When eBIS invests clients’ assets, we focus our attention on three important variables: risk, taxes, and costs. We call these three pillars the Investing Triumvirate, named after the three individuals (originally Julius Caesar, Pompey, and Crassus) who formed a ruling power coalition in ancient Rome. Just as the Roman Triumvirate dictated governance, each investing triumvir (risk, taxes, costs) plays a critical role in net returns and the long-term success of investors, which we outline in detail below. We do not pitch performance, hot stocks, high yield/illiquid securities, or undervalued sectors, which is the domain of the brokerage and insurance businesses. Pitching specific securities is just selling risk and ultimately destroys wealth. We firmly believe that net investment performance is just the outgrowth of managing these three factors: risk, taxes, and costs.
Our primary charge as an investment adviser: the management of investment risk. Risk stands at the top of investment management prioritization, paramount to the investor experience. We analyze the variables that influence investment risk and translate them into a risk allocation model, applied to every client. Our goal is to create the highest level of return for the risk that a client is willing to/should bear. Our model bifurcates risk into two buckets: high risk and low risk, each with a target for overall volatility, downside volatility, and return. More than any other factor, the allocation of assets across these two buckets will determine investor returns over long periods of time. Each client will receive an allocation split between these two buckets, e.g., 70% low risk, 30% high risk. We add value for clients if we are successful in two areas: 1) determining the level of risk that is appropriate for each investor given their specific circumstances; and 2) building a risk model that maximizes return for each level of risk.
First, we must answer this question: what is risk? Risk is the volatility, or variability, of outcomes. Of particular importance for investors is the downside volatility of returns, representing potential losses. Investors ideally want a target return with little or no variability. However, one of the primary tenets of Modern Portfolio Theory (MPT) is that there’s no free lunch: risk and return are directly related over long periods, with high risk being rewarded with higher returns, and low risk offering lower returns. In other words, if you want an attractive return, you need to take risk, which means the potential for losses in the short to medium term.
While fundamentally sound, the theory of risk and return that underlies MPT deserves a critique. Is this risk/return relationship perfectly correlated? Has the relationship changed through time or because of recently introduced variables or new asset classes? At eBIS, we try to answer questions like these by looking at risk through seven primary categories:
1) ASSET CLASS RETURN DRIVERS
Every security has a set of risks that determine the returns that can be expected from it. For instance, a bond offers two primary risks: credit and interest rate. Is the bond issuer in good financial health? How early can the bond be called and what is the expected duration? Are interest rates expected to increase or decrease at the bond’s duration, thus affecting its price? In determining that a security is worth an investment, one must implicitly determine that, once identified, the risks of that investment are worth shouldering. At eBIS, that’s exactly what we do before allocating funds to an investment: we define every risk and try to determine if each is adequately compensated. The importance of risk identification can’t be overstated. As Sun Tzu uttered, “Know thy self, know thy enemy. A thousand battles, a thousand victories.” We stand a fighting chance only if we can at least define and quantify what we’re up against.
At eBIS, we have a rich history of defining and quantifying risk, with successful engagements in areas like credit, market and liquidity risk quantification for some of the most complex and sophisticated financial institutions in the world (please see our Success Stories). We take that experience and apply the same principles to our investment management orthodoxy. By focusing our attention on risk factors, we can use them to inform our decision making on diversification and asset allocation, which ultimately improves our investment model.
Liquidity risk represents the risk that investors won’t be able to access their funds when needed, or must pay a penalty or sell at discounted price to do so. Liquidity risk can offer a return premium to investors for bearing these risks, and is included in the universe of asset class return drivers that we consider. We highlight this risk in investment management to point out the unintended consequences it can have for investors: cash isn’t of immediate concern until it is. When investors need cash unexpectedly, for whatever reason (medical emergency, family obligation, etc.), and can’t liquidate their holdings at a market clearing level and receive the proceeds within days, liquidity becomes a significant liability.
We at eBIS understand the importance of liquidity for retail investors and ensure that the vast majority of invested assets are unencumbered by liquidity risk. The mutual funds and ETFs that comprise the bulk of our portfolios can be liquidated at or very near Net Asset Value (NAV), with cash available within days. A portion of client capital, determined based on individual circumstances, may contain some level of liquidity risk. For example: a closed-end mutual fund that trades at a discount to NAV. We attempt to avoid “lock-up” liquidity risk, where funds are only available periodically (as with some LLC hedge funds). We may invest in very short maturity loans (6 months – 2 years) that may not offer a secondary market, but only if it fits the client’s liquidity profile. eBIS assesses the risk/reward tradeoff for any incremental liquidity risk assumed in the portfolio and does so sparingly and according to the client’s needs.
