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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 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.



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Portfolio Management Beliefs and Practices That May Harm Clients

A number of beliefs and practices have grown up in the area of portfolio management that may be detrimental to the financial well-being of clients. Here are a few of them.

The MPT problem. Modern portfolio theory is an elegantly wonderful confluence of insight and mathematics. Efforts to implement MPT have not been as beautiful as the theory itself.

To build an “optimal” portfolio you must know three things—the future expected returns, volatilities and correlations of the asset classes in your portfolio. Unfortunately, no one knows what those numbers are.

Optimal portfolios are like unicorns—they don’t exist in real life. Nevertheless, we act as though our capital market assumptions have a magical predictive quality. If they tell us to trade, we trade, thus incurring transaction and tax costs.

Let’s recognize that our capital market assumptions are guesses about the future, but the fees and expenses we incur trying to stay locked onto our optimal allocation are real.

The rebalancing problem. Even if our expectations about the future have not changed, we feel compelled to tweak our portfolios to bring them back to our “optimal” mix. This is called rebalancing.

Research suggests that its utility is dependent on factors such as time period, the direction of the market and the relative future expected returns of the asset classes being rebalanced. Yet we employ simple, mechanical rebalancing strategies that generate plenty of transactions, but add little or no value. A more thoughtful approach could improve results and reduce costs.

The style-drift problem. Just to make sure everyone knows how much we love our optimal mix, we punish active managers who commit the sin of “style drift.” Forget the fact that the manager was led astray by a perceived opportunity to make money. We want them to strictly adhere to their mandate. Even though we hired them for their skill, we want them to be closet indexers.

The asset class selection problem. Another problem is that most of us do not have a scientific process for selecting the asset classes we use in our portfolios. We just keep adding asset classes until it feels about right. Remember, every additional asset class brings with it additional transaction and tax costs.

Fear of volatility. Ah, volatility reduction. Is that a good thing, or a bad thing, or does it depend? Certainly all things being equal we’d like less volatility rather than more. But we rarely have the choice of getting the same return with less risk if Mr. Market is being efficient.

We get paid to take risk and to generate the returns our clients need; we must experience some volatility. Let’s not become overly fixated on eliminating it.

The data-mining problem. It has become popular to use our massive computing power to mine data in search of winning patterns in the historical tea leaves. Some of these patterns take the form of “factors” that, we are told, will allow us to tilt our portfolios in one direction or another to give us an edge.

In investing, there is no strategy that always wins. The future rarely replicates that past. Let’s set our expectations and those of our clients accordingly.

Conclusion. Every portfolio we manage has a client attached to it. We should examine our beliefs and practices to make sure they are consistent with the best interests of those clients.



Scott MacKillop
First Ascent Asset Management
Denver, CO

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Letting Go of Relationships

Compared with professionals in other industries, financial advisers typically enjoy uniquely satisfying relationships with their clients. One reason is that “clients for life” is more than a catchphrase. Given the myriad of critical financial issues, life circumstances, and market volatility that can occur in any 10- or 20-year period, it’s no surprise that deep relationships develop.

But what happens when it’s time to let go of these relationships so a new adviser can take over?

Time for transition
No matter how competent the new adviser, nor how well honed his or her relationship skills, the new adviser is often stepping into a situation where both the original adviser and the client are grieving the loss of the relationship. Two things can happen: in the healthy approach, the client and the original adviser mutually agree to let go of the past and foster the development of the new relationship. In the unhealthy approach, the client and/or the adviser holds on to the existing relationship for dear life, which could undermine or even sabotage the relationship with the new adviser.

For example, it’s not unusual for the original adviser to think that his or her way of doing things is best. Although a new adviser may do some things similarly, the likelihood that his or her way of doing business will be exactly the same is small. That’s true even when the new adviser is the child of the transitioning adviser. If the original adviser feels the need to swoop in and mediate, the relationship between the client and the new adviser certainly won’t get off on the right foot.

So what can advisers transitioning out of the business after decades-long relationships with clients do?

  • Acknowledge that leaving one’s career may create a sense of loss. For some, you may even go through a grieving period similar to when you lose a loved one. In such cases, it may be tempting to keep tabs on client relationships. If keeping tabs is purely personal or “golf-based”—fine. But the original adviser should avoid interfering with the professional relationship between the client and the new financial adviser.
  • Those transitioning out of the business should seek the counsel of those who have experienced the same process. Sometimes the transition out of a long-term career can lead to depression, especially in the last third of life. Another adviser who has already gone through the transition process may provide a good sounding board.
  • Plan for a transition early. Both the original and the new adviser should budget ample time for joint meetings with clients to transfer knowledge and to foster the transfer of the professional advisory relationship.

The bottom line is both advisers must do what’s best for the client—even when it means letting go.

Joni Youngwirth_2014 for web


Joni Youngwirth
Managing Principal of Practice Management
Commonwealth Financial Network
Waltham, Mass.