fi360 Blog

Building model portfolios

Working with individual clients, trusts, and even 401k plans inevitably leads to a discussion of asset allocation and the best way to build a portfolio for a client.  Model portfolios are a great way to efficiently pre-define model allocation profiles for clients. How can you build model portfolios?  Let’s explore some common techniques.

Mean-Variance Optimization

Perhaps the best known asset allocation method, mean-variance optimization was established by Harry Markowitz in his article Portfolio Selection.  Mean-variance optimization is a process that tries to maximize the return and minimize the risk for a portfolio of asset classes.  While return maximization techniques were not new, Markowitz understood that the risk and return relationships of asset classes are not independent when combined in a portfolio of multiple asset classes.  The correlation of risk and return between asset classes became the bedrock of mean-variance optimization techniques used in many portfolio applications today.  By combining the risk, return, and correlation data mean-variance optimization produces a set of portfolios that maximize return for a given level of risk.  This set of portfolios can be visually defined as an efficient frontier.

Resampled Efficiency Optimization

Resampled Efficiency, created by Dr. Richard Michaud and Robert Michaud of New Frontier Advisors, builds upon Markowitz’s work of defining an optimal portfolio given a level of risk.  This patented technique resamples the risk, return and correlation inputs to create a spectrum of alternative efficient frontiers.  The technique then averages frontiers together to create a new efficient frontier and new set of optimal portfolios.  Does this process work?  According to, Harry Markowitz it does. In a simulation test, Resampled Efficiency outperformed classical mean-variance optimization in all thirty tests.
 
Monte Carlo Simulation

While Monte Carlo simulation isn’t a portfolio construction process, it can be used to test the probability of success of a given portfolio given the historical risk and return profiles of the asset classes.  More broadly Monte Carlo simulation can also be used in the financial planning processto simulate cash flows and other income and tax considerations and how they affect a portfolio.  While Monte Carlo simulation was developed in the 1950’s at Los Alamos National Labs to simulate nuclear explosions, it has only recently become a tool available to both registered representatives and registered investment advisors.

Other Model portfolios

The techniques listed above are typically available in software applications. The fi360 Toolkits, for example, uses the Resampled Efficiency process in its asset allocation optimizer.  What if you don’t have the desire or time to work through these processes?  You can turn to pre-built models.  Many RIA and Broker/Dealer firms recommend pre-built models designed by in house staff that has the expertise and time to build the model portfolios.  I recommend talking to the person who built the model to get an understanding of their process, but this is a great resource for advisors.

Another public resource is the model allocations that target-date funds disclose in their prospectus.  Pick your favorite fund family and look up the prospectus for a target-date fund.  By using this information, you can “borrow” the expertise of the fund company managers who build the glide path of the target date funds.
 
Whatever you implement, it’s important to understand that the optimal solution should reflect the needs of the client. What techniques do you use when constructing model portfolios? Let us know below.

Monitoring client and investment fees

The fifth Global Fiduciary Precept is to control and account for all investment expenses. It is a fundamental duty of a fiduciary to ensure that all forms of compensation are reasonable for the services being rendered. As such, it is important that fees are evaluated as part of selection, benchmarked against similar options, and regularly monitored to ensure they continue to be reasonable given the alternatives available and as circumstances change.

Yesterday, Mike and Rich presented a webinar that went over why fees and expenses need to be monitored closely; the scrutiny fee transparency is currently receiving from the various lawmakers, rulemakers, media and investors; and the three main fee areas to look at when evaluating investments: client-level fees, operational fees, and shareholder fees.

The recording of the session and slides can both be found on the webinars page of our website. In addition to what is available as part of the recording, we also wanted to highlight some additional reading and materials that were mentioned throughout the webinar as good resources for monitoring fees:

• Practice SA-4.4 from the Prudent Practices for Investment Stewards handbook
• Practice SA-4.5 from the Prudent Practices for Investment Stewards handbook
• The American Jobs and Closing Tax Loopholes Act, which is the House bill currently in the works that will include a fee transparency provision.
• An update on DOL activities from Reish & Reicher, including 408(b)(2) fee disclosure rules expected later this year.
• Information on important, recent fee-related lawsuits:
  • Hecker v. Deere
  • Braden v. Wal-Mart Stores, Inc.
  • Martin v. Caterpillar, Inc.
  • Jones v. Harris
• Reporting and benchmarking tools available from:
  • fi360 Toolkits (the Fee & Expense Report was specifically mentioned in the webinar)
  • Fiduciary Benchmarks
  • Investment Company Institute's Factbook (free resource)
  • Brightscope
  • Ann Schleck & Co.'s Fee Benchmarker

UPDATE: RegisteredRep was in attendance and wrote a nice story about our webinar. Read it here.
  