For a more in-depth commentary of risk and asset class return drivers, please see our solution for portfolio risk management.
2) HISTORICAL PERFORMANCE VOLATILITY
Risk rears its head through volatility. A measure of the dispersion of observations, volatility is extremely important. By studying the historical volatility of any security or asset class, one can gain an understanding of the variability of returns. That knowledge, married with the definition of the risk factors that drove the volatility, starts to paint a robust picture for risk management. Thus, we capture and analyze various measures of volatility.
The definition of volatility is also important. Standard deviation is the most commonly accepted volatility measurement in retail investing, representing the statistical probability of an outcome over a time period, given a confidence interval and assumptions about the normalcy of outcomes. For instance, a stock fund with a standard deviation of 15 can be interpreted to have a probability of fluctuating around its expected return no more than 15 percentage points over a one year period about 68% of the time. While informative, it doesn’t differentiate between positive and negative inputs when determining overall volatility, as the measure assumes a normal return distribution. Why is that important? Because upside volatility is a GOOD thing, and downside volatility is a BAD thing. From a risk perspective, we only really care about the percentage of time returns vary to the downside, or lose money.
Mathematically, both overall volatility, and especially downside semi-variance, influence portfolio returns: overall volatility hampers compound returns, and negative returns disproportionately so. For instance, given three sets of returns with the same simple average, the set with the lowest dispersion of returns will have the highest compound return. See example below:
|Period 1||Period 2||Period 3||Simple Average||Compound Return|
Further, a negative return requires a positive return, factored by the size of the loss, just to break even, as shown below:
|Period 1||Period 2||Simple Average||Compound Return|
Thus, at eBIS, we focus a keen eye on measures like sortino ratio, which isolate and quantify downside volatility, or the negative semi-variance, relative to return. It allows us to better understand the probability and severity of negative returns, the volatility we feel is most important to manage. A return profile with a high sortino ratio indicates the asset has been less likely to suffer severe drawdowns and/or the drawdowns that do occur are shallow relative to a return profile with a low sortino ratio. If a security has an attractive return but a low relative sortino ratio, it raises a red flag, as the downside risk is likely not compensated by the nominal return. We feel our industry pays too little attention to downside volatility measures, but it informs much of what we do.
Correlation is the relationship between two variables. It helps define how one asset has reacted historically to the movement of another asset, or how they move in tandem. Ideally, as asset managers, we want to create portfolios with assets that have positive expected returns, yet low correlation to one another. Why? Because zigging and zagging of asset returns creates lower overall portfolio volatility, increasing compound returns through time.
At eBIS, we study historical correlation metrics so that we can understand how asset classes co-vary. We plot each asset class against every other asset class on a correlation matrix. Those asset classes with low or negative correlation to most other asset classes have special appeal to us, as they offer the promise of diversification benefits. The unicorn of asset classes is one that has a high nominal return, low volatility, and low correlation to other asset classes.
Of important note with correlation is its use as a type of insurance. Some asset managers pay premiums to insure their portfolios against downside risk through the use of derivatives, such as put options. We believe that, over the long term, it doesn’t make sense to buy insurance to protect portfolio risk, as the premiums do not justify the benefits. Instead, we favor the employment of correlation analysis as a surrogate. Correlation management can provide some of the same downside risk protection as purchased insurance, yet has a very important advantage: it’s free! There is a cost in time investment to understand correlation relationships historically and model and predict them moving forward, but that analysis is embedded in our management service. Net, we feel we enhance compound returns using correlation analysis while saving clients the direct cost of portfolio insurance premiums. Investment management is one important instance where it doesn’t pay to buy insurance.
4) CURRENT VALUATION
Understanding the current valuation of an asset class relative to historical norms plays an important role in our allocation model. Looking backward in time, we build an understanding of where current valuation metrics fall in a time-series. Is the current P/E ratio of small cap growth high relative to its 20 year average? Is the domestic yield curve steep, flat, or inverted, and what has that indicated in the past for the direction of interest rates? What do negative interest rates in international developed markets mean relative to historical norms? Is a closed-end fund trading at an especially steep discount?
