Things I learned from an actual big bank advisor portfolio

If you follow the world of financial advice at all, you know that professional financial advisors don’t have much patience for the so-called advisors you find tucked away in the corner of bank branches or affiliated with brokerage houses. Unlike fee-only Registered Investment Advisors, such firms have substantial flexibility to give “advice” that operates in the best interests of the firm, instead of the best interests of their customers. They may accept commissions for the sale of certain products, and they may be restricted by their proprietary platforms from offering clients certain funds.

I knew all that in the abstract, but a concrete example is always more useful than abstract knowledge. Fortunately, last weekend I had the chance to examine an actual portfolio put together by an advisor with a big bank’s advisory arm, and it was illuminating. Here are some of my biggest takeaways.

Ignore the equity/fixed income allocation

The portfolio I was looking at ostensibly had a 65/35 equity/fixed-income allocation. At least, that’s what it said on the front page. Digging into the actual fixed income portion, I found a large portion of the “fixed-income” position was a long-short PIMCO fund. Now, I’m not here to tell you whether PIMCO is good or bad at buying and selling bonds. They may be the best at buying and selling bonds. But some PIMCO fund manager gambling with your money is clearly not what most people think of as a “fixed-income allocation.” It’s simply a bet that you’ve picked the right active manager, and he happens to be gambling in bonds instead of equities.

I don’t have any bonds in my portfolio, but I don’t have any problems with bonds in the abstract. I’ve even written before about what you might do if the risk-free rate of return was enough to meet your investing goals. If you are nearing retirement, or have near-term obligations like down payments or educational expenses, it might make perfect sense to move assets into short-term or intermediate-term bonds in order to preserve your purchasing power against the coming economic calamities. That’s what the “fixed-income” portion of a portfolio means to me.

But if the actively-managed fund you’re invested in just happens to use bonds in order to gamble with your money, that’s properly allocated to your “gambling” asset allocation, not your fixed-income allocation.

Beware of fake diversification

There are two essential things you need to know about diversification. First, the purpose of diversification is not to improve the total return of a portfolio; it’s to improve the risk-adjusted return of a portfolio. Second, diversification only improves the risk-adjusted return of a portfolio if you diversify into uncorrelated assets. The lower the correlation between assets, the better they play the role of portfolio diversifier (if diversification is something you want in your portfolio).

The portfolio I examined had 11 mutual funds with equities (10 equity mutual funds, 1 “balanced” fund). I looked at the top 5 holdings in each mutual fund, and discovered the following:

• 4 held Microsoft;
• 4 held Google;
• 3 held Apple;
• 2 held Johnson and Johnson;
• 2 held Proctor and Gamble;
• 2 held Verizon;
• 2 held Investors Bancorp.

Meanwhile Amazon and Berkshire Hathaway were each owned by one fund.

The Vanguard Total Stock Market Index Fund’s top 10 holdings are:

1. Apple Inc
2. Microsoft Corp
3. Alphabet Inc
4. Amazon.com Inc
5. Facebook Inc.
6. Johnson & Johnson
7. Berkshire Hathaway Inc
8. Exxon Mobil Corp
9. JPMorgan Chase & Co
10. Wells Fargo & Co.

This isn’t an endorsement of the Vanguard Total Stock Market Index Fund (although it’s a very good, very cheap domestic stock fund). It is an indictment of obfuscating a client’s actual holdings through overlapping mutual funds. When you own a market-capitalization-weighted mutual fund you know exactly what share of each fund is represented by each company (if you can do a little math). When you own 11 equity mutual funds with overlapping holdings, how can you possibly hope to know what your actual exposure is to any given company or industry?

Maybe Facebook, Exxon Mobil, JPMorgan Chase, and Wells Fargo are bad companies and you don’t want to own any mutual funds that hold them (at least in their top 5 holdings — I didn’t check every single holding). That’s up to you. What doesn’t make any sense is to own 11 different mutual funds just to avoid 4 individual stocks.

Worst of all, in addition to mutual funds holding the largest domestic US stocks, the portfolio also included the individual stocks themselves! Under these circumstances it’s virtually impossible to determine how exposed the investor is to a single large company.

Simply put, this isn’t what people mean when they say “diversification.”

Costs Matter (1)

The cheapest domestic equity mutual fund (actually an ETF) in this portfolio had an expense ratio of 0.5%. The most expensive had an expense ratio of 1.08%. The cheapest held, in its top five holdings, both Google A shares and Google B shares. The most expensive held Google A shares. I do not care if you want to overweight or underweight Google in your equity portfolio. But there’s no earthly reason to pay over twice as much to hold Google in one mutual fund when you’re already holding it in another, cheaper fund.

Costs Matter (2)

This portfolio included as its primary real estate holding the Cohen & Steers Global Realty Majors ETF, ticker symbol GRI. This ETF aims to hold an allocation of 55% North American securitized real estate (mainly US) and 45% securitized real estate outside North America. It has an expense ratio of 0.55%.

I took the liberty of comparing GRI to an identically composed portfolio of Vanguard’s domestic (VNQ, 0.12% expense ratio) and international (VNQI, 0.15% expense ratio) real estate holdings. You may or may not be shocked to learn that the low-cost Vanguard blended portfolio outperforms GRI.

But you shouldn’t be.

Even blind squirrels find the occasional nut

I was modestly surprised to find in this expensive, weirdly-weighted portfolio that the advisor had also included what seems like an excellent intermediate-term socially-responsible bond fund, the TIAA-CREF Social Choice Bond. It has a not-unreasonable expense ratio of 0.4%, and is actually invested in legitimately interesting issues like water and sewer projects around the country. If that were the entire fixed-income allocation in this portfolio, I wouldn’t have anything else to say about it. Unfortunately, it was far outweighed (by an order of magnitude) by the kind of speculative “fixed-income” products I mentioned above.

Conclusion

If you’ve made it this far (hell, if you’ve even made it to this blog) you may think this is all old news and anyone who knows anything about investing, or has any money to invest, is already in a sensible Boglehead 3-fund or 4-fund portfolio.

The fact that you think that is why I wrote this post. Lots of people are not in sensible 3-fund or 4-fund portfolios, and it’s not their fault. It’s the fault of the people they trust to advise them.

It’s not unreasonable to pick an investment portfolio that reflects your values. There’s no law that says investments must be made with the goal of maximizing risk-adjusted returns, or even to produce any returns at all.

If you want to invest in socially- or environmentally-responsible companies, or buy the bonds of countries or municipalities that reflect your values, you have no obligation to put financial returns ahead of your values.

But no matter what your investment philosophy is, there’s no reason to let middlemen pocket 1-3% of your capital per year in order to implement it.