Implementing the Investment Plan Pt. 1: How to Own a Diversified Pool of Assets?

Wealth Management, The Practical Steps

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We started off by discussing how to create an effective plan of action and how to determine an optimal asset allocation. Now, let's delve into the practical steps: our recommendations for the execution and implementation of said investment plan.

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As we venture further, our focus will center on how to implement your chosen asset allocation strategy effectively, ensuring that it remains well-diversified, minimizes costs, and safeguards your investments from operational failures.

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Execution and Implementation of an Investment Plan: An Example

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Consider the scenario of Ryan, who recently sold his business and is keen on investing his proceeds. Ryan intends to step back from actively earning and let his savings generate a passive income. To do so, he formulates a plan to invest 60% in equities and 40% in bonds. His intention is twofold: to protect his savings against inflation and generate a steady 5% income that supports him and his family's lifestyle. Ryan grasps the importance of diversification and hence aims to buy a wide range of equities and bonds, with a target of at least 100 different types of each. He aims to steer clear of heavy concentration in specific industries or geographical regions.

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Separately Managed Accounts

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However, Ryan quickly recognizes the impracticality of his strategy — identifying and investing in so many different companies and bonds individually could be a full-time job in itself, which might even demand resources that he lacks. Therefore, he decides to consult a wealth management company, ABC Capital. Their advisors propose a solution known as a discretionary portfolio, also referred to as a discretionary mandate or a separately managed account (SMA). In this arrangement, ABC Capital will document Ryan's objectives and manage his portfolio accordingly, charging a fee for their services.

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Fast-forward a few years to where Ryan reviews his portfolio to find that it has performed closely in line with his expectations. However, a casual lunch with his ex-business partner, Adam, reveals that Adam's portfolio, managed by XYZ Wealth, has outperformed expectations by an additional 4%. This revelation casts a shadow of doubt on Ryan's satisfaction with his portfolio's performance.

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To resolve such issues and bring transparency, the financial industry employs benchmarks. These benchmarks provide an industry standard to assess the performance of specific types of portfolios. Ryan can use these benchmarks to gauge the performance of his equity portfolio, by comparing ABC’s investment management with the returns of a hypothetical portfolio that simply invests in the 500 largest US companies proportionately (known as the S&P 500 Index).

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Notably, studies have shown that separately managed accounts and discretionary accounts rarely outperform the indices used as benchmarks, especially after accounting for fund management fees.

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Mutual Funds

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In response to this reality, the best portfolio managers, instead of working for one client, create their own funds; these are known as Mutual Funds. Recognizing that most individuals have similar financial objectives, these funds allow any client to buy into or sell out of a common pool of assets.

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Prompted by his initial disappointment, Ryan decides to take a more active role in his investments. He invests 60% of his wealth in the top-performing equity mutual fund he can find, and 40% in a top-performing bond mutual fund. He also makes it a point to compare their performance against their respective benchmarks, to ensure he's getting what he pays for. More years pass, and Ryan finds that his equity investments are now closely tracking the benchmark. Yet, he's still puzzled by his inability to find a strategy that consistently outperforms the market.

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In fact, studies confirm Ryan's observations, with a significant percentage of mutual fund managers failing to outperform their relevant benchmarks.

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Index Funds

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This conundrum gave rise to Mutual Funds that, instead of being actively managed, instead focus on a passive strategy of replicating the index. This strategy would aim to match the performance of a benchmark index while minimizing fees. By investing in an index fund tracking the top 500 companies in the US, Ryan would gain exposure to a diverse range of companies that generate returns from various sectors globally. By allocating towards index funds as well, Ryan now also removed his reliance on the decisions of the professional fund manager.

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By delving into the operational element of implementation, it becomes easy for anyone, including Ryan, to lose focus on the original strategic objective. Ryan’s goal was never to “outsmart the market”, but to instead diversify away his company, sector, and geographical risks when owning different companies and lending to them as well. So he decides to employ various different professional methods of investing, by investing with active professional fund managers and with passive index funds as well.

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Exchange Traded Funds (ETFs)

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Although the most important focus of managing your wealth should be on the quality of the plan, it is also important to focus on the reduction of unnecessary costs and fees that could drag your income down.

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Therefore, in the 90s, a new type of fund structure was established to further reduce costs and enhance efficiency; the exchange traded fund (ETF). An ETF is a fund (could be passive or actively managed) that is listed on a stock exchange similar to how a company would be listed. Instead of having to go directly to the fund manager every time you want to invest or withdraw, having it on an exchange makes it easier to interact with. Amongst its other advantages, an ETF is more cost-effective. In the beginning of its introduction to the mainstream investment community, it was most popular as a vehicle for passive index-tracking investing. However, since then, it has expanded to where even the best actively professionally managed fund managers list their funds on exchanges as well.

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An investor like Ryan, could now simply through his financial advisor or digital platform, easily invest and withdraw money directly through access to the exchange and at a lower cost.

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Conclusion

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Choosing which vehicle to use to implement your investment strategy can be challenging; luckily, this is an area which is highly researched to optimize investor outcomes. At the moment, data is showing that passive investment strategies have historically outperformed active ones in less complex, developed markets such as US stocks. However, this trend does not hold as strongly in more complex markets, such as emerging markets or bonds. Employing various different strategies to achieve your financial objectives whilst keeping an eye on costs would be the best method. Our recommendation for your personal asset allocation would be to consult with a competent financial advisor whom can assist you in formulating a personal plan.