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A User's Guide to Portfolio Customization

What is it and what is it good for?

A User's Guide to Portfolio Customization Image.jpeg
Every wealth management firm we’ve spoken with strives to deliver “a customized solution.” It certainly sounds like it’s a good idea, but what does it really mean? What is customization, and how, exactly, does it benefit clients? What customization options are common (i.e., what are your competitors doing)? And how costly is it to provide customization?

We’re glad you asked. We thought we’d list the different kinds  of customization we see, and describe how each can be used to help investors achieve their goals.


Security Constraints, Sector Constraints and Custom Asset Allocation

Security constraints (“Never trade IBM," “Never buy MSFT,” “Never own Ford,” “Never sell GM,” “Purchase and hold X shares of Dell,” “Replace IBM with HP”)

Security constraints are the most commonly supported form of customization and can serve many purposes.

  • Ethical and legal restrictions
    A lawyer whose firm represents IBM may be prohibited by their employer from trading the security. If the lawyer has access to insider information, they may be legally prohibited from trading.
  • Counterbalancing employment or regional risk
    If a client works for Exxon—or if they just live in Houston—they already have exposure to Exxon’s success. It may make sense not to double down on this exposure by holding Exxon in their portfolio.
  • Counterbalancing outside holdings
    Likewise, if a client owns shares of Exxon in another account or owns employee incentive stock options on Exxon shares, it may be prudent to avoid further exposure.
  • Client personal preferences
    Clients may not like a company, either because of a bad experience with the company or a general disapproval of the company’s actions, and they simply don’t want to become an owner. Conversely, they may wish to support a firm whose conduct they approve.
  • Client return expectations
    Clients may have negative return expectations for a security and wish to exclude it from their portfolio (or at least not buy more). Or clients may have a positive return expectation and wish to make sure they hold some minimum amount of the security in their portfolio. Most advisors discourage this sort of thing in the belief that clients are unlikely to be good at stock selection, and talking about it distracts from more important conversations about financial planning and risk control.


Sector constraints (“Never own Energy stocks”)

The reasons for sector constraints are largely the same. The most common is counterbalancing outside holdings, or counterbalancing employment or regional risk. To use the same example as above, if a client works for Exxon, lives in Houston or has outside holdings in the energy sector — they already have exposure to the success of the Energy sector, and it may make sense not to double down on this risk. Sector constraints can also be used to reflect performance beliefs.

Ethical and legal restrictions on trading an entire sector, rather than individual securities, are rarer, but we have seen it.


Custom Asset allocations (“Reduce my Real Estate allocation to zero,” “Double my Real Estate Allocation to 10%”)

Custom asset allocation is usually motivated by a desire to counterbalance outside holdings. Less commonly, it is used to reflect a client’s performance beliefs.


Social Criteria Restrictions

Environmental/Social/Governance (ESG) Constraints (“Never buy Tobacco Stocks” or “Never own securities of companies with poor toxic waste spill records”) 

The motivation for ESG constraints is straightforward: clients simply don’t wish to be an owner of a company whose business or actions they disapprove of. This decision is made independent of return expectations.

Clients may in fact think that bad things will happen to bad companies. That is, they may think that these companies will perform poorly. But this isn’t social criteria investing; it’s just having an opinion on expected return performance.


Social impact mandates (“Buy companies whose products will help the environment”)

In contrast to ESG constraints, this is a positive screen.  It’s not about avoiding the bad; it’s supporting the good.

Social impact investing is trickier than applying ESG constraints because it may be hard to create a properly diversified portfolio investing only in firms with the selected positive social impact.


Custom Product Selection

In the old brokerage model, custom security selection was, in a sense, the main form of customization—brokers talked with their clients about various stocks and jointly picked the ones the client liked best. It’s notable that this type of customization is not high on the list of any firm we work with. We’ve never met an advisor who thinks it actually benefits their clients. On the contrary, advisors think it’s a distraction that reinforces a destructive view of what wealth management means and how it can help investors.

That being said, there is still a place for custom product selection. This is different than custom security selection and serves a different purpose:


Custom Product Selection (“I prefer all ETFs,” “I prefer Fidelity funds,” “I prefer a Direct Index for large cap US equities”)

For each asset class, clients may have a choice of how they’re going to invest. Common choices include one or more:

  • ETFs
  • actively managed mutual funds
  • actively managed proprietary basket of securities (i.e., direct ownership that bypasses the mutual fund/ETF structure)
  • actively managed basket of securities following third-party models (or an SMA managed by a third-party)
  • direct indexes

These choices come with different:

  • price points (ETFs, proprietary strategies and direct indexes being the least expensive)
  • levels of tax efficiency (direct indexes being the most tax efficient, then ETFs)
  • Minimum investments (ETFs and mutual funds having the lowest minimums)

The biggest divide is passive/active. Right or wrong, clients can hold strong beliefs in the active/passive debate, and it’s useful for firms to be able to accommodate these preferences.

