Institutional Asset Class
Mutual Funds: The New Paradigm
The concept
for institutional asset class funds (IACFs) was born out of Modern
Portfolio Theory (MPT). The theoretical foundation for
MPT was published by Harry Markowitz in 1952. Along with two associates;
Markowitz won the Nobel Prize in Economics in 1990 for his work on
the subject. Other academicians gravitated to this logical process.
Eventually, enterprising individuals implemented the MPT methods
by creating the asset class funds now available for investors through
independent registered investment advisors.
Institutional
asset class mutual funds are designed to deliver the investment
results of an entire asset class – such as large U.S.
value stocks or small international. These asset class funds are
best suited to create efficient portfolios that promote super-diversification.
There
are four important characteristics of institutional asset
class mutual funds:
1.
Lower Costs. The IACFs are true no-load funds. They
have no front or back-end loads, redemption fees or 12b-1 marketing
expenses. They
are also 100 percent liquid at all times.
All
mutual funds have operating expenses. These expenses are expressed
as a percentage of assets and include management
fees, administrative
charges and custodial fees. The average annual expense ratio
for all retail equity mutual funds was around 1.59 percent
in 2003.
In comparison,
the same expense ratio for an institutional asset class portfolio
was typically around 0.50 percent. These lower costs naturally
lead to
higher net rates of return when compared with
more expensive funds.
2.
Reduced Turnover. The average actively managed mutual
fund routinely has turnover rates in excess of 100 percent. This
is because they
attempt to add performance by trading often within a fund.
This high turnover means that if a fund holds 100 securities
at the
beginning
of the year, at the end of the year all of them would have
been sold
and perhaps repurchased.
A high
turnover ratio usually means that active management (timing and
picking) is taking place. This high turnover
is costly because, other hidden costs including
commissions, trading spreads and market impact costs have
a negative effect.
These hidden costs can even amount to more than a fund’s
total operating expenses if the fund trades frequently
or if it invests in a more inefficient
market (such as small company or international stocks where
trading costs can be even higher).
In addition,
highly active investors can cause excess turnover by chasing after
performance. They move from fund to
fund looking for
hot asset
classes or managers. This can force fund managers to
buy and sell even more often than they might like. These
return-chasing
investors
do
not pay their share of the transaction costs they create.
They
buy and sell at net asset value (NAV), freeloading on
the backs of long-term
investors who remain in the funds.
By contrast, institutional asset class mutual funds have
low turnover rates. They use an objective portfolio filter9
to
determine holdings,
which usually results in less than 33 percent turnover
per year. This keeps costs low, which in turn improves
performance.
3.
Tax Efficiency. Mutual funds are required to distribute 95 percent
of their taxable income each year (including
realized capital gains)
to remain tax-exempt. Managers do not want to have
their fund performance reduced by paying corporate income
taxes.
Therefore,
they distribute
all their income annually.
Taxable
distributions can have a negative effect on the rates of return
of equity mutual funds – particularly those that are involved
in active management. The frequent trading that is
utilized in an attempt to add value often results in short-term
capital gains in a rising
market. This means tax rates are in the 35 percent
range potentially vs. the 15 percent (10 percent for lower incomes)
long-term capital
gains rate. Because asset class funds are holding
their positions based on structured criteria, even the 33 percent
turnover is typically more
apt to result in long-term gains taxed at the lower
15 percent rate. This inherent characteristic provides much more
tax efficiency.
4.
Consistent Portfolio Allocation. Research has indicated
that the largest determinant of portfolio
performance
is asset allocation.
In other words – how the portfolio is divided
among different asset classes. Efficient asset
allocation is accomplished when the
mutual funds in your portfolio maintain their allocation
integrity. Most active managers change their fund
asset class percentages over
time. They may change their composition by moving
from growth to value or small to large or even
stocks to bonds. In addition, they often
increase or decrease their cash balances based
on cashflow requirements and market situations.
These ad hoc allocation adjustments, known as
fund drift, create portfolio inefficiencies and
can significantly change the composition of a portfolio
over time.
By using
active managers an investor will give up control of the asset allocation
to the managers
of
the mutual
funds. Since
the
managers do not know each investor’s situation,
they make allocation decisions based on their
needs -- not the client’s (misaligned interests).
A distinct advantage of IACFs in this regard
is that clients are able to maintain their asset
class allocation exposures as documented in
the investor’s investment policy statement.
Now
that we have discussed the building blocks themselves, we will
combine the principles
we have learned to
build an efficient
Market
Return Portfolio™ model.
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