portfolio is a unit investment trust that has
been developed to provide investors with asset allocation, diversification,
and an annual rebalancing opportunity through a single investment.
The Importance of Asset Allocation
Perhaps the most important investment decision is not the specific investments that are selected, but it's the manner in which the assets are allocated. Asset allocation is the process of developing a diversified investment portfolio by combining different assets in varying proportions. Spreading capital across a range of investments within each major asset class makes your portfolio less dependent on the performance of any single type of investment. Studies have shown that the number one factor contributing to a portfolio's performance is asset class selection and not security selection.*
Diversification makes your portfolio less dependent on the performance of any single asset class. The adjacent chart illustrates the annual performance of various asset classes in relation to one another over the past 20 years as well as a diversified portfolio consisting of an evenly-weighted combination of the asset classes. As you can see, the performance of any given asset class can have drastic changes from year to year making it nearly impossible, even for the most astute investors, to accurately predict the best combination of asset classes to maximize returns and minimize risk. It is important to keep in mind that diversification does not guarantee a profit or protect against loss.
The Relationship Between Risk and Return of Stocks & Bonds
As risk increases in an investment portfolio so do the return expectations. Investors can manage their risk tolerance through asset allocation and by selecting investments that meet their risk/return expectations. Effective asset allocation requires combining assets with low correlations—that is, those that have performed differently over varying market conditions. Investing in assets with low to negative correlation can reduce the overall volatility and risk within your portfolio and may also help to improve portfolio performance. The adjacent chart illustrates the effects of low correlation on the risk and return of varying combinations of stocks and bonds.
Return is measured by average annual total return and risk is measured by standard deviation for the 30 year period from 1982 to 2011. Standard deviation is a measure of price variability. The higher the standard deviation, the greater the variability (and thus risk) of the investment returns.
Rebalance to Avoid Unnecessary Risk
According to the College For Financial Planning, less than 45% of investors actively rebalance their portfolios after the initial allocation. Over time, the asset mix in a portfolio can begin to drift from its original allocation. If an asset class performs well for an extended period of time, it can grow to become a higher percentage of a portfolio and subsequently have a much higher impact on the intended overall risk and return of the portfolio going forward. Rebalancing can be a crucial element to helping reduce risk while ensuring a portfolio remains aligned with an investor's intended investment plan.
Consider the example in the chart below which shows the effect that changing markets can have on an asset allocation that is not rebalanced over time. The example begins with an equal investment between stocks and bonds in 1992. The investment is held and not rebalanced through the end of 2011, an especially volatile time in the markets. By the end of the 1990s, the non-rebalanced portfolio's assets had shifted to 72% stocks and 28% bonds. The stellar stock market performance in the 1990s resulted in a portfolio with a significantly higher allocation to stocks just prior to the bear market which began in 2000 and made the portfolio subject to greater volatility than the investor may have originally planned.
With the Strategic Allocation Portfolios, rebalancing is simple. When a portfolio terminates, investors have the option to reinvest their proceeds, at a reduced sales charge, into a new, rebalanced and reconstituted portfolio. It is important to note that rebalancing may cause a taxable event unless units of the portfolio are purchased in an IRA or other qualified plan.
A Tactical Approach to Security Selection
Because stock prices are subject to factors that can make them deviate from
a company's true value,we believe evaluating each company based on time-tested
fundamental measures is key to achieving a higher rate of long-term success.
Our approach to selecting stocks is based on a proprietary rules-based selection
process which is consistently applied to select the stocks for all three Strategic
Allocation Portfolios.This process embodies key elements of our investment philosophy
by focusing on financial measures that are least susceptible to accounting distortions
and erroneous corporate guidance.
When selecting stocks for the Strategic Allocation Portfolios we apply a model
which analyzes large-cap, mid-cap, small-cap, and international stocks to assess
valuations based on multiple risk, value, and growth factors. Our goal is to
identify stocks which exhibit the fundamental characteristics that enable them
to provide the greatest potential for capital appreciation. This process is
unique and represents a critical point of differentiation from indexing and
other management styles.
For the fixed-income portion of certain of the Strategic Allocation Portfolios
we include exchange-traded funds (ETFs) which invest in fixed-income securities.
