WHAT YOU LOSE BY NOT USING YOUR ADVISOR (PART 1 of 2)

By Mark Ukrainskyj in Trusted Advice

Many investors have seen studies showing that most funds do not outperform the market averages and have concluded that they do not need an advisor.  If they can't beat the market why do I need them?  As the Vanguard Group of Funds is closely associated with low cost index investing and do-it-yourself investing, they would be the last place you would expect to come to advisors defense.  Yet, that is just what they did, coming out with a study quantifying how much money investors are leaving on the table by not using an advisor.  They looked at three areas - Portfolio Construction, Wealth Management and Behavioral Coaching and found that investors could be losing about 3% points of portfolio returns after taxes and fees over time. Needless to say, because this amount is far more than what Covenant charges, we were intrigued.  Because each client is different and not all strategies apply to all clients in the same proportions, or at the same time, the timing and amount of loses varies, thus limiting the authors precision to 'about 3%'. Below and in Part 2, we will summarize the study's findings and also examine how we approach these areas at Covenant to keep our clients ahead of the game.

Portfolio Construction & Asset Allocation

At Covenant, we believe the foundation of every portfolio and investment strategy is an Investment Policy Statement (IPS) that outlines the portfolio's goals, time horizon, asset allocation, contributions, withdrawals, tax situation and client risk profile.  It outlines the overall strategy for the portfolio and provides the roadmap to properly manage the investments to achieve the client's goals.  However, most investors don't have one.  I don't know the number of times I have asked investors if they have an IPS and what their strategy is, only to have them admit they don't have one, ask what an IPS is, or change the topic.  While most investors may not have an IPS, the study agrees they are essential.  While not quantified due to each client's uniqueness, the benefits of an IPS and asset allocation were deemed significant and it was viewed as a key foundational element.  Without an IPS, you are randomly buying things for no specific reason, while with an IPS you are a strategic, disciplined investor investing for your goals.  If you don't have an IPS, reach out to us at Covenant to discuss your situation further.

Cost Effective Implementation

By not implementing the IPS's asset allocation in a cost effective way, the study finds that investors can lose up to 40 basis points (0.40%) of return  annually.  This comes from a comparison of the asset weighted expense ratio of the equity mutual fund and ETF industry and comparing it to low cost index funds.   At Covenant, we go even further by directly managing the US equity exposure in individual stocks, thus completely eliminating that layer of expenses from what is generally a significant portion of our clients' portfolio.  And as a Registered Investment Advisor (RIA) and fiduciary to our clients, low costs are a key item we look for in our clients' international and fixed income investments, further helping keep costs down.  And all of our clients, whether busy professionals, business owners or retirees appreciate that.

Asset Location

While the portfolio's asset allocation describes the mix of assets, the asset location describes what type of account each is held to maximize the tax efficiency.  Are growth stocks better in a taxable or tax advantaged account?  What about dividend stocks?  Junk bonds?  REIT's, MLP's?  And the list goes on.  At Covenant, we are very aware of tax location when we put together your portfolio.  In addition, we monitor the investment tax landscape for any changes that would affect it.    A low turnover tax efficient stock portfolio, such as Covenant's strategy, generally holds each position for longer periods of time, thus generating fewer capital gains.  In addition, those which are generated tend to be subject to lower long term capital gain rates.  Tax inefficient investments, should be located in tax advantaged accounts to shield their returns from the rates that apply to ordinary income, which could be as high as 39.6%.  And depending upon the circumstances that income could also be subject to the Medicare surtax of 3.8%.  By purchasing those investments in tax advantaged accounts the investor can take full advantage of their higher yields.  Depending upon the client's tax bracket, portfolio composition and split between taxable and tax advantaged (IRA's, Roth IRA's, 401(k)'s. etc) accounts, the losses from improper asset location can vary from 0 - 75 basis points (0.75%) according to the study.

Total Return vs. Income Investing

With yields on bonds at close to historically low levels, many investors that need income from their portfolios are caught in a quandry.  To maintain the level of income they are used to, while only drawing on income, they can either 1) overweight longer term bonds, 2) overweight high yielding or junk bonds or 3) increase the portfolio exposure to dividend paying equities.  However, each of these paths increases the risk of the portfolio.  Longer term bonds are much more susceptible to rises in interest rates than short or intermediate term bonds. And junk bonds and dividend centric stocks are much more volatile than investment grade intermediate term bonds.  In order to be able to access these higher yields, these tax inefficient investments would most likely be purchased in taxable accounts, thereby decreasing the net return. So they could end up increasing the volatility of their portfolio by a lot for not that much more net gain.  Not a good position. 

At Covenant, we believe a more appropriate approach in many cases is to use a total return approach, which considers both income and capital gains.  By using both income and capital gains to fund income needs, this allows a portfolio to be better diversified and more tax efficient, as there is no longer a need to purchase higher yielding assets in taxable accounts.  The additional income can be made up from long term capital gains which are taxed at rates (15 or 20%) that are generally much lower than ordinary income (39.6%). While the study does not quantify the benefit of total return investing, due to every investor's unique situation, it does conclude that the benefit is significant.