What’s in an expense ratio?

Last month’s Fund Analysis blog post, Three fundamental questions every advisor should be prepared to answer, focused on the Prospectus Net Expense Ratio and its revenue sharing components, including the 12b-1 fee.  This month, we're taking a look at two other common ratios, the Prospectus Gross Expense Ratio and Audited Net Expense Ratio, and how they compare and contrast to the Prospectus Net Expense Ratio.

So, what’s the difference between the Prospectus Net and Audited Net?  And, what’s the difference between the Prospectus Gross and Prospectus Net? Sometimes the numbers can be exactly the same, and sometimes they could be radically different.

Prospectus Net Expense Ratio vs. Audited Net Expense Ratio
The difference between Prospectus Net and Audited Net can be explained by a difference in time periods. The Audited Net is the audited fee charged during the previous fiscal year for the fund.  It can be considered a “backward-looking” number. The Prospectus Net is a “forward-looking” number and is the anticipated expense the fund company plans to charge for the upcoming fiscal year.  If the numbers are different, a comparison of the two can be conducted to see if the fund company anticipates an increase or decrease in fees charged.  Both numbers include the 12b-1 fee and other management fee or administrative costs for the fund.  They do not include any sales or transaction charges.

For fund of funds, the Audited Net and Prospectus Net will be different because two different numbers are being reported. The Audited Net will only report the wrap fee at the fund of fund level.  The Prospectus Net will report the wrap fee and the weighted average of the underlying fund expense ratios. 

Both numbers are net of any conditional waivers or temporary deductions in the expense ratios and this leads us to the second comparison.

Prospectus Net Expense Ratio vs. Prospectus Gross Expense Ratio
The difference between the two Prospectus ratios, Net and Gross, can be explained through conditional or contractual waivers or reimbursements the fund company may impose. The Prospectus Net will include the waivers or reimbursements, while the Prospectus Gross will exclude the waivers or reimbursements. 

You will typically see a waiver or reimbursement for funds with small asset bases.  For these funds, the actual fee that they are contracted to charge could be a significant percentage of the fund assets.  Therefore, they waive a percentage of the funds expenses to bring it into alignment with a “reasonable” number.  As the asset base of the fund grows, or if the contracted waiver period expires, the fund’s expenses could change. It’s important to check the fund prospectus to see if any waivers or reimbursements are in effect, and to see if this could change the expense ratio of the fund in the future.

In conclusion, no expense ratio is right for every application.  Consider the situation and intended use.  The following table may help.  For a complete definition of each expense ratio, refer to the fi360 Toolkit Help Center Glossary and look under the letter E. Each of the ratios is featured in the new Fee & Expense Report feature in the fi360 Toolkits released last month.

	Prospectus Net ER	Audited Net ER	Prospectus Gross ER
Data Source	Fund Prospectus	Audited Annual Report	Fund Prospectus
Time period	Upcoming fiscal year	Previous fiscal year	Upcoming fiscal year
12b-1 fees	Yes	Yes	Yes
Mgmt. fees	Yes	Yes	Yes
Admin./Asset-based fees	Yes	Yes	Yes
Sales/Trans. charges	No	No	No
Waivers/Reimbursements	Yes	Yes	No

401(k) plan fees: Three fundamental questions every advisor should be prepared to answer

If you advise 401(k) plans, you’ve probably heard the following fee questions from the plan sponsor or investment committee at some point in time.  If you consider the proposed 408(b)(2) regulations and the renewed focus by the SEC on the 12b-1 fee, the spotlight on fees is only going to get brighter in 2010. 

