Posts Tagged "diversified portfolio"

Mutual Funds: Great for portfolios up to $100,000

Posted by Preet on Jul 28, 2007 | 0 comments

I suppose many financial advisors licensed to sell ONLY mutual funds will cringe at this information. First, I want to say that if you have more than $100,000 in your portfolio it does not automatically mean that it is time to get out of mutual funds. But certainly once you pass this threshold you will want to look at alternatives to mutual funds as your options open up (based primarily on the fact that buying in bulk reduces your trading costs). If you remember in my first post on Mutual Funds we defined mutual funds as being the ideal investment for SMALL investors because trying to build your own diversified portfolio would cost too much in trading commissions.

Mutual_fund.jpgSo once you have built your portfolio past $100,000 it is time to compare costs of paying a mutual fund manager versus the costs of having a stockbroker build a custom portfolio (or yourself with a discount brokerage trading account if you have the knowledge).

Let’s look at the average Equity Mutual Fund. It has an MER (Management Expense Ratio) of approximately 2.6%. That means that for every $100,000 in your portfolio, you are paying $2,600 per year for management. When you were starting out your savings, perhaps you had $5,000 in the fund at the end of your first year – you were only paying $130 in fees. In fact, that is quite a bargain considering your advisor probably spent much time meeting with you, learning about your situation and creating a plan and investment recommendations. He or she does this so that when you become a larger investor, you become a larger source of income for the advisor. Also, by having built a relationship over time, it becomes a strong bond and there is less likely a chance that another advisor will lure you away (all thing being equal).

But let’s say you stay in this fund and now your portfolio has reached $1 million. You still pay 2.6%, and in this case you are now paying $26,000 in fees for the same management. It starts to get depressing if you consider that $26,000 every year could buy a new mid-size family car!

So let’s look at two options:

1. Fee based advisor

A fee-based advisor works on a set percentage of assets – think of it as similar to an MER, except that in the industry it is called a “Client Advisory Fee”. You don’t pay a trading commission for each stock purchase setting up the portfolio and similarly you can sell those stocks and buy new ones without incurring a separate commission. The Client Advisory Fee pays for all your trading costs, account admin fees, everything. Even if the Client Advisory Fee was the same as the MER (2.6%), it is advantageous because this fee can be written off for tax purposes whereas an MER cannot (for non-registered investment accounts only, you cannot write off fees for an RRSP). For easy math’s sake, let’s assume that our client is in a 50% Marginal Tax Rate. If they could write off the 2.6% Client Advisory Fee, then it effectively becomes reduced to 1.3%. That is a huge saving right off the bat.

But, it only gets better. While Client Advisory Fees usually can only be offered for $100,000+ sized accounts, this fee can be reduced automatically as the portfolio grows even larger. For example, the fee might be 2.5% up to $249,999 but once you reach $250,000 the fee might drop to 2.25% (and that would apply to the whole account, not just the funds over the threshold). Every advisor and firm have their own set of thresholds and fees – but know that you can negotiate the fee. As accounts grow to $1 million you should easily be able to negotiate the fee down to 1.25% (which, for a non-registered account could be written off and effectively reduce the fee to 0.625%) . When you set up your fee-based account, you will sign a document that clearly outlines the thresholds and fees for each level.

2. Transactional Advisor

In this case you pay a commission for each transaction – i.e. to buy or sell an individual stock. While it would take you maybe 20 purchases to setup the portfolio initially, and just for argument’s sake let’s say each transaction cost you 3% of the purchase price, then your first year would cost you roughly 3% in fees. BUT, once you’ve setup the portfolio most of the work is done, and the rest is maintenance. For example, you made 20 transactions in the first year, but in the second year you only made 6 transactions because it was time to sell 3 stocks, and you needed the other transactions to buy replacement stocks. So perhaps in the second year your total fees were only 0.9%. It all depends on how many trades you make in the year. (If you are an active trader, endlessly trading stocks then you already know you should be on a discount trading platform designed for active traders. )

It is important to note that you can replicate the characteristics of the mutual fund you’ve left with individual securities. But it might be more important to note that you can modify it now according to your personal preferences as well as paying a lower amount of fees every year.

