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.

Synopsis

• In their early 50s
• Have accumulated a $2,100,000 portfolio
• 98% of their total portfolio is invested in the CBC Monthly Income Balanced Fund, which includes non-registered, corporate, and RSP accounts
• Frustrated with investment results

	Portfolio Holdings	Mr. Balanced	Mrs. Balanced	Joint	Total
Non-Registered Assets:
	ABC Canadian Small Cap Fund	$22,633			$22,633
	A&F Global Equity Fund		$6,503		$6,503
	Grade A Dividend Fund		$6,424		$6,424
	Fortune Oil & Gas Common Shares	$4,020			$4,020
	Strata Oil & Gas Common Shares	$10,944			$10,944
	CBC Monthly Income Balanced Fund	$18,333			$18,333
	CBC Monthly Income Balanced Fund			$458,107	$458,107
	CBC Monthly Income Balanced Fund		$50,085		$50,085
	Total Non-Registered Assets	$55,930	$63,012	$458,107	$577,049
Corporate Assets:
	CBC Monthly Income Balanced Fund			$1,305,040	$1,305,040
Registered Assets:
	CBC Monthly Income Balanced Fund	$136,609			$136,609
	CBC Monthly income Balanced Fund		$114,101		$114,101
	CBC Monthly Income Balanced Fund		$28,106		$28,106
	Total Registered Assets	$136,609	$142,207		$278,816
Total Assets		$192,539	$205,219	$1,763,147	$2,160,905

Portfolio breakdown:

Fund			MER	TER	Market Value	% of Total Portfolio	Asset Class Exposure
ABC Canadian Small Cap			1.94%	1.05%	$22,633	1.05%	Cdn Equity
A&F Global Equity			2.90%	0.08%	$6,503	0.30%	Int'l Equity
Grade A Dividend			2.49%	0.08%	$6,424	0.30%	50% US, 45% Int'l, 5% Cdn
CBC Monthly Income Balanced			2.11%	0.10%	$2,110,381	98.34%
	45%	Dividend			$949,671	44.25%
	20%	Income			$422,076	19.67%
	5%	US Equity			$105,519	4.92%
	5%	Int'l Equity			$105,519	4.92%
	10%	Cdn Bond			$211,038	9.83%
	15%	Short Term Bond			$316,557	14.75%

Asset mix and fee summary:

Total Asset Class Exposure Canadian Equity 44.19% US Equity 5.07% International Equity 5.35% Canadian Fixed Income 45.39% Portfolio Weighted MER 2.11% Portfolio Weighted TER 0.11%

Analysis

1. This broken portfolio held several mutual funds from different fund companies and a couple of oil and gas stocks (Strata and Fortune). The clients revealed that they had dealt with a broker and their bank at different times. As a result, their portfolio was an accumulation of investments rather than a properly diversified portfolio.

   The stocks held in the portfolio demonstrate speculation mixed with investing. They had significantly higher risks associated versus the mutual funds, so were essentially "lottery tickets", with little chance for a successful outcome.

   Although there was a reasonable split between equity and bond, the Canadian Equity asset class was over-weighted and US and International Equity were underweighted.

   Although frustrated with their returns, they did not know what they were.

2. These clients were unaware of the high cost of their mutual funds; their management expense ratio (MER) averaged 2.11%.

   Their funds also incurred an average trading expense ratio (TER) of 0.11%, although the ABC Canadian small cap fund had a much higher trading expense (1.05%). While the ABC Canadian small cap fund charged a management expense ratio of less than 2%, add in the trading expense, and the funds' total cost approaches 3%.

   While some clients know the MER, few recognize the additional expense of an actively traded mutual fund. Thus, the broken portfolio incurred an average weighted expense ratio of 2.22%.

3. Private counsel firms charge fees that decline as the total portfolio under management increases. Mutual funds, however, charge the same fee, regardless of whether $20,000 or $2,000,000 is invested. Simply reducing the fee to 1.50% saved clients 0.72%, or almost $15,000 annually.

4. Another significant inefficiency occurred as a result of the heavy use of a balanced fund across all of the client's accounts. A balanced fund produces interest income and dividend income as well as capital gains and losses. The clients have taxable and non-taxable accounts.

   We replaced the balanced fund with individual asset class securities (index funds): a Canadian equity index fund, a U.S. equity index fund, an international equity index fund, a bond index fund, etc. This allows specific types of income to be matched with taxable and non-taxable accounts for tax efficiency.

   The result is lower taxes each year. Called “asset location for tax efficiency, this also saved the clients thousands of dollars annually.

5. A further note on the tax inefficiency of mutual funds in taxable accounts. When any unit holder redeems their units the mutual fund manager may sell securities to raise cash. Selling these securities could create taxable gains that are shared among all unit holders–not just the redeeming unit holder.

Corrective steps

1. Meet with Mr. and Mrs. Balanced Fund to determine their objectives, circumstances, and constraints.
2. Develop 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 management of the portfolio.
4. Implement asset mix with index funds to avoid underperformance and capture market returns.
5. Correctly position index funds among taxable and non-taxable accounts 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 they can't control markets or accurately predict their direction. Yet, there are things they can control, which are ultimately their responsibility. Better results require different thinking and investing.