Incorporating ETFs which invest in a broad range of fixed-income securities
results in distinct portfolios with varying risk/reward profiles. ETFs provide
investors with several benefits, including diversification, transparency, and
tax efficiency, all of which align with the principles upon which our portfolios
Consider the Additional Benefits of Our Investing Process
The Strategic Allocation Portfolios provide you with the convenience of asset allocation, diversification, and an annual rebalancing opportunity in one investment. Each invests in a fixed portfolio of securities which are selected by applying our disciplined investment process. These portfolios offer several important advantages:
- Complete portfolio transparency - Individual portfolio holdings and their
weightings are available daily.
- Low cash positions so more of your money is put to work.
- "Style pure" portfolios - Each component of the allocation contains
securities selected specifically for the stated style and investment objective
of its asset class, ensuring that the portfolio is "style pure" on the initial date
- No overlap - When constructing the portfolio we select a unique set of
securities for each asset class within the portfolio ensuring that there is no
overlap. Avoiding overlap is a common obstacle when building an
allocation on one's own.
- No manager driven style drift - Because each portfolio's holdings are
clearly defined and are not actively managed, there will be no style drift as a
result of manager driven trading. There can be, however, changes to a
portfolio's style from changes in market conditions.
- Diversification, discipline, and a periodic rebalancing opportunity helping to
decrease volatility and potentially increase returns.
You should consider the portfolio's investment objectives, risks, and
charges and expenses carefully before investing. Contact your financial advisor
or call First Trust Portfolios, L.P. at 1.800.621.1675 to request a prospectus,
which contains this and other information about the portfolio. Read it carefully
before you invest.
An investment in these unmanaged unit investment trusts should be made with
an understanding of the risks involved with an investment in a portfolio of
common stocks and/or exchange-traded funds. (ETFs)
Common stocks are subject to certain risks, such as an economic recession and
the possible deterioration of either the financial condition of the issuers
of the equity securities or the general condition of the stock market.
ETFs are subject to various risks, including management's ability to meet the
fund's investment objective, and to manage the fund's portfolio when the underlying
securities are redeemed or sold, during periods of market turmoil and as investors'
perceptions regarding ETFs or their underlying investments change.Unlike open-end
funds, which trade at prices based on a current determination of the fund's
net asset value, ETFs frequently trade at a discount from their net asset value
in the secondary market.
An investment in a portfolio containing small-cap companies is subject to additional
risks, as the share prices of small-cap companies are often more volatile than
those of larger companies due to several factors, including limited trading
volumes, products, financial resources, management inexperience and less publicly
Certain of the ETFs invest in TIPS. TIPS are subject to numerous risks including
changes in interest rates, economic recession and deterioration of the bond
market or investors’ perception thereof.
Certain of the ETFs invest in U.S. Treasury obligations which are subject to numerous risks including higher interest rates, economic recession and deterioration of the bond market or investors' perceptions thereof.
An investment in a portfolio containing equity securities of foreign issuers
is subject to additional risks, including currency fluctuations, political risks,
withholding, the lack of adequate financial information, and exchange control
restrictions impacting foreign issuers. Risks associated with investing in foreign
securities may be more pronounced in emerging markets where the securities markets
are substantially smaller, less liquid, less regulated and more volatile than
the U.S. and developed foreign markets.
Certain of the ETFs invest in taxable bonds.Taxable bonds are subject to numerous
risks including higher interest rates, economic recession, deterioration of
the bond market or investors' perception thereof, possible downgrades and defaults
of interest and/or principal.
Certain of the ETFs invest in high-yield securities or "junk" bonds.
Investing in high-yield securities should be viewed as speculative and you should
review your ability to assume the risks associated with investments which utilize
such securities. High-yield securities are subject to numerous risks, including
higher interest rates, economic recession, deterioration of the junk bond market,
possible downgrades and defaults of interest and/or principal. High-yield security
prices tend to fluctuate more than higher rated securities and are affected
by short-term credit developments to a greater degree.
Certain of the securities in the portfolio are issued by REITs.Companies involved
in the real estate industry are subject to changes in the real estate market,
vacancy rates and competition, volatile interest rates and economic recession.
The value of the securities held by the trust may be subject to steep declines
or increased volatility due to changes in performance or perception of the issuers.
Although this unit investment trust terminates in approximately 15 months,
the strategy is long-term. Investors should consider their ability to pursue
investing in successive portfolios, if available.There may be tax consequences
unless units are purchased in an IRA or other qualified plan.