I recently had the opportunity to review the retirement portfolio for a tax professional I respect greatly. He, like most practitioners, is highly competent and renders excellent advice and service. I have introduced him to clients on a number of occasions and have always been glad I did. And, while I was pleased to be asked, I expected my review of his portfolio to be entirely pro-forma. Surely a practitioner of his stature would have a retirement portfolio with few, if any, issues.
I suppose I should have known better. Expertise in one area does not always translate into competence in another. There were some important things he did not know about his retirement investments. The primary issues had to do with diversification and the value received for fees paid.
Diversification
Diversification is such an accepted principle of investing that it is easy to forget there was a time when such wasn’t the case. Until Harry Markowitz published his seminal study on portfolio allocation in 1952, the beginning of what we now call Modern Portfolio Theory, the prevailing approach to investing was to pick individual high-yielding stocks without regard to their effects on a portfolio as a whole.
But, just because we accept the concept of diversification as a way to mange a portfolio’s risk (variance) does not mean it is always applied effectively.
A common approach to achieve diversification is to use mutual funds. Mutual funds, due to economies of scale and professional management, are helpful as diversifiers. But, there is more to diversification than simply owning several mutual funds.
My practitioner colleague held ten different mutual funds with ten supposedly different investment objectives (real estate, health, tech, etc.) Yet five of these ten funds featured a position in the same company. Which company is not particularly important (it was Microsoft), what is important is that my friend thought he was diversifying when, in reality, he was duplicating.
The thing he needed to know but didn’t was the actual investments owned by his mutual funds.
Sector funds
Another enemy of diversification is the “sector” mutual fund. These are funds that concentrate on a particular industry or life-style interest. Common examples include funds focused on technology, health care, precious metals, or leisure pursuits.
Such funds, by definition, limit their investment focus to a narrow slice of economic activity. Investing in them is akin to placing a bet on a particular sector of the economic pie. Five of my friend’s funds were sector funds.
The thing he needed to know but didn’t was that that sector funds limit, rather than enhance, diversification.
US versus foreign
Another common diversification oversight is to be too concentrated in U.S. companies. There is a natural comfort that comes from investing in familiar, well-known companies. However, this is not always an advantage when diversification is the goal.
International companies make up nearly 70% of the market value of all global stock values. And, while it seems as if the global economy is blending together, the reality is that U.S. stocks and international stocks tend to rise and fall at different times.
Further, global diversification also means currency diversification. If, for example, you own European companies in your portfolio, not only do you profit from their business growth, you also gain the added benefit of transacting that business in Euros.
What my friend needed to know but didn’t is that his mutual funds were only 19.4% invested in international stocks.
Big vs. small
Another great way to diversify is to own small companies along with big companies. Small company stocks, due to their added risk, generate greater returns than the shares of large companies.
What makes them an excellent tool of diversification is that small company stocks tend to rise and fall at different times than their large company cousins.
Only 6.3% of my friend’s portfolio was invested in small company shares and all of that was in the United States.
What he needed to know but didn’t was that adding small company investments, both international and U.S., is an effective way to add return and offset the volatility of his large company investments.
What my friend didn’t know was where he had actually invested his money and how to effectively diversify. He, like most, thought he was diversified because he owned several mutual funds. Others think they are diversified because they work with more than one broker.
The key to effective diversification lies in the “asset classes” actually owned. The key is to own stocks in asset classes that have deliberately different price movement behavior. Owning large and small company stocks in the US and abroad is a good start.
Value stocks
A further dimension of diversification is to add “value” stocks into the mix. Value companies (companies whose accounting or “book” value is high relative to its market value) reward their shareholders with greater returns than so-called Growth companies.
Value and Growth stocks demonstrate dissimilar price movement behavior much like large and small company stocks.
The best way to define an effective plan of diversification is to own mutual funds that own stocks in the following asset classes:
| Large U.S. Growth | Large International Growth |
| Large U.S. Value | Large International Value |
| Small U.S. | Small International |
| Short-term U.S. Fixed Income | Short-term Int’l Fixed Income |
I add Short-term Fixed Income as an additional way to moderate portfolio volatility. Not everyone is suited to own an all-stock portfolio. Depending on personal goals and objectives and individual risk tolerance the addition of short-term fixed income is a great way to customize a portfolio.
Costs and Fees
Fees and costs present an even greater challenge for most investors because they don’t know what to look for or where. A good place to start is whether or not a mutual fund imposes an up-front fee on each new investment, a front-end load or commission.
There is no good reason to pay front-end loads in this day and age. My friend got this one right. He knew he needed to eliminate this cost by only investing in “no-load” mutual funds, funds that do not impose an upfront fee for investing.
But, front-end loads are only the beginning. Every mutual fund is run by an investment manager who charges a fee to the fund for the advisory and management services they provide.
This fee is called the “expense ratio” because the fee is expressed as an annualized percentage of the total assets in the mutual fund. Expense ratios are not standardized and can range from 10 basis points (1/10 of one percent), like for Vanguard’s S&P 500 Index fund, to nearly 2.0% per year for some actively managed international small company funds.
My friend’s mutual funds were “actively” managed. In other words, the fund managers were actively seeking, through their research, to identify the best stocks to own and the best time to own them.
Their research activities were reflected in the expense ratios of my friend’s funds, which ranged from 1.03% to a high of 1.66%.
While how much you pay for fund management is an issue, what you get for what you pay is even more important. The question is, “Does the fund manager add sufficient value for the fee they charge?”
The answer to this question is found in a calculation known as R2 (R squared). R2 is a statistical measure that represents the percentage of a fund or security’s movements that are explained by movements in the market. In other words, R2 determines how much of the returns generated by a mutual fund are due to the market as a whole (the asset class) versus the value added by the fund’s management. The calculation is expressed as a percentage and ranges from zero to 100.
A high R2 means that the market has had more to do with a fund’s performance than the manager’s stock picks. My friend’s mutual funds had R2 calculations that ranged from 94 to 98.
What my friend didn’t know but should have was that he was paying a premium to his fund managers to get what the markets were essentially offering for free. He would have been better off investing in a passively managed asset class (“index,” for lack of a better term) funds with substantially lower expense ratios.
Quality no-load asset class mutual funds have expense ratios of 0.60% and lower.
My friend also didn’t know that he was paying a 0.25% annual 12b-1 fee on each of his funds. 12b-1 fees can be imposed on mutual funds over and above the cost of management’s investment advisory activities to defray marketing and service related expenses. They are usually paid to the brokerage firm who originally sold the fund to the investor.
The irony of the fee in this case was that my friend did not use the services of a broker or a brokerage firm. He purchased his funds directly from the mutual fund company. He needed to know but didn’t that he was paying an additional 0.25% per year for services that weren’t needed or even being provided.
All of this information is publicly available through morningstar.com, finance.yahoo.com and schwab.com.
Conclusion
Effective diversification and diligent cost management can enhance returns and significantly lower risk over time. A knowledgeable, professional investment advisor can help clients gain an understanding of what they don’t know but need to know in order to reach their important long-term financial goals.
