This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Craig Israelsen, Ph.D., creator of the 7Twelve portfolio, consultant to 7Twelve Advisors, LLC and executive-in-residence in the Financial Planning Program at Utah Valley University.
The importance of keeping portfolio costs low is crucial for several reasons: 1) portfolio costs come directly out of the client’s pocket; 2) cost competition from robo advisors is acute and expanding; and 3) costs are often controllable, whereas market returns are not.
The two primary portfolio costs consist of the expense ratio of the mutual funds and/or ETFs being used in the portfolio, and the advisory fee being charged. Therefore, both costs have to be kept as low as possible.
For fee-only financial advisors, the cost of the funds being used in the portfolio is the key issue (however, the fee being charged by the fee-only advisor essentially also comes out of the portfolio, just not directly—thus it needs to be reasonable as well).
This article focuses primarily on the cost of the funds being used in the portfolio. The average expense ratio among all mutual funds and ETFs is 0.99% (or 99 basis points) as of July 31, 2020.
Interestingly, the asset-weighted expense ratio for all funds and ETFs is 0.40% (40 bps). Either low cost funds attract investors, or economies of scale is actually working—that is, as the asset base of a fund grows, the expense ratio is lowered.
As we analyze the impact of lowering total portfolio costs, let’s assume (as a baseline) an annual advisory fee of 100 bps and 100 bps as the cost of funds (mutual funds and/or ETFs) being used. Thus, the baseline total portfolio cost is 200 bps.
At a portfolio cost of 200 bps, the average annual withdrawal for a retiree invested in a diversified seven-asset portfolio was $123,405 between the ages of 72 to 97 (assuming only the amount specified by the required minimum distribution was withdrawn from the portfolio each year, and assuming a starting retirement account balance of $1,000,000).
This average annual withdrawal of $123,405 was calculated by analyzing the performance of an equally weighted seven-index portfolio over the 26 rolling 25-year periods between 1970 and 2019. In the seven-asset portfolio, large cap U.S. equity was represented by the S&P 500 Index. Small cap U.S. equity was represented by the Ibbotson Small Companies Index from 1970-1978, and the Russell 2000 Index starting in 1979. Non-U.S. equity was the MSCI EAFE Index.
Real estate performance was based on the NAREIT Index from 1970-1977 and the Dow Jones US Select REIT Index starting in 1978 (annual REIT returns for 1970 and 1971 were based on research by Chan, Erickson, and Wang in the book “Real Estate Investment Trusts: Structure, Performance, and Investment Opportunities,” Table 2.2). Commodity performance was based on the Goldman Sachs Commodities Index (GSCI). U.S. Aggregate Bonds was the Ibbotson Intermediate Term Bond Index from 1970-75 and the Barclays Capital Aggregate Bond index starting in 1976. Cash was represented by three-month Treasury Bills.
Now, let’s use ETFs with lower expense ratios. If we reduce the average expense ratio from 100 bps to 50 bps, the overall portfolio cost can be reduced from 200 bps to 150 bps. By doing so, the average annual withdrawal for the retiree increases to $132,822, or $9,417 more pretax income each year. That works out to a “raise” of about $785 in pretax monthly income during retirement
But we can do even better. It’s possible to build a diversified retirement portfolio for around 10 bps.
Additionally, if the advisory fee were reduced by a mere 10% (from 100 bps down to 90 bps), the overall portfolio cost could be lowered to 100 bps. At that cost level, the retiree withdrew an average of $143,046 each year. That works out to an additional $1,637 of pretax retirement income each month compared to a 200 bps portfolio.
Clearly, the impact of portfolio cost on retirement income is huge—and the best place to start reducing costs is with the portfolio ingredients.
The Impact Of Reducing Portfolio Cost
* Assuming a $1,000,000 starting balance at the age of 72
An All-Season Diversified Portfolio
An example of a diversified portfolio for use during the accumulation years and/or the retirement years is the 7Twelve portfolio. It is a modular portfolio model that can be built easily and at very low cost.
The 7Twelve portfolio uses 12 separate mutual funds and/or ETFs to achieve broad, multi-asset diversification. Each of the 12 funds is equally weighted at 8.33% of the portfolio. The equal weighting is maintained by periodically rebalancing each of the 12 funds back to an 8.33% allocation.
Low-Cost ETF 7Twelve models
Shown in the following table are four ETF-based 7Twelve models, ranging from 9 bps to 22 bps. Building a diversified portfolio for as little as 9 bps is not theoretical—it’s a low-cost reality.
Low-Cost Retirement Portfolios Using The 7Twelve Model