Anatomy of a Portfolio Change – Core Equity Spotlight on SCHF

money on the brainAs part of our ongoing series of spotlighting one of our Investment Model preferred holdings, I would like to provide some color on the Schwab International Equity ETF (symbol: SCHF). SCHF is brand new to our Core Equity Model Portfolio so we thought it may be educational to our readers to go through the mechanics involved during a portfolio change to spotlight some of the behind-the-scenes processes.

Our main investment management goal: participating in “good” times and protecting in “bad” times. To put it in baseball terms, and I must do that as the Chicago Cubs are playing meaningful baseball still here in June, those that have worked with us know that we aren’t focused on hitting “home runs”; instead we are more interested in avoiding unnecessary risk and “hitting steady singles and doubles.”

How we seek to accomplish our goal:

  1. We have three main strategies: our Core Equity, Core Fixed Income, and Liquid Alternatives models.
  2. We use a combination of passive and active styles within our strategies. We generally use passive for our Traditional Core Equity and Fixed models, and use active for our Liquid Alternatives model.
  3. We generally only use relatively low-cost mutual funds and ETFs. (From last month’s blog, you learned that our Core Equity model had a weighted OER of 0.34% (now 0.32% after change described below), and our Core Fixed Model has a weighted OER of 0.37%.)

So, what’s our process? Here’s the short list in layman’s terms:

  1. Keep informed and educated. We stay abreast of the latest by reading a lot, attending conferences and trade shows, and networking with others both inside and outside of the financial industry.
  2. Constantly monitor the investment landscape for what’s new and knowing what’s already out there.
  3. Monitor and track current holdings. Adjust weights if needed.
  4. Analyze if anything out there is better than what we already have in place.
  5. Avoid unnecessary transactions and over-trading: transactions can be costly if not done correctly. Furthermore, it may lead to unnecessary tax ramifications.
  6. Understand where the market cycle is and never fall victim to trading based on emotion. I.e. buying the latest fad (buying high) or selling something temporarily out of fashion (selling low).
  7. Rebalance regularly to get your asset allocation percentages in-line with their target, thus, in concept, buying low and selling high.
  8. Trade efficiently. Strive for best execution. Every client is treated fairly when traded on a global basis.
  9. Ultimately, make thoughtful, wise changes where expected value is apparent. (No knee-jerk reactions).

Now, let’s look at that process in action. Last month, as part of our regular research, we came across a swap opportunity within our Core Equity strategy.

We found some advantages of holding the Schwab International Equity ETF (symbol: SCHF) over one of our then current Core Equity model holdings: the Dreyfus International Stock Index mutual fund (symbol: DIISX). Listed below are the major reasons why:

  • Similar coverage: both seek diversified international developed exposure, something we desire to hold for a minority allocation within this Core Equity strategy.
  • Lower Operating Expense Ratio (“OER”): SCHF has the lowest OER of any of its peers in this space at a ridiculously lean 0.08%.
  • No transaction fee: Typically, ETFs have a $8.95/trade transaction fee, but as part of Schwab’s relatively new ETF OneSource platform, SCHF can also be bought and sold with $0 transaction costs which is the same as DIISX, but…
  • Not subject to a Short-Term Redemption Fee (“STRF”): Mutual funds on Schwab’s OneSource platform generally need to be held for 90 days or are subject to a 2% STRF. STRFs were put in place to prevent “day trading” these funds which in many people’s eyes are meant for the long-term. However, ETFs are a different breed of animal in that they trade intra-day and the day trading issues are really not valid. As such, ETFs both on and off Schwab’s ETF OneSource platform are not subject to any STRF. Fabulous!

DIISX had been good at providing us with diversified international developed exposure while charging a modest 0.60% OER. But in this fast paced age, new products are increasingly becoming available. A lot of them are just a silly variation of something we already have, or something completely unnecessary. But every once in a while something decent comes out which may not be a perfect fit at first, and we keep it on our radar. In the case of SCHF, we needed to make sure that Schwab ETFs would develop a meaningful following and that this security would have appropriate liquidity (measured by its average trading volume) – those are both valid today. Furthermore, the success so far of the Schwab ETF OneSource platform, with its attractive characteristics listed above, made our decision to make a portfolio change an even easier one.