If a valuation metric is especially elevated for an asset class, that might indicate a good time to be contrarian, and under-weight the allocation. The opposite can also hold true: an under-valued asset class might warrant a relative over-weight. While we never try to time markets by trading in and out in totality, we will at times tilt the portfolio allocation away from over-valued assets and toward under-valued assets. Doing so is in-line with our mission of being contrarian, selling high and buying low. We believe that asset classes generally revert to their historical valuation means, and understanding current valuations against those means is an important technique in staying ahead of the curve and adding value for investors.
5) PROSPECTIVE MARKET DRIVERS
Asset class return drivers observed in the past don’t necessarily perpetuate into the future. Formulating a perspective on what lies ahead can help inform our use of historical volatility and correlation. Will the same market drivers that influenced these measures in the past continue into the future? If so, will they be present at the same magnitude? If not, what new market drivers could take their place? These questions are very important to consider when assessing the risks of any market environment.
A perfect example: the domestic interest rate environment in 2016, where the risk-free rate on a 10 year U.S. Treasury security hit a modern-era low of 1.36% in July. From 1981 through 2015, interest rates have trended steadily downward, acting as a tailwind to bond returns. Over this period high quality bonds acted as the perfect diversifying asset class, with the Barclays US Aggregate Bond Index providing positive total returns in all but 3 of those 35 years. With interest rates near historic lows, will we see similar performance over the next 35 years? If not, what returns should investors expect from a diversified basket of domestic bonds? Most importantly, what can act as a diversifying asset class if domestic bonds cannot?
At eBIS, we feel these are some of the most important questions to ask, in effect challenging conventional wisdom. We put much thought and research into answering each question, with each answer informing our approach to portfolio construction. Risk is managed into the future, not the past, and an attempt to understand what lies ahead is fundamental to our mission.
6) INNOVATION IN AVAILABLE ASSET CLASSES
Just 10 years ago, it was very difficult for retail investors to allocate assets to anything other than stocks and bonds. Retail investing, however, has fundamentally changed over the last 10 years. We believe that investors can not only benefit from, but need to embrace, innovation in finance and asset management to adequately manage risk. With U.S. Treasury yields across the maturity spectrum low relative to historical norms and stocks appearing overvalued by many measures, a failure to embrace new asset classes, and their unique sources of return, places undue risk on investors at the most inopportune time.
Examples of new retail asset classes introduced during this time period include: student loan debt, real estate bridge loans, direct equity investments in real estate, peer-to-peer unsecured lending, merger arbitrage, market neutral (alpha investing), options-based insurance strategies, options-based collar/strangle/straddle strategies, long/short fundamental investing (equity, debt, currencies, commodities), managed futures trend following, renewable energy trusts, energy infrastructure master limited partnerships, and business development companies. Are any of these a Potemkin Village? Can any actually help investors lower risk or enhance return? The answers: yes and yes. It takes a significant amount of research and analysis to understand each new innovation and its underlying risk/return drivers. But it’s worth the effort. Some of these new asset classes can fundamentally change the average investor’s experience for the better.
One of our greatest strengths as a firm is our history in finance technology (FinTech), having implemented technology solutions for managing financial risk at some of the largest banking institutions in the world. We understand how technology, if analyzed and managed correctly, can fundamentally benefit everyone. Moreover, we believe that those who don’t embrace beneficial technological innovation will be left at a disadvantage. Disadvantage is bad, especially in investing. Technology has introduced new asset classes that can fundamentally reduce risk and improve risk-adjusted returns. We analyze each new FinTech innovation and only invest in those that can improve our risk model and your investing experience. We believe few, if any, advisers have the experience and perspective to do it as well as we do.
7) RISK REBALANCING
Managing risk also means being contrarian. It means buying what is unloved and selling what is performing well. “Buy low, sell high” as the adage goes. Applying this maxim in a disciplined manner ensures that your portfolio stays within a risk band that is appropriate for you. Further, studies  show that a risk rebalancing program, while keeping returns approximately equal to a “buy and hold” strategy, contributes to enhanced risk-adjusted returns by reducing portfolio risk, potentially at the most critical times, e.g., an over-valued stock market. This result squares with our core investment philosophy: manage downside risk to enhance compound returns and improve the investor experience. At eBIS, we apply our contrarian philosophy through a rebalancing routine that sells investments within asset classes when they rise too much relative to other asset classes and buys investments within asset classes that have underperformed on a relative basis. Unlike some programs that rebalance based on a defined schedule, our rebalancing is triggered when risk tolerance thresholds are breached, which are set at the asset class level. This approach lowers trading costs, taxes, and remains true to the intent of the program: managing the allocation of risk. Our program uses a prioritization routine that sequentially allocates cash to asset classes that are the furthest below threshold on a percentage basis.
