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Fixing Broken Portfolios: Case Studies

Consider the following case study. It reveals how common it is for intelligent and successful people to end up with broken and dysfunctional portfolios. Fund names have been changed.

Portfolio Audit Case Study: Portfolio Turnover

Synopsis

  • In their early 60s and preparing to retire
  • Frustrated with portfolio results and volatility through difficult markets of 2007–2009
  • Concerned with the amount of trading in their mutual funds
  • Portfolio concentrated in Cosmic mutual funds

Annual portfolio turnover

 

2009      2008      2007      2006     

Cosmic Growth Fund

152.06%

225.73%

169.06%

187.22%

Cosmic Balanced Growth Fund

158.85%

260.97%

278.57%

176.86%

Cosmic Balanced Fund

171.38%

210.78%

226.66%

364.49%

Cosmic Balanced Income Fund

227.92%

234.40%

78.95%

176.51%

DFA Canadian Core Equity Index Fund

4.79%

7.29%

10.52%

9.39%


Analysis

  1. This clients suspicions were justified. The Cosmic Quarterly and Annual reports revealed consistently high levels of buying and selling. Note the much lower rate of portfolio turnover of the DFA Index Fund.

    Remember that portfolio turnover of 100% can increase fund expenses by as much as 1%. For example, the Cosmic Balanced Fund incurred portfolio turnover of 364% in 2006. This equates to a portfolio of stocks being entirely sold and then repurchased over three times in a year!

    A close look at the fund's annual report was revealing.

    Cosmic Annual Report: Financial Highlights:

    (2) Management expense ratio is based on total expenses (excluding commissions and other portfolio transaction costs)

    (3) The Portfolio’s turnover rate indicates how actively the Portfolio’s sub advisors manage its portfolio investments. A portfolio turnover rate of 100% is equivalent to the Portfolio buying and selling all of the securities in its portfolio once in the course of the year. The higher a fund’s portfolio turnover rate in a year, the greater the trading costs payable by the fund in the year, and the greater the chance of an investor receiving taxable gains in the year.

  2. Also interesting was the number of stocks in the Cosmic Balanced fund versus the benchmark TSX Composite Index. While the commercial benchmark consists of 234 Canadian companies, the Balanced fund held 160.

    How should we interpret this? Can we assume the manager of the Balanced fund had 160 favourite stocks? How well does he know 160 different companies across 10 different industries

    Or because the manager's performance is compared to the benchmark index, is there an incentive for the manager to avoid producing returns lower than the index?

Number of stocks: Cosmic Balanced Fund vs. TSX Composite Index vs. DFA

 

TSX
Composite
Index

Cosmic
Balanced
Fund

DFA
Canadian
Equity Index Fund

Consumer Discretionary

20

15

45

Consumer Staples

11

9

22

Energy

55

44

124

Finance

43

24

65

Healthcare

4

1

32

Industrial

20

16

48

Info Tech

5

6

42

Materials

62

39

188

Telecom

5

2

7

Utilities

9

4

14

Total Number of Stocks

234

160

587

 

Portfolio managers who wish to reduce the chance of underperforming often choose securities very similar to the benchmark index holdings.

Investors view "closet indexing"1 negatively because they could simply choose an index fund and pay lower fees.

Watch for funds with high MERs and holdings that look similar to the holdings of its benchmark index.

Corrective steps

  1. Meet with the clients to determine their objectives, circumstances, and constraints.
  2. Identify an appropriate asset mix adding sufficient asset classes to reduce risk.
  3. Build an investment policy statement to document steps 1 and 2 and guide the management of the portfolio.
  4. Implement the asset mix with index funds to avoid underperformance and capture market returns.
  5. Correctly position index funds among taxable and non-taxable account types for tax efficiency.
  6. Reduce management fee.
  7. Reduce portfolio turnover and tax. Rebalance only when necessary.
  8. Implement proper reporting of returns and expenses and taxes.

Final thought

Investors must recognize that they can't control markets or accurately predict their direction. Yet, there are things that they can control, which are ultimately their responsibility. Better results require different thinking and investing.


Fixing Broken Portfolios:
Case Studies

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