Keeping it simple

Over the years, I have reviewed the portfolios of many self-professed do-it-yourself index investors. I’ve also seen portfolio-design details used by many financial advisors – including some of the newer “robo-advisors” – which state they embrace “passive investing.”

The vast majority of these portfolios aren’t structured in a way consistent with indexing’s underlying theory. If you are an advisor who leans toward passive investing, you should strongly consider fully embracing indexing in its purest form.

Indexing’s basic tenet is to obtain the broadest exposure possible at the lowest available cost. In theory, this means gaining exposure to all private and public assets (other than T-bills) – which isn’t feasible. The next closest thing is to obtain financial market exposure through broad market-tracking mutual funds and/or exchange-traded funds (ETFs).

For example, a world stock market ETF and a world bond market ETF would cover the globe. This broad exposure called for by indexing purists can be balanced with the need to match investment assets with spending plans. For the equities part of a portfolio, consider investing one-third of the assets in a Canadian equity ETF and two-thirds in a world (ex-Canada) equity ETF. And seek out a Canadian bond ETF for the bond portion of the portfolio. No “smart beta.” No gold tilt. No U.S. overweighting. Just pure, broad market exposure.

This three-ETF portfolio carries an annual management expense ratio of just 15 basis points (bps). But this solution is overlooked. Too often, I see advisors with practices built on the premise that picking active portfolio managers is unreliable, so they opt go “all passive” with ETFs. The problem is that most advisors still add a financials ETF here, a gold ETF there, and split up the U.S., Europe, Australasia and Far East and emerging markets (in markedly different proportions). All this slicing and dicing adds up to active portfolio-management decisions – but, in this case, by the advisor or broker. And if your pitch to clients is that mutual fund portfolio managers can’t add value, what makes you think you can? If you really want to offer your clients the benefits of indexing, design a simple indexing portfolio with razor-thin fees.

The challenge is persuading a client to pay for such a simple, passive solution. And if you focus on investment management and nothing else, perhaps this hurdle is too high. But if you like the idea of passive investing and also do a reasonable amount of planning for clients, there are compelling reasons to embrace the simplest and cheap solutions. These include:

More time for value enhancement. This solution leaves a lot more time to devote to the most value-added activities – i.e., client discovery, goal quantification, financial planning, asset allocation and nudging clients away from wealth-destroying behaviour.

No active management risk. With a simple, indexed portfolio, you need not worry about a money-management firm getting so successful it attracts too much money. Nor do you need to worry about key lead portfolio managers leaving for competitors or to launch their own firms. Due diligence and research still is required, but not nearly as much.

Rebalancing is simplified. Rebalancing becomes easier, more focused and probably less frequent. It’s cheaper, too, compared with the costs of adjusting a portfolio consisting of eight or 10 products – for which trading costs can add up.

Low client cost without cutting your fee. If you choose products for clients that have annual management fees of 15 bps and you add 1% for your services, you have an all-in cost of 1.28% (including HST in Ontario). And with so little of the fees embedded in the products, you maximize your client’s potential for fee tax-deductibility. From a fee perspective, this strategy is the best of both worlds. You charge a full fee, but leave your clients with a total cost that rivals even your lowest-cost competitors – including robo-advisors.

Performance has been decent. A portfolio of 20% Canadian stocks, 40% global stocks and 40% Canadian bonds using the three-ETF model above held up well during a tough January 2016. This portfolio posted a solid return in 2015 (4.4%) and boasted average annual returns of 4.6% for the two decades through February 2016. All of these returns are net of the aforementioned all-in costs.

Almost nobody else is doing it. If my anecdotal evidence is at all representative, you will stand out in terms of philosophy and approach. So, part of the appeal is that your portfolio structure, design and underlying philosophy are pretty unique – not a bad thing when trying to differentiate yourself from your competition.

Dan Hallett, CFA, CFP, is vice president and principal with Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for affluent families and institutions.