Through our seven categories of risk management we believe we have compiled the most robust risk framework available to retail investors. Stock and bond investing – set it and forget it – is dead as we know it. Today’s risk variables demand a more advanced approach, delivered through eBIS’s proprietary risk models.
- Edesess, Michael, Advisor Perspectives, 15 April 2014
Second in the hierarchy of investment management is tax management. Everyone is subject to taxes on their investments in some form, either now or in the future. The correct investment allocation for anyone really depends on two variables: 1) an understanding of the tax profile of each potential investment; and 2) the tax circumstances of the individual, with an understanding of his/her marginal tax rates at the federal, state, and local levels, and his/her amount of tax-free (Roth IRA) and tax deferred (401(k), traditional IRA, etc.) assets. eBIS strives to understand both of these variables in detail. Our asset allocation is customized to each client after a survey of their specific tax circumstances.
TAX COST RATIO
Every investment has the potential for realizing taxes, if held in a taxable account, through one of three distributions: capital gains (long and short term), interest, and dividends (qualified and non-qualified). Each distribution is taxed in a specific way, with short-term gains, taxable interest, and non-qualified dividends being the most onerous, taxed at one’s marginal tax rates. A tax cost ratio is available for baskets of securities (ETFs, mutual funds, etc.) that quantifies the tax drag on an investment from these distributions, based on assumed federal tax rates against the investment held in a taxable account. This tax drag can be significant, sometimes in excess of 3%, meaning that an investment with a nominal return of 10% returns 7% after taxes. That’s a hefty price to pay, one that deserves attention and management. It’s also telling that our industry pays so much attention to investment cost, highlighting the cost differentials between and ETF that charges .25% and a mutual fund that charges 1%, while the tax cost differential between the two might be a multiple of that, yet receives very little press. Moreover, the tax cost from mutual funds is often concentrated in annual or semi-annual distributions; if held in a taxable account, we take care to understand these distribution schedules to avoid buying into a taxable distribution. We feel strongly that taxes in all forms are a variable that should be front and center in investment decision making.
eBIS uses the tax cost ratio as a starting point, adjusting it to your tax circumstances. Are you resident in a high income tax state? If so, the ratio is even higher. Are you in a mid-tier federal bracket, resident in a state without income taxes? If so, the ratio is a bit lower. The key is applying an approximation of the tax cost of investing to your situation. We create multiple tax models considering the tax attributes of each investment and fit you into the most appropriate model. Because investing isn’t just about risk and returns; it’s about what you actually keep after a visit from taxing authorities.
Asset location is the placement of investments into account types that are appropriate to their tax profile. Each type of account (trust/taxable, Roth IRA, SEP IRA, etc.) has a specific tax profile: taxable, tax-deferred, and tax-free. We first determine the tax attributes of each potential investment and then, if it fits our investment criteria, place it into the appropriate account type. Our allocation models delineate by tax treatment, ensuring that an investment is appropriate for the account it is placed in. We prioritize the investments made in each account type as follows:
- Taxable: Low tax cost ratio, limited or no capital gains, volatile return profile
- Tax-Deferred: High tax cost ratio, asset classes deemed high priority for diversification benefits
- Tax-Free: High tax cost ratio, highest assumed long-term returns
Further, our asset location adapts to your circumstances. First, we review your most recent tax return, often in consultation with your tax professional, to understand your marginal tax rates and any special tax circumstances, such as tax loss carry-forwards. Then, we determine the account type with the fewest assets, and fill it with the investments prioritized to its tax profile. We iterate in this manner until all account types are filled with tax-appropriate investments. For instance, if you have very few tax-deferred and no tax-free assets, we use the least tax-efficient investments, offering the highest diversification benefits, in our tax-deferred model to fill the tax-deferred accounts. The remaining taxable assets are invested based on our taxable model, representing the allocation most sensitive to your marginal tax rates. We also analyze your exposure to Alternative Minimum Tax (AMT) as it affects income from sources like municipal bonds, and adjust your specific allocation accordingly. Finally, we assess changes in tax laws that affect asset location, such as the pass-through deduction of REIT income under the Tax Cuts and Jobs Act, to arrive at the most tax-efficient approach.
Asset location is the vehicle used to ensure tax efficiency. It’s the place where our analysis of tax cost ratios is put into practice to save you money and provide efficient after-tax asset growth.