Here are three typical 401(k) plan fee questions you may encounter and some thoughts on how you might want to answer them:

Q. Why should I keep my plan with you when another firm is offering a “no-cost” solution?

Let’s start by examining two basic ways to pay for services in a 401(k) plan: 

• The plan can pay via check/invoice on a periodic basis based on a set price stated in the plan agreement. The price can be a flat dollar amount, a per-participant amount or a percentage of net assets (typically quoted in basis points).
• The plan can pay via the investments the participants hold, which is called revenue sharing. When using mutual funds, the total expense ratio paid to the mutual fund company can be used to compensate not only the fund manager, but also the investment advisor/broker/consultant and the service provider/TPA. Two components of the total expense ratio–the 12b-1 fee and the sub transfer agency (sub-TA) fee–are typically passed from the mutual fund to a third party.

It’s easy to see that when the services are paid via revenue sharing, an unknowing plan sponsor could consider the plan setup as “no-cost.”  Obviously, that’s not the case.  Have the plan sponsor ask the other firm for its revenue sharing arrangements with the fund companies the plan is using.

(Note: There is also an alternative method that many plans are moving towards, which we will address in Question #3.)

Q. How can I tell if our plan’s funds are paying any revenue sharing?

As mentioned above, a mutual fund can pay revenue sharing via the 12b-1 fee and the sub-TA fee. First, let’s look at the 12b-1 fee.

The maximum value for the 12b-1 fee is stated in the fund’s prospectus and can differ by fund share class.  Most financial reports, including the new fi360 Fee & Expense Report, also include the maximum 12b-1 fee as a standard data point.  What most plan sponsors don’t realize is that there can be two components of this fee:

• Sales fee: The most common use of the 12b-1 fee. It is used to compensate the selling agent, such as a financial advisor or broker. You could think of it as similar to a front or deferred load. Loads are typically much larger, but they are only assessed once. The 12b-1 fee is assessed annually.
• Service fee: Helps to reduce other costs of the plan, such as recordkeeping, custody, participant accounting, etc.

The two components may be listed in the prospectus, but you should specifically ask your TPA (or equivalent) if they are receiving any of the 12b-1 fee and, if so, exactly what percentage they receive.

Secondly, the sub-TA fee is used to compensate a third party such as a TPA for participant accounting.  This third party executes, clears and settles buy or sell orders for mutual fund shares, and maintains shareholder records of ownership.  Typically, sub-TA fees are not disclosed in the prospectus and can vary depending on the client's circumstances. Therefore, you should specifically ask your TPA (or equivalent) if they are receiving a sub-TA fee and, if so, exactly what percentage they receive.

Q. What is a “level-compensation” or “revenue neutral” fee structure?

When paying the plan fees through revenue sharing, plan fees can vary and increase drastically over time as the assets grow.  The increase in plan assets doesn’t necessarily correspond one-to-one with the required level of service needed to support the plan.  Hence, fees should not always rise proportionately with assets.  Revenue sharing can also be problematic in that it may incentivize an advisor providing advice to participants to recommend options where they receive greater compensation.

To help with these issues and to encourage complete fee transparency, many plans are beginning to use a combination of flat/contract stated fees and revenue sharing.  Here’s how it works:

1. The plan’s investments pay revenue sharing to the third parties (advisor, broker, TPA, etc.) as described above.
2. The third parties aggregate this money and rebate it back to the plan.
3. The rebated money is then used to pay the plan expenses. If the amount of rebated money is less than the total stated fees in the plan agreement, the plan will cut a check to the respective parties for the difference. Otherwise, the plan will maintain a positive balance in what is typically referred to as an “ERISA budget account.” This money can be used in the future to pay plan expenses, or, if it grows too large, it can be given back to the participants. If it does grow too large, the plan agreement should likely be revised to utilize lower cost investment options with less revenue sharing.

One item to note with this structure is when the investments in the plan lineup don’t all have the same revenue sharing levels.  In this situation, some participants could be paying more (or less) of the plan’s fees if they choose funds with higher (or lower) revenue sharing.

I hope these Q&As provide some guidance and insight into the ever-complicated world of 401(k) plan fees and expenses.  What do plan sponsors ask you?  Please comment.

Why does my index fund fail my due diligence screening?