The next biggest divide is commingled vehicle (like an ETF or mutual fund) or direct ownership of a basket of securities. The direct ownership is both less expensive and more tax efficient, but usually requires a larger minimum investment. 


Cash Management

Cash/liquidity constraints (“Min cash = $5,000,” “Max cash = $25,000”)

Clients have different liquidity needs. Usually, this takes the form of different minimum levels of cash. It’s a minor, but very common form of customization.


Reserve cash (“Do not invest cash if below $15,000”)

Some clients have regularly scheduled withdrawals. These clients need their cash management to be a bit forward looking. No one wants to invest cash on the 31st of a month, only to have to sell the purchased securities the next day to fund the next monthly withdrawal. The key is to set aside income up to some predetermined threshold, e.g., three months of withdrawals.


Glide Paths

Individualized glide paths (“Migrate the client from an Aggressive Growth allocation to a Conservative allocation smoothly over 30 years”)

A “glide path” is a multi-year path for migrating a client’s asset allocation as the client ages. Typically, glide paths move clients to less aggressive asset allocations, with updates on a quarterly or annual basis.


“Transitioning” is the multi-period process of migrating a new client’s portfolio from its current holdings to a recommended asset allocation and security selection. Most new clients have legacy holdings and can benefit from transitioning services. Institutional investors mostly worry about the potential market impact of large trades, and minimizing market impact is their major motivation for transitioning accounts. In contrast, individuals are mostly motivated by tax concerns.  They want to minimize gains, especially short-term gains, and spread the costs over multiple periods (either to smooth expenditures or to avoid being bumped up into a higher tax bracket). On occasion, a secondary motivation is “regret avoidance” — spreading out trades over time reduces the chance that everything is sold at a market low.

Some common tools for managing transition include:


Tax management, especially tax budgets (“Minimize realized gains, consistent with obeying constraints and controlling risk,” “Keep net capital gains taxes under $5,000/quarter”)

The main component of tax-sensitive transition is the same gains-deferral strategy of ordinary tax management. Phrased differently, all tax management, except for loss harvesting, is transition management — you’re managing trade-offs between taxes, drift and return expectations.  

Tax budgets are used to spread tax liabilities over time.


Turnover budget (“Max 5% turnover per quarter”)

Turnover budgets are less common than tax budgets, but can be useful for comforting a client who may be uncomfortable with a single “big bang” conversion.


Equivalence sets (“This is my recommended holding, but the following securities are “good enough” and shouldn’t be sold if they’re already in the portfolio”)

While advisors and the firms they work for usually have a default recommended product for each asset class, this product may be only weakly preferred to several alternatives.  If the client already owns one of these almost-as-good substitutes, there’s no real value in trading them — taxes aside, it may not even be worth the transaction costs. This logic can be addressed by setting up “equivalence sets” for every recommended security.


Tax Management

Last, but very much not least, there’s tax management. Tax management increases after-tax returns, and for taxable investors, it’s after-tax returns that matter. Tax management is arguably the single most important form of customization for most investors.

The purpose of tax management and its value to investors is obvious (see some of our previous posts Why We Created a Taxes Saved Report, Documenting the Value of Tax Management: 2017 Taxes Saved). We won’t go into detail about tax management here (we’ll pick that up in a separate post).


The above list of customizations is not exhaustive, but it covers most of what we see in common practice. With the likely exception of letting clients pick winners, every customization provides genuine value to investors.

And all of these forms of customization are becoming more common. Customization is not an advisor’s main value proposition, but it is becoming unacceptable not to offer it. Product-oriented value propositions (“we’re going to help you beat the market”) are in decline, replaced by financial planning and a back-to-basics need to do a better job of delivering genuine value. Customization fits the bill. There’s also no good excuse not to offer extensive customization. Rebalancing automation tools (like, well, ours) reduce the incremental cost of customization to near zero. As long as the customization can be stored as a parameter (e.g., “Never trade IBM”), implementing the customization is just folded into the rebalancing analytics. It takes time to talk to clients up front about the customization options, but no extra time or effort is required to actually implement the customization preferences once they’re selected.

The differentiating value of customization is not so much in the execution, which is becoming commoditized, it’s in figuring out what type of customization serves the client’s interests. That is where advisors shine. “Delivering a customized solution” is real. It’s feasible, economical and scalable. And it’s growing.


Related: Why We Created a Taxes Saved Report, Documenting the Value of Tax Management: 2017 Taxes Saved


For more on this topic, check out A Guide to Tax Management.

President, Co-Founder