By Ronald W. Rogé, MS, CFP®
We pride ourselves on being a completely transparent company – from our fee structure to our fiduciary oath. Although our overall Plan, Achieve, Live® strategy is evidence-based and time-tested, we are constantly learning and growing as financial professionals, always working with the goal of providing the most efficient and cost-effective services to our family of clients. In the spirit of transparency, we want to offer a behind-the-scenes look at our current blueprint for managing client portfolios and showcase the lessons we have learned about investing and portfolio management.
More than a decade ago, we realized that we were having difficulty controlling the amount of cash in our portfolios, due to the underlying mutual funds we were using. We also realized that we had issues of unexpected distributions from mutual funds. We conducted research into alternative products that would help us solve these concerns.
We concluded that the best way to resolve the problem was to begin using low-cost index funds in both a mutual fund and exchange-traded-fund (ETF) structure.
Along the way, our research also suggested that the role of foreign investments in a diversified portfolio was overstated in the new global economy – where most of the domestic large-cap revenue was being derived overseas. The solution was to begin eliminating direct investments in foreign securities.
Today, it is widely accepted and backed by research that indexing has a significant advantage vs. active managers for large cap equity. As many of our long-time clients might know, we used to pride ourselves on scouring the world to find the best actively managed mutual funds. It took a tremendous amount of self-reflection to acknowledge the shift in the investment environment and move away from what was once our investment philosophy. We still take pride in being able to say we recommended and used 15 mutual funds in our clients’ portfolios, back when Enron, MCI Worldcom, and Tyco went bankrupt, yet none of our recommended funds had a single dollar in any of those company’s stock.
The transition to index funds and ETF’s allowed improvement in the following areas of portfolio management:
- FEES: We were able to dramatically lower underlying fund fees; in many cases over a full percentage point.
- CASH: Many of the actively managed mutual funds, raise cash when they believe the market is overvalued, especially deep value mutual funds. In doing so, some of them had as much as 40% cash on hand, which created issues in managing how much cash was in our client portfolios. While our portfolio cash target may have been 3% to 5%, when we performed an x-ray analysis of the underlying funds in the portfolio, we found we were sitting on 15% to 20% cash, which could cause underperformance. Using index funds allows us take control of the cash position in our client portfolios because index funds are mandated to invest the cash back into the portfolio.
- TAXES: Many active mutual funds are tax inefficient. They can reduce our control of when capital gains are distributed, and our clients may or may not have participated in the performance depending on when they purchased shares. This was because the mutual funds had sold shares of the underlying investments and all its gains were shared equally by all the shareholders of that fund. Index funds, and especially ETFs are very tax efficient. In fact, we have found that our clients are less likely to be taxed unless they sell the ETF held at a profit. This usually occurs only when there is a need to rebalance a portfolio to control its risk exposure.
- RISK: Since academic studies 1 have shown that 90% of a portfolios return 2 can be attributed to the portfolio’s asset allocation, the use of ETF’s and index funds allows us to focus on the most meaningful ways to manage risk and return.
In reducing underlying fees by as much as 1%, gaining better control on cash position and risk, and increasing tax efficiency, this strategy shift, with all other factors being equal, has helped to improve the return to our clients. It is a great approach that has served us well.
In addition, our research into domestic large cap companies’ sources of foreign revenue led to our decision to eliminate direct investments into foreign securities, because it was overstating the foreign exposure in our portfolios. When coupled with the benefits stated above, this decision has also helped our clients with a not well-known underlying risk exposure.
Given all the positives that index investing provides, are actively managed mutual funds ever going to find there way back into our client’s portfolios? Sure! There are still areas of the market where using indexing and ETF’s may not be appropriate because they are inefficient, or illiquid (hard to purchase and sell smaller securities). When using index funds or ETF’s size does matter due to liquidity issues.
Also, strategies like event-driven, merger, and arbitrage do not work well in a passive, index-based strategy. Smaller company stocks can provide active managers with opportunities to find undiscovered investment opportunities.
Some other characteristics we favor in actively managed funds include investing with a team, instead of a star manager, and only investing with managers that know their size limit. Star managers eventually leave and it’s important to have continuity in a strategy over the long run. Any actively managed fund we choose to invest with will have a maximum capacity limit where they will close the fund to new investors.
Our last requirement is tight cash constraints on whatever strategy we invest in. Our clients were affected, in the past, by outsized cash positions. Now, we make sure that any potential active managers maintain their style discipline and are able to handle cash inflows in a responsible way, which may mean temporarily closing the fund to additional investment.
These requirements of our actively managed funds should help avoid some of the pitfalls that many portfolio managers, including ourselves, have experienced in the past. We believe they also provide us the greatest likelihood that our managers are set-up to provide the best returns possible for our client’s portfolios.
If you are interested in learning more about index funds or selective active management and the challenges and success we have had by using them in our portfolio management strategy, please reach out to us at 631.218.0077 or firstname.lastname@example.org. We would be happy to go into further detail and answer any questions you may have on this strategy or any other subject you may have.
R.W. Rogé & Company, Inc. helps clients Plan, Achieve, and Live the life they want. To learn more about how we do this, click here. To discuss your financial future with a knowledgeable Senior Wealth Advisor, contact us at 631.218.0077 or at email@example.com for a complimentary consultation.