As always, please don’t hesitate to ask any questions about costs, trading, investment vehicles or anything else. And, go Cubs!

How Much Are Your ETFs and Mutual Funds Costing You?

Perhaps it’s the new Tony Robbins book that has created this stir, but we’ve gotten a lot of calls and emails lately from people interested in using an independent RIA like us. We’ve also had a lot of questions regarding what type of vehicles we use and the fees involved with them (i.e. Operating Expense Ratios [“OERs”]).

We love taking these questions head on. Since day one, we’ve always preached low cost is better. Transparency about fees and costs is integral to our business. As an Accredited Investment Fiduciary, fees are something we absolutely review and use in consideration of any product.

Furthermore, given the math of compounding, we know (and have given seminars on) the huge benefit that minimizing expenses can have on a portfolio over time. See the graph below:

Expense graph 042915














Here are some Frequently Asked Questions:

Do you use individual stocks?

No. Here’s why: it creates unnecessary company-specific risk. Prudent risk management tells us to avoid company-specific risk and diversify.

What vehicles do you use?

Predominantly, low cost mutual funds and Exchange-Traded Funds (“ETFs”) within our Core Equity and Core Fixed Income models.

Why do you use mutual funds and ETFs?

Each mutual fund and ETF within our Core Equity and Core Fixed Income models provides inexpensive exposure to an underlying basket of securities, hence, providing the investor with great diversification to the multiple market exposures we think an investor needs. These include markets such as large cap, mid cap, small cap, international, emerging markets, investment-grade bond, high-yield bond, floating rate bond, international bond, etc.

How can you tell if a mutual fund/ETF is expensive or not?

Check out their Operating Expense Ratio, which can be found in their prospectus or on Morningstar or Yahoo Finance. OER includes costs such as portfolio management, operating expenses, distribution, and administration. There are some exceptions, but typically an OER under 0.50% is pretty cheap and an OER over 1.5% is pretty expensive.

You said your Core Models are inexpensive. How inexpensive are they?

Our Core Equity model has a weighted OER of 0.34% and our Core Fixed Model has a weighted OER of 0.37%. That compares to the average 1.31% paid to the US stock mutual fund. That is almost 1% in savings. Take a look at the graph above to see what a difference that 1% can make over time. Like Tony Robbins said in his “Money: Master the Game” book: “By simply removing expensive mutual funds from your life and replacing them with low-cost index funds you will have made a major step in recouping up to 70% of your potential future nest egg! How exciting!” How exciting indeed!

I heard ETFs are cheaper than mutual funds. Is that true? 

It’s not black or white. The real question is whether the security (i.e. mutual fund or ETF) is utilizing passive or active management. With active management, there are a lot of added costs: a portfolio management team, traders, rent, etc. Passive management typically follows an index which means a lot of those “active” costs don’t exist. Hence passive management is cheaper.

Most, but not all ETFs, follow a passive management approach. Many, but not all mutual funds, follow an active approach. But that doesn’t necessarily mean that all mutual funds are expensive and all ETFs are cheap. In fact, the mutual funds we utilize in our Core Equity and Core Fixed Models are the ones that follow a passive approach and therefore are just as cheap, if not cheaper, than many of the ETFs out there right now. For example, the Schwab S&P500 Index Mutual Fund logs in at a miniscule 0.09% OER!

So, it’s not the wrapper that makes it expensive or not; it’s the methodology under the hood.

Do you use passive management, active management, or a combination? 

A combination. As a firm, it’s about 75% passive and 25% active. We generally use passive for our Traditional Core Equity and Fixed models, but use active for our Liquid Alternatives model. In most cases within today’s world, one cannot get alternative exposure without the use of an active manager. As the investment world evolves, it is possible that passive management will be employed more and more. But for now, we use what is available. (For more info on why we use both passive & active, see our March 2014 blog).