TAX LOSS HARVESTING
Tax loss harvesting is the capture of tax losses in taxable accounts. Capital gains taxes, both short and long-term, are charged on a net basis, with short-term losses offsetting short-term gains and long-term losses offsetting long-term gains. In addition, aggregate net losses act as a deduction against income up to $3,000 per year (for individuals), with residual losses carried forward, offsetting net short and long term gains as they occur in future years. Capturing tax loses is thus a very important exercise in the effort to limit overall tax exposure.
At eBIS, we take steps to not only capture tax losses when they occur, but also position volatile assets in account types where harvesting is possible. Although we invest with the expectation that all investments will eventually provide a positive return, it is inevitable that some investments lose money over the short to medium term. We thus try to assess the volatility of asset classes and position the most volatile in taxable accounts (see Asset Location). A loss in a tax-deferred or tax-free account is a wasted loss. Whenever a taxable loss occurs, we have pre-set thresholds for loss capture, ensuring that the trading costs of capturing the loss don’t eclipse the tax benefit. When trading out of a position, we make every attempt to maintain exposure to an asset class by trading into a close substitute investment without breaching SEC wash sale rules. Once beyond the time span for wash sales, we normally trade out of the substitute investment and back into the original investment, thus resetting the cost basis.
We attempt to time the tax loss harvest, in the case of mutual funds, before annual fund company distributions are made if the loss is long term in nature (> 1 year). In this way, we ensure that negative tax arbitrage does not occur: the distribution and recognition of a short term gain that is offset by a larger long term loss on sale (mutual fund prices decrease by the magnitude of the distribution). In this case, the tax differential between short and long term gains works against investors if the distributions are realized.
Tax loss harvesting is performed periodically throughout a calendar year in all taxable accounts managed by eBIS.
LIQUIDATION OF CONCENTRATED/LOW COST BASIS POSITIONS
Investors can accumulate concentrated positions in certain securities for a number of reasons: stock grants/exercised options/stock purchase plans from an employer, inherited securities from relatives, securities transferred as part of a divorce settlement, etc. Concentrated positions introduce unwanted risk into a portfolio, as the performance of that/those securities has a large effect on total net worth. As the bankruptcy/forced sale of a number of once-respected companies, e.g., Lehmann Brothers, Enron, Washington Mutual, etc. shows, large bets on a single company can lead to unexpected losses.
eBIS recommends liquidating and re-allocating concentrated positions to a more diversified, risk-sensitive model. If a position has a high cost basis, tax management is of less a concern, although care should be taken to sell into long-term tax treatment while avoiding income recognition that could push tax payers into more onerous capital gains treatment and a Medicare Contribution Tax surcharge. If a concentrated position has a low cost basis, we can offer more advanced tax management approaches, such as contribution to a Charitable Remainder Trust, options strategies and exchange funds, which can diversify or hedge your concentrated position with mitigated tax consequences. In certain circumstances, it is appropriate to enlist the help of a corporate/estate attorney who can establish advanced tax-mitigation structures for concentrated positions, such as corporate shells.
If a concentrated position is in a small-capitalization or illiquid name and liquidation is the appropriate course of action, eBIS can establish a scheduled “drip” trading approach in an attempt to avoid downward price pressure with volume selling. In some instances, we can place the position with institutional buyers, avoiding market liquidity issues altogether.
Above all, it’s important to balance the risk of excessive exposure to a given security with the tax costs and fees of liquidating it. eBIS will work with you to determine an appropriate balance between risk and costs and then execute the risk/cost mitigation strategy for you.
Investment costs, although relatively less important than risk and taxes, play an important role in investment decision making. If fact, studies show that costs are the single biggest driver of performance within an asset class, with low cost investment options consistently out-performing high-cost investments. In making investment decisions within an asset class, eBIS pays close attention to direct investment costs, as well as other indirect costs (trading, liquidity, cash drag, etc.) that can affect investment performance.
Some securities and baskets of securities, such as mutual funds, charge loads or commissions, paid to the adviser(s) who sell them to clients. They normally take the form of sales fees charged as a percentage of the invested balance and realized upon initial purchase, subsequent sales, or deferred and paid based on the client’s holding period. Some sales loads are in excess of 7%, representing an immediate loss to the client based on the magnitude of that charge. As a firm policy, eBIS never places a client in an investment that charges a load or commission. We believe this compensation model creates moral hazard by structurally favoring those investments that charge the highest commissions. Moreover, nothing prevents an adviser from moving clients in and out of load-based products, earning a commission from each transaction. Such practices are known as “churning” and represent a clear conflict of interest.
