ETFs and Mutual Funds in Asset Allocation

Building a properly allocated portfolio requires the right tools.  The first step is to understand the tools of the trade in asset allocation.  Professional investment managers often use diversified pools of securities as one of these tools.  While there are different kinds of pooled investments, the most popular are mutual funds and ETFs.

Funds aren’t an asset in themselves; they are vehicles that help you invest in various asset classes.  Traditional mutual funds are a collection of securities that are actively managed by an investment manager and his team.  They often compare themselves with investment indexes of similar asset classes.  Mutual funds have evolved over time, and now some invest in a multitude of assets, some buy other mutual funds, and others simply track an investment index.  Mutual funds are typically bought for the benefits of diversification, professional management, and low capital outlay.  Many kinds of mutual funds can be expensive to own and cumbersome to sell.

Here are some of the fees mutual funds can charge:

• Management Fees – (normally 0.5%-2.0%) this is how mutual fund companies pay their fund investment managers and staffs.
• 12b-1 Distribution Fees – (0.25% and 1.0%) for marketing to new prospects.
• Administrative Fees – (0.20% – 0.40%) to keep the lights on at the office, paper in the copier, etc.
• Sales Loads – (3.0% – 5.75%) Also known as sales commissions, they are used to pay the sales force who sell the funds.
• Exchange Fees – Additional fees you can incur if you decide a mutual fund no longer matches your investment objectives.

If you buy a mutual fund with a sales load, your investment has to dig itself out of a hole before you can make a penny.  That sort of expense is a big drain on your rate of return.  Ensure that you evaluate the cost against the value you’ll be receiving when considering a purchase of fund.  You can also purchase mutual funds that have no sales charge (load).

An alternative that has been making tremendous strides to mutual funds in the last decade are ETFs.  ETFs, short for Exchange Traded Funds, are collections of stocks, bonds, or other assets. They can track a number of different underlying indexes such as the S&P 500.  The increasing popularity of ETFs has provided a large menu to choose from.  Whatever kind of investment pool you’re looking for, there’s a good chance at least one ETF tracks it.

ETFs are similar to mutual funds in being pooled investments, but have some enormous advantages.  Often, the expenses are fractional in comparison to funds, so you don’t have to waste your hard-earned savings on fees every year.  The average ETF charges 0.1% – 0.65% annually.  This can mean enormous savings over time.

An added benefit is that ETFs provide up-to-the minute pricing while the market is open.  You don’t have to wait for end of day pricing, common with most mutual funds. You can buy and sell an ETF knowing the price you’ll pay.  ETFs also tend to be more tax-efficient.  The passive management of index investing coupled with the lack of pass-through taxes, inherent in most active mutual funds, can reduce your tax headaches.

ETFs still have their challenges.  Light trading volume or shallow markets can affect the pricing of some ETFs.  In addition, transaction costs can add up if you’re a high frequency trader, although there are ways to reduce these expenses.  Some other features such as automatic dividend and capital gain reinvestment that are available in funds, are not generally possible in ETFs.

Pooled investments are an important tool for a majority of investors.  The uniqueness and benefits of mutual funds and ETFs are stark compared to individual securities.  If you’re constructing a portfolio and you want to buy a diversified block of assets, mutual funds and ETFs are great options.  The benefits they provide can be paramount to a successful portfolio.

Asset Allocation: The Great Balancing Act

Last week we explored the first part of asset allocation in Asset Allocation: Tools of the Trade. We reviewed the asset classes investment managers use to build portfolios for their clients. This week we will explore how client portfolios are constructed and change over time as assets are deployed. Before looking at the mechanics, we should review the primary foundational principle of asset allocation: client objectives.

Client Objectives

Every investor is different. While many may have similar goals, all have unique circumstances. Some might be looking forward to a retirement full of international travel and posh leisure activities. Other investors’ objectives may be more modest in nature, but no less important. Whatever the goal, good investment managers start by understanding their client’s objectives. Then, they put together an investment plan that will seek to meet these objectives while minimizing the risks associated.

Portfolio Construction

A big part of the investment plan is asset allocation, which is using different asset classes to construct a portfolio designed to meet client objectives. These asset classes are varied. They include cash, stocks, bonds, commodities, real estate, insurance, and more. Experienced investment managers use many or all of these asset classes in varying degrees to build portfolios for their clients.

Hypothetical Asset Allocation

To illustrate how asset allocation can work, we have a very simple, hypothetical case: Sam and Sally. Sam, 40 years old, is married to Sally, also 40, and they have no children.

They enjoy what they do, but both want to retire when they are 65. They plan to travel extensively and prefer to relocate to the beach upon retirement. That gives them roughly 25 years to make their world traveling, beach living retirement a reality. Both are comfortable with taking on higher-risk for the potential of more growth in their investments, so they are okay with greater volatility.