So why use alternatives at all?

The non-traditional alternative marketplace is an inefficient one. The use of active managers can help exploit these inefficiencies. Studies have shown that adding non-correlated assets, aka alternatives, to a portfolio can improve return and reduce volatility. Alternatives can help cushion your portfolio when there is stress in the traditional markets, thus creating a smoothing out effect on the long-term results of your portfolio. By incorporating a strategy where the majority of the portfolio is invested in traditional equities and fixed income complemented with a minority allocation to liquid alternatives, we can help protect the downside thus making new highs earlier and more often.

In a market environment that may produce only single digit returns, fees play a bigger role than ever. It is critical to use an investment manager like DWM who is looking under the hood and factoring in these costs when making investment decisions. Feel free to contact us for more info on how DWM keeps expenses to a minimum in its clients’ portfolios.

What is NAPFA?

NAPFAElise recently helped me change the artwork in the office. Added some, moved some, and removed a couple. The best addition was a map of Sanibel Island signed by our kids and grandkids, and now, thanks to Elise’s help, it includes pics of everyone. Sanibel has always been a special vacation place for our family. Great memories.

Another nice addition was my NAPFA acceptance letter, related Fiduciary Oath signed by me, and the recent Accredited Investment Fiduciary (AIF®) certification I received. Brett has these three items in his office as well. We’re often asked by clients and others for more information on NAPFA and AIF® so we thought it might be worth an explanation.

NAPFA (pronounced ‘Nap-Fah’) stands for the National Association of Personal Financial Advisors. NAPFA and its members are all about bringing integrity, honor, and trust to its clients and to investors in general. Its members are strictly fee-only, independent, Registered Investment Advisors just like DWM. NAPFA vets its candidates very carefully, including credentials, experience, peer review of a sample comprehensive financial plan, and signature and adherence to NAPFA’s Fiduciary Oath.

The AIF® designation is awarded by the Center for Fiduciary Studies, the standards-setting body for fi360, the first full-time training and research facility for fiduciaries in the country. AIF® is a very select group. There are only 6,000 AIF® designees currently, as compared to 70,000 CFP® certificants. AIF® designees are the only recognized professionals trained to perform fiduciary assessments, which measure how well investment professionals are fulfilling the fiduciary duties required of them by the applicable investment legislation, case law, and regulatory opinion letters. AIF® designees, like Brett and myself, are able to use the knowledge and resources they have gained through their training to better organize, formalize, implement and monitor their processes and procedures. Studies show that a prudent process improves investment results.

There is a tremendous investor movement away from large brokerage firms to smaller, fee-only independent firms such as DWM. In my opinion there are two key reasons for this: results and trust.

According to the WSJ, “Investors are Fleeing Active Stock Managers.” Actively managed stock and bond mutual funds are the building blocks used by many large institutional wirehouses. The operating expense of an actively managed mutual fund is generally a minimum of 1% more per year than a passive, low cost mutual fund or ETF. Actively managed funds have a lot of expenses a passive fund doesn’t have. These can include research (to try to beat the market), trading, marketing, upfront fees, sales fees and others. Of course, the institutions that promote these actively managed funds to investors receive part of those operating expenses as “revenue sharing.” The investor comes out the loser in this format, since studies have shown time and time again that actively managed stock and bond funds over time don’t “beat the market”, but rather they consistently underperform the benchmark indices. And, that underperformance is usually by about 1% or more, just about the same amount as the “excess fees” over passive investments. The extra 1% in expenses goes right to the bottom line, especially these days when diversified stock returns are more likely in single digits than double digits. A 1% drag on a $1 million portfolio would reduce the appreciation over 20 years by $600,000 or more. It’s no surprise that many large institutions don’t even provide performance results with their statements. The reports can be 100 pages long and yet there is no performance data provided (i.e. time-weighted return calculations). The WSJ article puts it this way, “U.S. active managers destroyed the trust of individual investors and financial advisers, neither of whom want to pay up for active management that can’t beat an index.”

