PART I: WALL STREET'S FAILED METHODS

Chapter 1 - Market Timing

Chapter 2 - Stock Picking

Chapter 3 - Chasing Returns
 

PART II: CREATING WEALTH WITHOUT WORRY

Chapter 4 - The Financial Services Industry

Chapter 5 - Success for All

Chapter 6 - Building a Market Return Portfolio

(the following is an excerpt from Wealth Without Worry)

Chapter 6: Building a Market Return Portfolio

Institutional Asset Class Fund Characteristics

The concept for 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 naturally gravitated to this logical process.

Interestingly, multimillion-dollar institutional investors, such as pension plans and scholarship funds, have used both asset class mutual funds and Modern Portfolio Theory for some time because of their fiduciary responsibility to protect the investments placed in their trust. They have used these approaches in an effort to reduce the various risks to which their funds are exposed.

In the early 1990s, enterprising individuals implemented the MPT methods by creating the asset class funds now available for individual investors through independent registered investment advisors. Now these same techniques are available for anyone who is interested in the preservation of capital and its steady, long-term growth.

Institutional asset class mutual funds are designed to deliver the investment results of an entire asset class—such as large US 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 actively managed retail equity mutual funds was around 1.58 percent in 2004. In comparison, the same expense ratio for an institutional asset class portfolio typically averages around 0.40 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 near 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 one hundred securities at the beginning of the year, at the end of the year nearly 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, as discussed in chapter 2, 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 fair 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 objective portfolio filters to determine holdings. This process usually results in a turnover rate of less than 33 percent per year for equity funds. 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 versus the 15 percent (5 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 cash flow 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 particular situation, they make allocation decisions based on their own needs—not the client’s (misaligned interests). A distinct advantage of IACFs in this regard is that they fully maintain their allocation in their assigned asset class at all times. This means that investors are able to maintain their asset class exposures as specified in their 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.

Click here to continue reading: Using the "Portfolio Filter" for Fund Management  >>
 

 

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