When you’re dining out at a fancy French restaurant, you probably don’t mind paying a premium price for an elaborate four-course meal featuring high-end, hard-to-find ingredients prepared by a skilled chef. On the other hand, you probably wouldn’t want to pay a premium price for mass-produced chicken tenders fried up by a high school kid in a paper hat (even if those chicken tenders are deliciously satisfying). It’s kind of the same thing with your investments.
Regardless of your asset allocation or the type of investments you own (ETFs, mutual funds, annuities, etc.), they generally fall into three categories – Beta, Smart Beta and Alpha. Beta strategies are essentially broad market exposure, based on investing in the S&P 500, Russell 100 or a broad bond index, such as the Barclays Aggregate Bond Index.
Smart Beta strategies offer a slight alternative to simply investing in a broad index. For instance, a popular Smart Beta strategy is a portfolio invested in high-quality dividend-paying stocks or a more concentrated portfolio made up of large-cap growth stocks. The third option, and arguably the most advantageous component of an investment portfolio, would be Alpha strategies. These are investment strategies designed to outperform Beta and Smart Beta strategies all the while, at least ideally, taking on less risk than their less complex counterparts.
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Sophisticated investors have long appreciated the value of Alpha strategies. There is little question that there is value, and consequently a commensurate cost, to generating market-beating returns while taking on lower levels of risk. Nonetheless, given that all investment strategies go through periods of underperformance, prudent investors deploy a variety of strategies, combining Beta, Smart Beta and Alpha strategies to achieve their investment goals.
Unfortunately, most investors often are paying similarly high costs for Beta and Smart Beta Strategies as they are for Alpha Strategies. Given that in most cases Beta and Smart Beta strategies represent the largest component of a portfolio, and that these strategies are readily available in many forms and cost as little as a few basis points (1 basis point = 1/100 of 1%), many investors are vastly overpaying for their investments.
It is not unusual for an investor with a $1 million portfolio to pay a 1% annual investment advisory fee, plus underlying portfolio and trading costs, which often amount to another 1% or more. The grand total for these fees can easily be $20,000 per year!
Take a hypothetical $1 million portfolio invested in a traditional, albeit increasingly less effective, 60/40 stock-and-bond portfolio. Odds are that over two-thirds of the portfolio is invested in Beta and Smart Beta strategies, providing the investor with the opportunity to significantly cut costs without sacrificing returns.
Assume $250,000 is invested in a Smart Beta strategy, such as a portfolio of high-quality dividend-paying stocks or growth stocks with fortress-like balance sheets. This can be efficiently achieved by investing in the iShares Core S&P U.S. Growth ETF (ticker: IUSG), which costs 5 bps. Another $250,000 might be invested in an S&P 500-like investment (Beta). There the State Street S&P 500 ETF (SPY) offers the purest exposure and only costs 10 bps. For the fixed income component of the portfolio ($200,000), the Vanguard Total Bond Market ETF (BND) costs 5 bps.
By reducing the implementation and investment cost as illustrated above, from 1% to less than 1/10th of 1% (6.78 bps to be exact) for the Beta and Smart Beta portion of their portfolio, the investor would save $6,525 in underlying portfolio costs in year one, and depending on growth, more in subsequent years.
What this means for investors is, while it's important to seek professional help as you prepare for retirement, don't be afraid to take on the more basic portion of your portfolio yourself. With a few simple, low-cost funds, you can build a base for yourself, while leaving the rest to the experts.
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