So, many large brokerage institutions have tried to gain the public’s trust (and their money) by advertising themselves as fee-only and fiduciaries. While there may be a small portion of their offering that does qualify to use these terms, their overall business model is generally focused on making money for the institution and its employees. They may charge a client a percentage of asset fees for managing money. That’s not all they get. They often receive “revenue sharing” from mutual fund companies they promote to clients and receive commissions for selling annuities and life insurance contracts.

Have you seen the recent Charles Schwab “Why” TV Commercial? The ad revolves around a boy who quizzes his father about the real value the family’s financial advisor provides. It suggests that most children can see that the wirehouse business is stacked in favor of the advisor, not the client. These days, both children and their parents are really questioning what they are getting and paying these brokers. True fiduciaries put their clients’ interests first and disclose any potential conflict of interest. They hold themselves accountable for results and make full disclosure to their clients. And, they provide additional value-added services and transparency. The general public, I believe, is recognizing that the wirehouses just don’t do that.

NAPFA and its members are gaining a lot of traction. Investors looking to move from the old wirehouse paradigm can contact NAPFA and use its website, to find vetted financial advisers in their area who might be a good fit for them. DWM gets communication, prospects, and ultimately clients from our association with and link to NAPFA. No money changes hands between us. Like DWM, NAPFA is all about doing the right thing; bringing integrity, honor and trust to its clients and investors in general. That’s why we are proud to be members of NAPFA® and AIF® designees.

WSJ: “Actively Managed or Index Funds? Why Not Both?”

passiveactiveicecreamWe agree. We’re not alone. A recent WSJ survey showed that 42% of investors own both active and passive funds, while 36% own only actively managed funds and 22% own only index/passive funds. Some investors swear by index funds and some love only active management. It really shouldn’t be an either or decision.

Use indexes/passive funds for efficient markets. As the Economist pointed out in their February 22nd issue, “The costs of actively managed funds are higher than most investors realize”. Think of it, an active fund needs to do research, make lots of trades, spend lots on marketing to “sell” their strategy and therefore, their cost of operations can be 1.50% or more. An index fund merely replicates an index and cost can be as low as .05%. Is it any wonder that 60%-80% of actively traded equity funds fail to beat their market index each year? And, 60% to 90% of actively traded fixed income funds fail as well. Why? Active management has to overcome high fees, transaction costs and tax ramifications.

Expenses matter. A 1% difference in performance over long time periods can really add up. $100,000 invested that earns 6% for 30 years grows to $574,000. At 5%, it only grows to $432,000; a 25% reduction.

We believe that traditional capital markets work and price securities fairly. Despite what the financial press and fund marketing literature suggests, study after study shows the majority of active managers underperform. So, yes, passive/index funds are superior to active funds for equity and fixed income- traditional efficient markets. But, what about non-traditional inefficient markets?

Use actively managed funds for inefficient markets. The last two decades have seen a great proliferation of investments that are not correlated to the stock market. Many are publicly traded and easily redeemable. They often follow hedge-fund like strategies designed to reduce volatility. These liquid alternatives may include arbitrage funds, global tactical allocation funds, closed-end specialty funds, MLPS, and long/short funds. Studies have shown that adding non-correlated assets to a portfolio can improve return and reduce volatility.

These actively managed alternative funds will typically have an operating expense ratio in the 1-2% range. This is understandable. They do considerable research. Their trading costs are often higher due to the use of derivatives and lots of trades. And, yes, they have marketing costs to educate and inform prospects and clients. One benchmark for these funds might be an “absolute return” of 1-6% above LIBOR.

“Use a mix of passive and active funds to bring down overall expenses and to hedge against market crosscurrents” was the conclusion of the WSJ article March 4th. Again, we agree. The bulk of a portfolio, equities and fixed income, should be in index/passive funds, with a weighted average operating expense of perhaps .35% or lower.

