Mark Brandon is the Managing Partner of First Sustainable (http://www.firstsustainable.com), a registered investment advisory catering to socially responsible investors. In addition to Socially Responsible Investing (SRI), he may opine on social venturing, microfinance, community investing, clean technology commercialization, sustainability public policy, green products, and, on occasion, University of Texas Longhorn sports.

Monday, December 12, 2005

Reason #1 to Fire Your Mutual Fund Company

Tenth in a Series

This is the last in my series dedicated to the proposition that small investors are getting ripped off with mutual funds thanks to a complex scheme of self-dealing and back scratching.

Reason #1 – There are better, cheaper, less-risky alternatives

As I have said many times in this series, active management would be palatable and worth the outsized fees charged by mutual fund companies if they consistently delivered superior performance compared to a pre-defined benchmark, but they do not. Less than forty percent of actively managed funds beat their benchmarks in any one year. Over several years, that percentage becomes infinitesimal. If I have not convinced you yet of the superiority of passive strategies, then I recommend you re-read some of the previous posts. The point of this post is to outline the vehicles that enable you to get these results. While I admit that I am biased, I will attempt to be balanced in the discussion by explaining the drawbacks.

Separately Managed Accounts (SMA’s)


At First Sustainable, this is the vehicle we recommend for investors with $50,000 or more to invest. An SMA is an account that is set up by your investment advisor, which allows you to hold your own portfolio of well diversified instruments. The advisory makes its money by either charging a fee as a percentage of assets under management, a flat fee per year, or an hourly fee for the advisor’s time. Trading commissions are either nominal or free. Your adviser should take into account your needs and then arrive at a portfolio that is, for lack of a better term, the “YOU” Index.

Benefits. I love this vehicle, and here is why:

  • Your portfolio is completely tailored to your needs. You do not need to study every prospectus that comes to your door to see if a fund’s strategy has changed without your knowledge. Periodic rebalancing is all that is required when your financial situation changes.
  • You and your adviser can be patient. Because the adviser is getting paid from assets under management, there is no incentive to churn your account, which as I’ve demonstrated, destroys portfolios.
  • At least with First Sustainable, you can buy fractional shares of individual equities, enabling your portfolio to be spread among dozens, if not hundreds, of instruments. This factor accounts for why this vehicle is only now catching on. Until technology enabled this feature, an SMA only made sense for the very wealthy.
  • The above factor means that you can still invest periodically without messing up your asset allocation. Before, indexing in an SMA was only good for investing a lump sum. Now, you can set up a disciplined savings program.
  • Because your turnover should be lessened, your annual tax bill should be decreased.

Drawbacks. Your adviser will likely not have a published track record. Even if one was available, it would not necessarily be an adequate measure of your adviser’s competence. This account should be tailored to your specific needs, and thus, not comparable to anybody else’s portfolio, thereby making a comparison useless. At First Sustainable, we overcome this aspect by making available indexes that we subscribe to. These indexes do have track records and professional oversight.

What to Watch Out For. Do not let your adviser place you in this account if he is going to, in turn, recommend vehicles that also have high expenses. For instance, paying the SMA fee for the privilege of getting placed in other actively managed funds is not a good deal, as you are paying twice. Advisory firms get paid twice this way, and it should be outlawed. Yet, this is a common practice among our less dutiful competitors. The ONLY time this would be an acceptable practice is if your portfolio is small enough that the adviser recommends VERY LOW COST index funds or ETF’s. Even then, you should insist on a reduced SMA fee.

Index Funds


As investors have awakened to all the drawbacks of active management, these funds have exploded in popularity. They are essentially mutual funds that attempt to mirror the performance of an index. The most common indexes are the S&P 500, Russell 3000, Dow Jones Industrials, and a Total Market Index comprising all of these indexes. However, there are dozens of indexes for which funds are created. It is important that you and your adviser are capable of assessing the suitability of this index for your situation.

Benefits.

These funds have the lowest expense ratios around. The largest funds have expense ratios in the .05 percent range (that is .0005). A typical actively managed fund charges 3500 percent more.
They offer instant diversification
They require less research up front and less ongoing research.
They are ideal for investors who are just starting out with a small, disciplined savings plan.
Because indexes do not have high turnover, they are usually more tax efficient than actively managed funds.

Drawbacks. Not all index funds are created equally. First, some funds still claim to be low cost, but still charge well more than the stingiest funds. Many S&P 500 funds still get away with charging .5 percent, or ten times what the largest funds charge. Second, most indexes are created on a market capitalization basis. This means that their weighting is based on the company’s total market value. This could lead to an overweighting of the high PE stocks that are most likely to retreat in a correction.

Exchange Traded Funds (ETF)

An ETF is a closed-end fund that is comprised of an index and trades like a stock on an exchange. Like their open-ended counterparts, there are dozens of alternative indexes than the most popular Spiders (S&P 500), Diamonds (Dow Jones Industrials), and QQQ (Nasdaq 100).

Benefits. Because they trade on an exchange, they are continuously priced. Most open ended funds are priced once a day. This allows an investor to take advantage of short term moves. Some (including me) would say this is a drawback.

Drawbacks. Closed end funds still carry an expense ratio. Theoretically, this should be less since the management company does not have to deal with inflows and outflows. The largest ETF’s are less expensive for the most part. The less famous ETF’s still carry a high expense ratio, which is not as well disclosed.

I hope this series has been helpful. I would be interested in your feedback.

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