I recently moved a client from another institution to my care. He had a portfolio of $180,000 entirely in mutual funds with an MER of 3.03%. We setup a fee-based account with a client advisory fee of 1.5% up to $1 million, and it would reduce to 1.25% over $1 million when he gets there. It was a non-registered account so he can also write off the Client Advisory Fee. Let’s do the math:

Before:

$180,000 x 3.03% MER = $5,454 yearly cost

After:

$180,000 x 1.50% Client Advisory Fee x 50% Write off of fee = $1,350 yearly cost

This client will save roughly $60,000 in fees over a ten year period. This will be due to the fact that the portfolio will appreciate over time and the yearly savings will also increase.

This is another “no-brainer” investment decision quite frankly. If you have over $100,000 in your investment portfolio, it’s time to speak to your advisor about fees. They would rather lower their income and keep you as a client then lose you and get NO income… And of course if your advisor can only sell mutual funds, it may be time to look for a full service broker who is authorized to sell everything (mutual funds, stocks, bonds, etc.).

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What is a Financial Plan?

Posted by Preet on Jul 25, 2007 | 0 comments

I’ve included this in the General section because it is a topic that applies to all knowledge levels.  Why? Well, I’ve found that even the most sophisticated investors lack a financial plan. You can have the most properly diversified portfolio in the world, proper asset allocation and great returns but it doesn’t mean squat if you are not achieving your goals.

Why is that? Well, if this sophisticated investor was averaging 1% more per year in his portfolio than everyone else, but was saving $50 a month thinking that his investing prowess will make him/her retire early, but the person who is earning the average return (1% less than the sophisticate) but putting away $1000/month – who do you think is better off?

Of course it’s not quite as simple as that either, but I think it adds to my point.

Think of a financial plan as similar to a business plan for a company. A business plan is going to include information on every aspect of that company, including projections for growth rates, tax analyses, risk management protocols, etc. Everything is well defined.  And it isn’t just crafted at the company’s inception and then forgotten about! It is continuously reviewed and revamped as things change.

So now we have a loose concept of what a financial plan is supposed to be like, but let’s take it further.  There are generally 8 main categories that a financial plan will encompass:

1. Cash Flow Management

2. Investment Planning

3. Retirement Planning

4. Mortgage Planning

5. Estate Planning

6. Tax Planning

7. Credit and Lending Planning

8. Insurance Planning

…and believe you me, each category is very expansive.

A Financial Plan will co-ordinate all these categories together and at different times will focus on some categories more intently than others (depending on your life stage).  I’m going to tell you that most people think that a table that shows them compound growth of $100/month with a return of 8% is a financial plan, and when you ask them if they have one, they truly believe they do!

Most Financial Plans are under 10 pages which I think is better than no plan, but not good enough. Now, perhaps because of my scientific background and being ANALytical beyond belief my average financial plan is about 75 pages long. I have written plans well over 100 pages and rarely are they below 40. Of course I include some serious analyses in my plans like a Monte Carlo Sensitivity Analysis on the clients current plan and compare that with the same analysis on the recommended plan.

(In a nutshell, the Monte Carlo Sensitivity analysis allows for greater confidence in your plan writing as it takes into account the fact that if you use an 8% rate of return for the investments as the AVERAGE, the portfolio will have returns above and below that over the course of the plan – and the sequence of returns has a huge impact on your net worth as you retire.  It also randomizes your life expectancy so you could see if your plan would work if you lived 15 years longer than your family’s average life span. It’s uber cool stuff for a geek like me! I’ll write a post about it later in more detail.)

I’m going to clean up one of my financial plans from any mention of client names, change some data and remove some logos and then post the pdf on this site so you can download and take a look see. If you have a financial plan you will want to take a look and compare – and then go to your advisor and ask them to write you one.  If you don’t have a financial plan, you’ll still want to look and see what you should be getting… and the sooner the better!




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