Passive and active funds perform differently in various market conditions. While stocks were up 30% last year, fixed income did poorly and a basket of liquid alternatives we follow had an absolute return of 4%. Then, in January, when stocks lost 3-4%, fixed income rebounded and this basket of liquid alternatives was slightly positive. In short, a nice blend of passive and active funds is designed to help investors participate in the upside of markets and protect in down markets. And, because DWM is committed to protecting and enhancing our clients’ net worth and legacy, that works well for us and our clients. Very well, indeed.

Why “Smart Beta Indices” can be Smart for your Portfolio

Core and Satellite pie chart
(Click above for full size image)

Most of our clients are very familiar with our core and satellite investment approach where we see the investing world in primarily three investment classes: equities, fixed income, and alternatives. Furthermore, they have heard us preach that we like to use low-cost, generally passive vehicles for the traditional asset classes (equities and fixed income) and active vehicles for the non-traditional alternative asset class. What they may not realize is that we also utilize something that falls somewhere in between truly passive and truly active, something known as “smart beta” or “enhanced” indexing. 

We’ve always been proponents of low cost. Active management brings higher expenses to the table as those management companies need to pay for overhead (such as talent, rent for bigger buildings, marketing, etc) that passive shops do not. This generally leads to higher expenses, higher transaction costs, and more tax ramifications for the investor which explain the empirical studies that show that over time active management funds underperform their benchmark. If one believes in relatively efficient markets, then these active/higher fee funds don’t make much sense when there are passive vehicles that follow an index with much lower fees. In fact, as of August 2012, actively managed mutual funds had a weighted average OER (Operating Expense Ratio) of 0.88% whereas passively managed mutual funds had a weighted average OER of 0.13%.* By going passive instead of active, that difference of 75 basis points goes straight to one’s bottom line, all else being equal.

However, as great as low cost index securities seem, they are not perfect. 

Let me explain: traditional indices are capitalization-weighted. Which mean cap-weighted index funds overweight the biggest companies and underweight the smallest ones. For example, using cap-weighted methodology, an S&P500 Index fund’s biggest holding currently would be Apple at about 3% and its smallest holding would be Graham Holdings at just 0.02%. Apple’s weighting is 150 times Graham’s holdings! Should we be taking a 150x bet on Apple versus Graham? Maybe, maybe not. What we do know is that empirical studies show that there is a small size and value premium. Hence, cap-weighted equity index funds tend to overweight overvalued securities and underweight undervalued ones, creating a 2% return drag in developed markets and more in less efficient ones, according to Rob Arnott at Research Affiliates.

So if smart beta indices aren’t weighted by capitalization, then what are they weighted/created by? One of the first methods to come about, and one of the simplest ones, is equal-weighting. For example, an S&P500 equal-weighted smart beta index would have 0.20% of every one of the 500 companies within the S&P. Another example would be fundamentals-weighting which is where weights of the portfolio are determined by fundamentals like earnings, dividends, and cash flow. (FYI, DWM utilizes this method within its Core Equity model via the Schwab Fundamental US Large Company Index [symbol: SFLNX]). Other smart beta indices weight the index to low volatility or upward price momentum. The one thing they all have in common is that size does not matter. And, because of that, we’ve seen outperformance. 

Smart beta utilizing non-price-weighted indices can be quite attractive. Smart beta indices retain the benefits of traditional cap-weighted indices, such as broad market exposure, diversification, liquidity, transparency, and low cost access to markets, while at the same time they offer the opportunity to achieve enhanced performance over the cap-weighted benchmark. 

Smart beta strategies are pretty exciting yet also can be pretty complicated to many. One really needs to “look under the hood” to get a good understanding of exactly how these work. Be sure to use an investment professional like DWM to filter through all the different choices when investing.

*Mutual fund expense ratios as of August 21, 2012. Asset weighting based on net assets as of July 31, 2012. Data provided by Morningstar, Inc. Passive funds are those coded by Morningstar as Index Funds.