Saturday, May 1, 2010

Portfolio 2: Genesis

In this post, we look at the genesis of Portfolio 2. This may be of interest to those of you who are currently relying on an investment firm or broker to manage your investments, and who are interested in moving to a lower cost, more efficient solution.

For several years before December 2008, our Portfolio 2 investors had relied upon an investment management firm to manage their investments. The firm was charging 1% of assets, and was investing mostly in mutual funds with expense ratios in excess of 1%. So our investors were paying at least 2% per year, and probably closer to 3% considering less visible fees, such as turnover (trading) costs. To put this in dollar terms, assuming a portfolio value of $300,000, you would be paying a minimum of $6,000 per year in fees and expenses, and probably closer to $9,000; that’s $500-$750 per month!

On top of the high expenses, the firm was not managing the portfolio in a manner consistent with the investors' risk tolerance, and was not keeping the investors updated on their investment strategy or tactics. For example, a significant portion of the bond allocation (which is supposed to be the conservative part of the portfolio) was in high yield bonds, which are very risky. So, this couple who thought they had a relatively conservative portfolio actually had a quite risky portfolio. Unfortunately, the way they found this out was through much greater than expected losses during the 2008 bear market. Also, there were more than 20 funds in the portfolio, and the couple had no idea what their asset allocation was (and the firm couldn’t tell them what it was!).

After some discussion and reading (a couple of the books on my recommended reading list), the investors decided to move their investments to Vanguard. I explained to them how they could create a simple portfolio that they could understand and manage themselves, that would cost them less than 0.2% per year, and that would match their risk tolerance. Assuming the same $300,000 portfolio as above, the cost would be less than $600 per year or $50 per month – one tenth or less than what they had been paying.

Since the investors didn’t understand much about investing, I felt a high priority was keeping the portfolio simple. Many highly respected investing professionals and academics recommend a global portfolio containing a few broadly diversified index funds, and I knew Vanguard would support this approach (I encouraged them to get a second opinion from Vanguard). One of the simplest approaches is to use a total US stock market fund, a total international (non-US) stock market fund, one or two bond funds, and a money market fund. We chose the Vanguard Total Stock Market ETF (US stocks), the Vanguard FTSE All World ex-US ETF (non-US stocks), and the Short-Term Investment-Grade bond fund. They purchased the desired Vanguard funds at their current firm (after selling all of their existing positions), then transferred them to Vanguard. The remaining cash from the old account was transferred into the Vanguard Prime Money Market fund.

We chose to use the ETFs (Exchange Traded Funds) primarily because I knew they would be able to buy them at their old firm, since they can be bought and sold like any other stock. Other than that, the comparable Vanguard mutual funds would’ve served their purpose.

Since the transfer in December 2008, the investors have been delighted. They have a portfolio that they understand and are comfortable with, they are saving lots of money on fees and expenses, and they have participated fully in the market recovery since early 2009. In the next post, I’ll share a bit more about how things have been working for the investors since the move to Vanguard.

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