Understanding Sam and Sally’s objectives and risk tolerance is crucial for determining how to deploy assets in their portfolio, and typically there’s a lot to work that goes into determining the proper asset allocation. Let’s go forward with the understanding that this extensive planning process had been completed because the point is to illustrate the difference in asset allocation models at different stages in life. A reasonable asset allocation mix over time for Sam and Sally may be:

Phase 1: Age 40-55

• Allocate 60% in stocks, 15% in commodities/real estate, 20% in bonds, 5% in cash.
• Continue to work, receive average raises in relation to inflation, and save 15% of their income per year before taxes.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

Phase 2: Age 55-60

• Start re-allocating to a 50% stocks, 30% bonds, 10% commodity/real estate investments, and 10% cash portfolio.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

Phase 3: Age 65+

• Start re-allocating 30% in stocks, 50% in bonds, 10% in cash, and 10% in commodities/real estate investments.
• Monitor and rebalance portfolio every year for the best in class assets, but do not adjust overall strategy unless investment goals change.

As this couple gets closer to generating income from their portfolio, their investment approach transforms from a growth portfolio to an income portfolio and you can see how their portfolio is restructured over time to reflect this. Still, at no time is their plan one of extremes. There is always a growth component and conservative component, just of differing degrees to reflect their needs in life.

Real retirement plans should never be all in one asset class, whether in growth mode or income mode. You need the proper balance to protect your plan from the multitude of risks out there. Additionally, you’ll notice this asset allocation schedule roughly follows the Three Phases of Retirement Investing. Asset allocation is fundamental to investment planning, and although there are different ways to be successful in managing your investments, it remains a staple of how to reduce risk.

Five Tips For an Easier Retirement

Generally, retirement planning isn’t considered a relaxing leisure activity, but it’s a necessary step to enjoy your later years. We’ve warned you before about four risks that could ruin your retirement. In a more positive context, we want to help your retirement be secure to reduce stress and have a tidy nest egg waiting for you when your working days are over. Here are five tips to help accomplish that objective.

1) Never stop growing.

Inflation isn’t a four-letter word. But when it comes to the impact on your retirement, inflation is one of the nastiest words in the dictionary. Rising costs coupled with taxes can ravage your portfolio without proper planning. Remember that health care costs are rising faster than general inflation, and health care will be one of your biggest costs in retirement.

2) Hedge your bets.

One of the best ways to protect your portfolio against risk is to allocate your resources amongst different asset classes and to diversify your holdings inside those asset classes. Unfortunately, “Asset Allocation” is too narrowly defined at times, and diversification is often not enough to protect common day investors. Real Estate, commodities, and even currency hedges can be a valuable part of an overall investment plan. Also, ensure that you have a strategy for your portfolio. Invest-and-forget can lead to untimely volatility with often severe impacts on your retirement plans.

3) We’re here to pump you up: Always Max Out.

You’d be surprised how many investors don’t contribute all they can to their IRA accounts and 401(k) plans. If you’re under 50, you can contribute up to $5,000 a year to a Roth IRA or to a traditional IRA. Contributions to the latter may be tax deductible. If you’re under 50, you can contribute up to $16,500 a year to a 401(k) plan as well.

If you’re over 50 and need to bolster your nest egg, don’t worry. Take advantage of the “catch up” provisions allowable by the IRS; $6,000 a year to each IRA and up to $22,000 to your 401(k) if you’re over 50. If you have the investable cash available, contribute as much as you can.

4) Hold on loosely.

It always surprises me how many folks confuse loyalty to their companies with holding too much of its stock. Does anyone remember Enron? AOL? Adelphia? Many loyal employees, who decided not to sell their stock or stock options and then diversify, when they had the chance, ended up with next to nothing. This happens all too often, yet many are still compelled to keep a big part of their portfolio in their employer’s company stock. This is too much stress to put on a portfolio. Ten percent or less is a good rule of thumb for one security in a portfolio. Sometimes these holdings can be intricate to unwind, so consult an investment professional if you need help to diversify.

5) Don’t let the tax tail wag the dog.

Few people enjoy paying taxes. Taking advantage of available tax-advantaged accounts is important in retirement planning. Equally important is minimizing tax liability. However, tax avoidance shouldn’t preclude you from mitigating risk. I’d much rather folks pay a little more in taxes and keep more of their portfolio than risk their retirement by refusing to diversify. Yes, you might have to pay some taxes, but that might be better than waiting around only to see the bottom fall out. Remember, capital gains means you made money on an investment. Don’t cut off your nose to spite your face. If your portfolio requires you realize a little taxable gain in order to reduce risk, then you should do it or else risk that gain melting away for good.

The thought of retirement can be captivating, but the road to a successful retirement takes a well thought-out plan and the discipline to follow that plan. Keep your eye on the prize and your feet on the ground. If you don’t know where to begin, consult a professional. Retirement dreams can become reality with hard work and wise preparation.