In the modern financial industry, portfolios are usually structured using funds as building blocks. The reason for this is that they are the simplest and most efficient means of achieving high degrees of diversification.
To understand, let’s say you want to structure a portfolio of $1,000,000, with a 50/50 split between U.S. stocks and bonds, in a diversified fashion. To do that a simple approach would be to own all the stocks in the S&P 500 Index, and all the bonds in a classic U.S. bond index (for example, Barclays U.S. Aggregate). To do that through direct investment (i.e., buying each individual stock and bond) you would need to buy 500 stocks, and close to 9,500 different bonds. Such an effort would present a series of challenges:
1. Operational Complexity
Imagine the effort required to execute 10,000 individual trades just to start investing, and then manage that investment through time. Keeping track of each individual asset and rebalancing the portfolio to maintain the 50/50 split through time would prove quite the ongoing burden.
2. Trading Costs
Not only starting, but also maintaining a balanced portfolio requires trading on a regular basis. Each trade will have a related cost, either a direct trading commission, or a price spread between the price at which you are trading and the actual market price of the security. These costs will add up over time.
3. Tax Burden
Even if you can minimize the above-mentioned cost, each trade may have tax implications. For example, you might be taxed on the realized gains of sold securities.
4. Feasibility
In addition to the above, for a $1,000,000 portfolio you actually can’t buy all those individual securities. As the number of assets is large, each trade will have to be quite small. In the bond section of your portfolio, each trade would need to be of around $50, which is not possible to do as bonds often are traded in $5,000 increments at the minimum.
Rather than the do-it-yourself approach, you could achieve the same investment goals much more simply, and likely even more cost effectively, through mutual funds or ETFs, by trading just two securities. Perhaps the simplest option, you could buy an exchange-traded funds that tracks the S&P 500 Index, such as the Vanguard S&P 500 ETF (VOO), and add to it an ETF that tracks the U.S. bond market, such as the iShares U.S. Aggregate Bond ETF (AGG).
With this, you achieve the same level of diversification with just two trades, and the four problems mentioned above are mostly solved. Complexity is clearly lower, and trading costs are dramatically diminished, as the number of trades you will have to perform is much lower. Your tax burden likely would be minimized, because you are selling securities in a less regular basis, while ETFs tend to be more tax-efficient with regard to capital gains. And with just two ETFs, you do not need to worry about not being able to target most any manner of split between stocks and bonds.
We did mention that the challenges of the initial approach would be mostly solved. Costs remain a factor when investing with ETFs, as the burden of that complexity is shifted to the ETF provider. Even so, those managers tend to be better at such tasks than individual investors, with major advantages when it comes to scale and cost. While there was a time when the costs associated with fund investing might have proved a higher hurdle to clear, the modern financial industry can offer these, and other many other types of exposures for portfolios, at costs that almost beg the superlative comparison to a do-it-yourself model.
Glosary
The S&P 500 Index measures the performance of 500 largest US companies and captures approximately 80% of available market capitalization.
The Bloomberg US Aggregate Bond Index measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (MBS), asset-backed securities (ABS), and commercial mortgage-backed securities (CMBS)
The Vanguard S&P 500 ETF (VOO) tracks the performance of the S&P 500 Index. The ETF primarily holds large-cap US stocks. It invest in all 500 stocks that comprise the index. The ETF weights the holdings using a market capitalization methodology and rebalances quarterly
The iShares U.S. Aggregate Bond ETF (AGG) tracks the Bloomberg US Aggregate Bond Index by investing in securities within the total U.S. investment-grade bond market. This includes treasuries, government-related and corporate securities, MBS, ABS and CMBS
One cannot invest directly in an index. Index performance does not reflect the expenses associated with the management of an actual portfolio.
Investing in any investment vehicle carries risk, including the possible loss of principal, and there can be no assurance that any investment strategy will provide positive performance over a period of time. The asset classes and/or investment strategies described in this publication may not be suitable for all investors. Investment decisions should be made based on the investor's specific financial needs and objectives, goals, time horizon, tax liability and risk tolerance.
Disclosures
This material is for informational purposes and is intended to be used for educational and illustrative purposes only. It is not designed to cover every aspect of the relevant markets and is not intended to be used as a general guide to investing or as a source of any specific investment recommendation. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. This material does not constitute investment advice, nor is it a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. In preparing this material we have relied upon data supplied to us by third parties. The information has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made by Altafid, PBC or its affiliates, as to its accuracy, completeness or correctness. Altafid, PBC or its affiliates do not guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regard to the results obtained from its use. Altafid, PBC or its affiliates have no obligations to update any such information.
Disclosure:
Investing involves risk, principal loss is possible, and there can be no assurance that investment objectives will be achieved. Past performance is not indicative of future results.
Past performance is not indicative of future results and actual returns may vary materially and adversely. Therefore, no current or prospective investor should assume that the future performance of any specific investment or investment strategy will be profitable or equal to past performance levels.
This material is for informational purposes and is intended to be used for educational and illustrative purposes only. It is not designed to cover every aspect of the relevant markets and is not intended to be used as a general guide to investing or as a source of any specific investment recommendation. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. This material does not constitute investment advice, nor is it a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. In preparing this material we have relied upon data supplied to us by third parties. The information has been compiled from sources believed to be reliable, but no representation or warranty, express or implied, is made by Altafid, PBC or its affiliates, as to its accuracy, completeness or correctness. Altafid, PBC or its affiliates do not guarantee that the information supplied is accurate, complete, or timely, or make any warranties with regard to the results obtained from its use. Altafid, PBCorits affiliates have no obligations to update any such information.
