Portfolio Exam: A $1.75 Million Portfolio Weighed Down by Fees
What's one trademark of a poorly designed investment portfolio? The answer is a portfolio whose risk character is incompatible with the risk character of its owner.
Frequently, these risk incompatibilities are camouflaged by a hot stock market. But when the market reverses and begins to fall like it has lately, the problems of investment portfolios with unsuitable risk levels becomes apparent.
My latest portfolio report card is for "PK," a 74-year old single retiree living in Colorado. He asked me to analyze and grade his $1,756,192 investment account, which consists of a taxable trust account and a Roth IRA.
PK told me he gave his portfolio to an investment advisor who sold everything and set up the current portfolio in October 2013. Prior to that, he had invested heavily in commodities, gold and technology -- and had not done well. His Roth IRA has $684,376 while his taxable trust account has a value of $1,071,816 and both accounts are managed by an advisor.
How does PK's portfolio do when it comes to cost, risk, diversification, taxes and performance? Let's find out.
PK's Top 5 Holdings
Fund Name | Ticker | Category | Category |
|---|---|---|---|
RIDGEWORTH LARGE CAP VALUE EQTY | STVTX | US Stocks | $113,938 |
VOYA CORPORATE LEADERS TRUST | LEXCX | US Stocks | $68,788 |
IVY INTERNATIONAL CORE EQUITY CL Y | IVVYX | Intl. Stocks | $57,390 |
AMERICAN FD WA MUTUAL INV FD CL F1 | WSHFX | US Stocks | $55,302 |
AMANA INCOME FUND INV | AMANX | US Stocks | $52,855 |
Cost. Reducing investment cost, commissions and transactions should be a priority for all investors. Why? Because the less you spend, the more you keep. How does PK do?
Some of PK's holdings, such as the American Funds Washington Mutual Investors Fund (ticker: WSHFX), American Century Mid-Cap Value Fund (ACMVX), and the American EuroPacific Growth Fund (AEGFX) have obscured 12b-1 fees that get funneled to his advisor. Yet, this same advisor is collecting another 0.85 percent on top of the 12b-1 fees. Talk about double dipping!
Overall, PK's portfolio holds 33 mutual funds in the taxable trust account and 26 mutual funds in the Roth IRA. The asset-weighted annual fund expenses are 0.71 percent, plus another 0.85 percent for advisor fees, which pushes the portfolio's annual expenses to 1.56 percent.
The cost of PK's portfolio is eight times higher versus a blended benchmark of index exchange-traded funds matching PK's asset mix.
Diversification. Any investment portfolio without broad market exposure to the five major asset classes -- stocks, bonds, commodities, real estate and cash -- is not adequately diversified.
PK's portfolio has exposure to U.S. and international stocks, bonds, commodities, real estate and cash. Outstanding! However, the portfolio has several overlapping positions that creates a condition known as over-diversification.
For example, PK owns duplicated exposure to U.S. large-capitalization stocks via the Ridgeworth Large Cap Value Equity Fund (STVTX), the American Funds Washington Mutual F1 Fund (WSHFX), American Funds New World Fund (NWFFX) and Voya Corporate Leaders Trust Fund (LEXCX).
A contributing problem to PK's portfolio diversification shortcomings is that he owns way too many mutual funds -- 33 in the trust account and 26 in his Roth IRA.
In the end, PK's portfolio has sloppy diversification, which is all the more unacceptable because it was assembled by a fee-charging advisor.
Risk. PK told me, "I like having a safe, balanced investing strategy that does not take a lot of management." On my 10-point risk scale, he was five, which makes him a moderate investor. He also told me his investment time horizon is five to 10 years.
The overall asset mix of PK's total portfolio is the following: 61 percent stocks, 29 percent bonds, 5 percent real estate, 0.5 percent commodities and 4.5 percent cash. This asset mix tilts on the aggressive side for a mid-70s moderate investor. A market decline of 20 percent to 40 percent would subject the combined portfolios to potential market losses of $212,000 to $425,000.
Tax efficiency. PK's overall tax efficiency is OK for the Roth IRA, but can be improved in the trust account. Most of the active funds held in this account aren't particularly tax efficient because they have elevated tax cost ratios. PK could definitely benefit by owning more tax-smart investment vehicles like index ETFs.
Performance. PK's portfolio grew $32,886 (1.9 percent) from June 2014 to June 2015, versus a gain of 1.9 percent for the index benchmark matching his same asset mix.
Although he matched the performance of a blended index ETF benchmark over the past year, PK's portfolio costs are eight times higher. In other words, he would've done better had he simply invested in a basket of index ETFs matching up with his asset mix!
The final grade. PK's final report card grade is "C" (weak). This means his portfolio has major flaws in three out of five grading categories.
Cleary, the cost of PK's portfolio is excessive, his diversification is sloppy, his portfolio's risk is elevated and his advisor is directly responsible for the mess. Additionally, PK's portfolio has 59 mutual fund positions, which is overkill for a portfolio of this size. Although PK's one-year performance matched the benchmark, he could've enjoyed identical results with eight times lower cost by simply investing in index-based ETFs.
Now that PK's portfolio has been diagnosed, it's up to him to fix the flaws. And I can confidently say that firing his current advisor would be an excellent place to start.