Every once in a while the fi360 Tools team is asked the question, “Why does my index fund fail my due diligence screening?” The answer changes from fund to fund and is dependent upon the data and circumstances at the time. However, the common conception that index funds as passive investments are “set it and forget it” strategies is incorrect. They must be monitored along with all investments. Furthermore, don’t be surprised if the index fund you’ve selected earns a poor Fiduciary Score or lags its peers in performance.

To illustrate this point, we examined index funds in the fi360 Toolkits for the period ended September 30, 2009.  We identified index funds that fell below the median for both the Fiduciary Score QTR and AVG (see the fi360 Fiduciary Score Methodology Document for more information on our process), and index funds that fell below the median manager in their peer group for several return periods.   The results in the table below show that index funds can rank poorly against a comprehensive process like the Fiduciary Score or, for that matter, many performance periods.

	# of Peers	Index Funds below Median	% Below Median
Fi360 Fiduciary Score (QTR)	968	398	41.12%
Fi360 Fiduciary Score (AVG)	968	351	36.26%
1 Year Return	968	647	66.84%
3 Year Return	968	534	55.17%
5 Year Return	735	419	57.01%
10 Year Return	273	196	71.79%

The next important step in the monitoring process, especially for index funds, is to dig into the shortfalls.  For example, you may want to begin by comparing the index fund’s performance to its specific tracking index in addition to its assigned peer group.  Funds may be correctly tracking the stated index, but still fall below the median manager in their peer group.  This could occur because:

• The fund manager is tracking an index not followed by others in the peer group.
• The peer group chosen for a fund may not be appropriate.

Certainly, there are other qualitative analysis points that may need to be pursued when monitoring an index fund. The point being, the combination of both a core due diligence process and an evaluation of the fund’s tracking index will help identify any deficiencies of the index fund, and lead to improved decision-making related to watch vs. replace decisions.

These are our thoughts. How do you examine index funds in the course of your due diligence process? Let us know in the comments section below.

Seven Qualitative Due Diligence Factors

A sound due diligence process is the first step in investment selection. A good due diligence process begins by measuring investments using quantitative factors against set benchmarks and in relation to peers.  The fi360 Fiduciary Score, for example, is calculated using eleven quantitative factors that we consider to be the minimum due diligence criteria that you should use when evaluating an investment.  But in addition to quantitative analysis, fiduciaries should consider applying qualitative factors, which can help detect organizational instability. Organizational instability, over time, usually leads to underperformance.

Here are seven qualitative factors that a fiduciary should consider implementing into their due diligence process:

1. Manager Quality – Does the portfolio manager have the necessary experience to manage the type and size of portfolio you are investigating?  In addition to credentials, take a look at prior experience. This is especially important if the manager is new to the firm.

2. Staff Turnover – Along with the portfolio manager, you should also look at the professional staff of the investment company. Has there been significant turnover?  If significant turnover is found, you should dig deeper to find out why.

3. Organizational Structure – You should also investigate any structural changes to the investment company.  It’s important to examine the firm’s mergers or acquisitions to see if the organization is more focused on “castle building” than managing money. If they are building the firm, how will it benefit your client?

4. Level of service provided - Does the investment company provide a better level of service than other firms in the marketplace for a comparable fee? Does the money manager provide other share classes for a fund or Separately Managed Accounts? Depending on your client’s situation, you may be able to invest with the same portfolio manager, but at a lower cost.

5. The quality and timeliness of the money manager’s reports – Registered investment companies are required to report information to the SEC, but do they do so in a timely manner? In addition, does the manager provide an adequate amount of information to make an informed decision? If they do not, what is the cause of delay or omission?

6. Response to requests for information– Like every other service company, the investment company has customers, primarily advisors and investors.  Do they treat their customers with care? If you request information from the investment company, do they provide it in a timely manner with a relevant response?

7. Investment Education - Does the portfolio manager provide an adequate explanation of the investment decisions she makes and the factors she considers in making decisions?  Is the portfolio manager able to easily articulate the portfolio mandate, the plan to follow the mandate, and any problems they see in achieving the mandate?

This is by no means a comprehensive list. Instead, it’s a demonstration of the type of probing analysis an advisor can use in their selection and monitoring process.

What qualitative items do you look at when you are performing due diligence?  Let us know in the comments below.