Investing: How to Get the Best Long-Term Returns

    To obtain the best long-term gains with the least amount of risk, research shows you need to hold a portfolio diversified across a minimum of seven asset classes.  Nobody that has researched portfolio management for five minutes is going to argue against diversification.  However, many will argue what diversification means.

    In the broadest sense diversification means constructing a portfolio from a wide range of different asset classes, each with different risk/return characteristics.  Asset classes are the different baskets of similar investments you divide your portfolio into.  For example: Large-Cap Stocks, Cash, International Bonds, Commodities, or Real Estate.  To properly diversify you need to hold a group of baskets (portfolio of asset classes) matching your unique investment profile.  If you do not own investments spread between different asset classes than you are losing most of the benefits of diversification.

    To properly diversify you need to diversify on two levels; within each asset class and between asset classes.  Some people would argue that owning a mutual fund or owning stocks representing different asset classes provides diversification.  However, most mutual funds only diversify within one or two asset classes and without owning a hundred stocks you can not be both diversified across multiple asset classes and within each asset class.  You need approximately 10 asset classes, each consisting of a minimum of 10 different securities, to maximize the benefits of diversification.

    To accomplish this with mutual funds you would need to own between 8-10 different funds, each with a different investment strategy.  Creating a portfolio in this way would allow the individual investor to diversify across different asset classes and it would provide diversification within each asset class.  But, as I'll explain shortly, mutual funds create another set of problems for investors.

    I invest client's money in a portfolio of up to 15 different asset classes specifically tailored to each client's goals, restraints, and risk profile.  Within each asset class, client's own the individual stocks and ETF's that best represent each asset class.  This lowers fees, provides better diversification, and improves transparency in your portfolio.  These portfolios are called Diversified Asset Class Allocations or DACA's.

Fees:  How Different Investment Managers Charge You

    This differs from most investment managers.  Investment managers fall into two categories; investment advisors and brokers.  The difference is how they are paid.  Investment advisors charge a percentage of assets and brokers charge a commission, based on transactions.  This means from a compensation standpoint an investment advisor's goal is to increase the size of your account because they make a percentage of assets, whereas, a broker's goal is to create transactions.

    Paying someone on a transaction basis (even if it's a discount broker and you are your own investment manager) creates a damaging conflict of interest between you and your investment manager.  Both parties motivation for buys and sells can be greatly influenced by the amount of money paid for each transaction.  I've personally seen brokers the day before payday call a client to sell a winner only to increase their paycheck.  I've also seen client's turn down a recommendation to sell a loser because they didn't want to pay a commission, only to lose ten fold what would have paid in commissions.  There's no way around it, and it's nearly impossible to determine when it's happening, but the conflict of interest exists on both sides and is fundamentally damaging to managing a well run portfolio.

    However, even most investment advisors who charge a percentage of assets create conflicts of interests.  Most invest client's money in mutual funds or other investment vehicles that charge a fee.  This creates a dual fee structure because both the advisor and mutual fund are charging the client for managing the same money.  In many cases, the investment manager also receives part of the fee charged by the mutual fund, earning fees that are undisclosed to the client.

    As a "fee only" investment advisory IMYERS does not charge any fees or accept any payment except those explicitly stated in our client agreement.  In short, you pay us a predetermined percentage of assets under management and there are no other charges.

Mutual Funds:  Why They Should be Avoided

    The only way to do this is to avoid using mutual funds.  This usually raises two questions:  Why avoid mutual funds?  And: How do you avoid using mutual funds?

    Why I avoid mutual funds and why I believe most investors should is because they do not fully disclose fees and they make it extremely difficult to effectively manage a properly diversified portfolio.

    The fee disclosure issue is a simple one: If you don't know what you're paying, how can you possibly determine the value of the service.  Mutual funds disclose their management and operating expense ratios.  However, they do not disclose their trading costs or revenue sharing agreements in the same way.  Unfortunately, unless you are trained to find and account for these additional costs, there is no way to determine the full cost of mutual funds.  Three separate studies have shown these hidden fees are approximately equal to the disclosed fees...effectively doubling the cost most investors think they are paying when investing in mutual funds.

    Additionally, mutual funds have inherent problems if you try to use them to manage a diversified portfolio.  Almost all stock mutual funds hold some cash, usually 5-8%, and some bonds, usually 2-5%.  They hold this cash to pay investors when they redeem shares, to pay expenses, and for making changes to the portfolio.  Without tracking the cash and bond holdings of all the mutual funds in your portfolio and adjusting your portfolio weights based on this information you will always be overweight cash and bonds.  This is part of the reason most mutual funds don't beat the market.

    Mutual funds also typically do an extremely poor job of maintaining a focus on their investment objective.  All mutual funds have a stated investment objective and this is how investors determine what asset class they are investing in.  If mutual funds stuck to this objective (and you could account for the excess cash and bond holdings, and determine their actual fees) they would make great investment vehicles.  Unfortunately, due to the pressure to perform relative to the overall stock market almost all mutual funds stray from their investment objective.  This is called style drift.

     Over time, almost all funds begin to drift towards the sector and stocks that have recently gone up the most.  During 2007 most funds began adding oil and gas stocks when that sector was doing well.  This may have improved their results in the short-term, but it erodes the benefits of diversification for your portfolio, and when oil and gas stocks stopped performing well in 2008, all the funds that drifted towards these stocks suffered.

     Due to the undisclosed fees, inability to hold 100% of an asset class, and style drift, mutual funds are extremely tough to use to manage a properly diversified portfolio.

IMYERS:  How We Do Things Differently to Benefit You

    To avoid mutual funds I use FOLIOfn as a custodian.  As the custodian, they hold your cash and securities, perform trade execution, and clearing services, and provide your electronic confirms and statements.  For more informations go to www.FOLIOfn.com.  With FOLIOfn's technology I can create Folios.  Folios are portfolios made up of the stocks and ETF's I choose.  So rather than owning a Large-Cap mutual fund, I subscribe my client's to my Large-Cap Folio and each subscribed client owns the individual stocks in the exact same percentages as the Folio.

    Currently I maintain Folios representing 15 asset classes and subscribe client's to them based on their unique investment profile to create their Diversified Asset Class Allocation.  This eliminates the problems associated with mutual funds and provides unique customization benefits to clients.

    The 15 Folios are filled with the securities that best represent each asset class.  This prevents the style drift and overlap experienced with mutual funds.  You own each security in the Folio directly.  This eliminates the need to maintain a dedicated cash balance in every Folio, creating an easy to maintain allocation percentage between asset classes that is nearly impossible with mutual funds.  There are no commissions for trades and all charges by FOLIOfn are included in my fee.  This eliminates any potential for undisclosed or hidden fees.  Simply put, I create a well diversified portfolio without any of the problems or hassles associated with using mutual funds or other investment vehicles, and I do it with one simple fee.

    Although it's negotiable and dependent on the size of the account my fee is a percentage of assets starting at 2% for small accounts and going down to 0.50% on portions of large accounts.