Bending the Cost Equation in Favor of Investors

Advisors have more products and information at their disposal than ever before to build cost-effective portfolios.  Capitalizing on these tools can yield significant savings and substantially better outcomes for clients.

Pricing is the driver that steers the invisible hand of capitalism – directing more efficient allocation of resources and ultimately better outcomes.  It is ironic that the investment management industry – an essential ingredient to healthy capital markets, remains one of the most price insensitive markets.  The total cost for an investor to have their portfolio managed can range from as low as 0.30% to more than 3.00%.

Of course there are many variables that affect pricing, including the scope of advisory services provided, the products used in the portfolio, and the size of the account.  However, pricing is clearly less than efficient, despite easier discovery and comparison than ever.  There are also more options for controlling cost.  As the quote from Charlie Ellis suggests, it may be time to exercise some of these options.

A full review of the issues that undermine more efficient pricing and all the potential remedies is beyond the scope of this commentary.  Instead, we offer a couple of practical ideas and considerations for bending the cost equation in favor of clients and improving their long-term outcomes.

Less Expensive Access to Active Managers

Most portfolios that subscribe to active management are formulated using a variety of managers to fulfill the various asset classes in the portfolio.  Access to these managers can be achieved through a range of vehicles, including mutual funds, separately managed accounts (SMAs), or models-based management.

Models-based management has emerged as a new alternative to mutual funds and traditional SMAs.  In a models-based approach, the portfolio manager acquires the investment models of third-party managers and incorporates them into a single unified account (referred to as a Unified Managed Account, or UMA).  A key benefit of using models-based management in a UMA is the control the portfolio manager can exercise to coordinate trading across managers, and to customize the portfolio as needed.

There is another benefit of the models-based approach that is more basic, but equally profound.  It significantly reduces the cost to access third-party managers.  The difference in the cost of acquiring models versus outsourcing each sleeve of the portfolio to a separate account manager may be as much as 30-40 bps.  Over time, that cost savings goes a long way to enhancing the net outcome of a client’s portfolio.

Core/Satellite Strategies: Separating Beta from the Pursuit of Alpha

Research shows that a substantial portion of return for active managers is a function of simply participating in the market (Beta).  This is particularly true for core markets, such as large cap stocks, where markets are quite efficient.  As a result, it’s very difficult for active managers to achieve a meaningful excess return over the market (Alpha).

Since there is typically a significant premium in the fees for active managers, a growing number of investors have migrated to passive products like ETFs or index funds to achieve a market return at a lower cost, and forego the pursuit of excess returns.  There remains a deep philosophical divide and plenty of debate on this topic, but is clearly a simple way to reduce cost.

Another alternative that has received less attention, but warrants consideration, is the idea of a core/satellite portfolio.  In a core/satellite portfolio, a portion (the core) is invested in low-cost passive products, while the remainder (the satellite) is invested in actively managed products.  The objective of this approach is to generate similar potential returns as all-active management, at a lower cost.

A core/satellite strategy is based on the principle of “active risk” and how it is generated.  Active risk is a measure of the amount an active manager is deviating from their benchmark in an attempt to achieve Alpha.  The amount of active risk taken defines how much an active manager may outperform – or underperform the market.

A variety of strategies can be used to achieve active risk in a portfolio.  The table below illustrates three examples of portfolios with active risk of 4% accomplished in different ways: (i) using all active managers, (ii) using a passive ETFs in the core and active managers for the satellites, or (iii) using a higher % of ETFs in the core and alternatives with higher active risk for the satellites.

Note that the core/satellite portfolios deliver comparable active risk with much lower total fees.  This savings is accomplished by “buying Beta” through passive ETFs in the core portfolio, and concentrating the pursuit of Alpha, and the higher costs associated, into the satellite components.

Effective execution of a core/satellite strategy requires a qualified portfolio manager, but the potential benefits make it an option well worth considering.