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Pay Attention to the Details: Don’t Overlook the Obvious in Portfolio Construction

We all want to build great portfolios for our clients. But in our effort to gain a performance advantage for our clients sometimes we overlook the obvious.

In 2010, Morningstar studied the relationship between low fees and mutual fund performance. They found: “In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.”

Vanguard did a study in 2015 that measured the effectiveness of different factors in predicting mutual fund performance. They found: “The ex-ante expense ratio separated poorly performing funds from better performing funds more successfully than all other metrics…”

In another Vanguard study, they compared the returns of mutual funds in the lowest cost quartile with funds in the highest cost quartile in different asset classes over the 10 years ending in 2013. Again, the low-cost funds beat the high cost funds in every asset class.

Clearly you don’t get more by paying more. Here’s how to incorporate this reality into your investment process.

Keep a watchful eye on:

  • The internal expenses of the funds and ETFs in your portfolios
  • Ongoing trading and rebalancing costs incurred in managing the portfolios

Almost everyone understands the theoretical importance of keeping an eye on fees and expenses, but far fewer do it in practice. Yet it can make a huge difference to your clients over their investment time horizon. Here are some examples. (All transaction costs are estimates that include allowance for the bid/ask spread on ETFs.)

Let’s say you have a client who needs a standard 60/40 balanced portfolio. The average expense ratio for a balanced fund in the Morningstar database is about 87 basis points. You could buy the “average balanced fund,” or you could build a perfectly good balanced portfolio with internal expenses of under 10 basis points using ETFs. The difference is 77 basis points.

If you build your client an eight-position portfolio using ETFs, the transaction costs might be around $80. Or you could build a 16-position portfolio using actively managed funds. That might cost around $320. The difference is about 24 basis points for a $100,000 account.

If you rebalance your eight-position portfolio annually and trade one-quarter of your positions, your annual rebalancing costs could be about $20. If you rebalance your 16-position portfolio quarterly and trade one-quarter of your positions each quarter, your annual rebalancing costs would be $320. That’s an annual difference of about 30 basis points for a $100,000 account.

You can see how fees, expenses and transaction costs can add up and detract from your clients’ long-term investment returns. In the Morningstar study referred to earlier they found: “Each 1 percent in additional fees eats up 28 percent of the ending value of an account over a 35-year span.” You can see that saving even 1 percent annually could fund years of additional retirement for your clients.

My point is not to advocate for the use of ETFs or for any particular approach to portfolio management. But I do want to underscore the significant impact that paying attention to the details can have on a client’s long-term financial well-being.

It’s easy to build portfolios with many high-cost positions and trade them frequently. Some people might even equate the complexity, all the moving parts and the frequent activity with more sophistication. But, as Leonardo da Vinci said, “Simplicity is the ultimate sophistication.”

scott-mackillop
Scott MacKillop is CEO of First Ascent Asset Management, a Denver, Colo.-based firm that provides investment management services to financial advisers and their clients. He is a 40-year veteran of the financial services industry. He can be reached at scott@firstascentam.com.