Functional Asset Allocation (FAA)

Modern Portfolio Theory, on which most asset allocation theories are based, focuses on diversification across asset classes to reduce the volatility (risk) of the portfolio.  Usually asset managers identify six to twelve different asset classes, and then use computer models to ascertain the "efficient frontier".  The efficient frontier is presumably the exact mix of investments in each asset class which has historically provided the highest return for a given amount of risk. While this approach may be suitable for managing large pension funds, most middle income people don't have enough zeros in their portfolio for this approach to be practical.  There are several other problems with implementing the theory which we won’t discuss here.

We call our strategy "Functional Asset Allocation" because, when working with families and individuals, each category serves an important function, or purpose, beyond simple diversification.  For example, while Real Estate is recognized as a separate asset class by most money managers, the value of your personal residence is more than a straight financial calculation.  A great deal of your home's value is in your own enjoyment.  Likewise, Functional Asset Allocation takes into account the reality that taxes are a driving force in Middle America.

While Modern Portfolio Theory seeks to optimize statistical returns on a passive, static investment portfolio relative to risk based on historical performance, Functional Asset Allocation uses a different paradigm.  It is based on optimizing value in the utilization of assets in a household, and on the psychological needs and life goals of real people in a dynamic society.  Interestingly, our experience and comparative analysis have found that Functional Asset Allocation not only provides most of the diversification benefits of Modern Portfolio Theory, but also yields a better after-tax return with less risk for Middle America.

Using Functional Asset Allocation, your assets should be distributed across three asset categories to accomplish specific purposes:

Interest Earning consists of two broad asset classes (Cash and Bonds) and serves the purpose of Capital Preservation.  We want to be sure you have adequate cash flow, regardless of what happens in the financial markets, in order to maintain your standard of living for a given period of time.  In the early stages of the Financial Life Cycle, we recommend you accumulate enough in this asset category to provide six to twelve months of liquidity, before making long term investments.  In later stages of life, our formulas are structured to provide a sure cash flow for ten, twelve or even fifteen years.  The appropriate attention to Capital Preservation in each stage gives you POM (Peace Of Mind) when you build Cambridge Model Portfolios.  To assure maximum tax efficiency, we recommend using primarily retirement assets to fund this category, except for the amount needed for day-to-day liquidity.

Real Estate is divided into three asset classes:

• Personal Residence
• Productive (including REITs and rental property), and
• Non-Productive (such as vacant land, second homes and passive limited partnerships).

The unique functions of real estate include personal use and enjoyment (as discussed previously), and the opportunity to leverage by mortgaging the property.  Positive financial leverage through a home mortgage provides Americans with the most advantageous after-tax investment vehicle in the world.  This is why we place so much emphasis on this asset category relative to what most investment managers recommend.

Equities includes four asset classes:

• Domestic mutual funds,
• International funds and Gold bullion (which hedge the dollar),
• Individual Stock holdings (segregated because of the higher volatility with little diversification), and
• Stock/Options from an employer (which carry a clear market advantage).

Equities are the growth engine, but subject to the most volatility.  Most standard asset allocation approaches ignore the reality that company stock plans are the driving force (requiring careful tax management) in the portfolios of many employees, and that "recreational investments" in stocks carry a different risk component because there is usually not enough money to adequately diversify.  We recommend using non-pension assets invested in passively managed or index funds to take advantage of low turnover and favorable capital gains tax rates.