We believe in a fee-only model where adviser fees are charged as a percentage of assets under management, removing moral hazard by aligning adviser incentives with those of the client: both parties benefit when the aggregate value of the portfolio increases. As loads represent a significant cost to investors, this approach not only removes conflicts of interest, but also represents the greatest opportunity to reduce overall investment costs.
The expense ratio encapsulates a number of the costs charged to investors by the underlying investment vehicle, such as a mutual fund or exchange traded fund (ETF). Those costs are normally charged as a percentage of assets and broken down as follows:
- Management: the charge for professional investment management of the portfolio.
- Administrative/Operating: costs associated with day-to-day operations of the fund, including renting office space, printing prospectuses, and keeping records.
- 12b-1: an ongoing marketing fee, charged only in certain classes of funds, paid to brokerage firms and other related entities for their distribution and marketing services.
As a firm policy, eBIS does not invest in any fund structure that charges a performance fee, which is paid to the manager(s) of the fund based on predefined performance criteria. eBIS strives to minimize all fund fees and in general will avoid those that charge above average fees, preferring investments that rank in the bottom quartile, and ideally decile, within its asset class. Further, eBIS strives to avoid paying unnecessary fees. As a consciously formulated policy, however, sometimes eBIS will place clients in funds that charge a 12b-1 fee, although eBIS never receives any part of this fee. These funds pay the clients’ brokerage firm a marketing fee, and as a result the brokerage firm does not charge clients a direct trading fee (see Trading Costs). This approach can lower aggregate trading costs for the client for those funds in which eBIS trades with regularity (for rebalancing, new money purchases, redemptions, etc.), as the direct trading costs may eclipse the 12b-1 fee in these instances. In general, eBIS will designate a “trading” investment fund in each asset class, and this fund may be one that charges a 12b-1 fee.
Trading costs are the costs associated with trading in and out of any security and are charged by the brokerage firm that executes the trade. These costs are charged directly to eBIS’ clients and appears on their brokerage statements. Trading cost schedules are disclosed in advance by the brokerage firm and can vary by security type and size of the trade. eBIS goes to great lengths to minimize these costs by choosing a custodian/brokerage firm that is competitive, and preferably the lowest, in published trading costs. We also strategically choose the class of investment, based on anticipated trading frequency, to limit the overall trading cost to clients (see Expense Ratio).
It is important to note that clients incur trading costs at two levels: 1) by trading in and out of securities in their brokerage account, and 2) through the trading that occurs within the funds they purchase. Unfortunately, trading costs within funds are not disclosed through the expense ratio and are generally not fully transparent to investors. Fund trading costs are embedded in the reported fund performance, however.
Liquidity is an important indirect cost consideration for exchange traded funds (ETFs). Investors can incur liquidity costs in two ways: 1) through the spread between what sellers of the security are asking and what purchasers are bidding (bid-ask spread), and 2) through the premium or discount to Net Asset Value (NAV) at which the fund can trade. The bid-ask spread can fluctuate depending on the total volume of trading, with funds trading at low volumes incurring higher spreads (higher liquidity costs) and funds trading at high volumes trading at thinner spreads (lower liquidity costs). Discounts and premiums are impacted similarly: funds with high volume trading tend to trade in a tight band around NAV, where funds with low volume trading can trade at larger discounts and premiums. This liquidity cost can hit existing investors when selling volume overwhelms a thinly traded ETF, pushing fund pricing into a discount. If the investor were to sell into that environment, he/she would receive proceeds based on NAV minus the liquidity discount. There’s a great advantage to selling at NAV, especially in choppy and downward trending markets.
eBIS thus puts a priority in minimizing liquidity costs. We require that ETFs meet certain capitalization and trading volume thresholds before we invest, limiting the effect of liquidity costs.
Cash drag is an important indirect cost consideration for open-end mutual funds. Unlike ETFs, open-end mutual funds must hold cash on hand to meet withdrawal requests, the cash from which are made available to investors the next business day. Some percentage of assets managed by the mutual fund are thus kept in cash instead of invested in securities. This fact tends to push down investment returns in up markets and buffet returns in down markets. We generally like to avoid cash drag, preferring to keep client funds invested in the target asset class. As such, we prefer open-end mutual funds that limit cash drag, and prefer ETFs to mutual funds, all else equal, for their avoidance of cash drag.
- Kinnel, Russel, Morningstar, 9 August 2010
INTERACTING WITH EBIS & OUR IMPLEMENTATION PROCESS
eBIS provides a free initial consultation to any potential investment management client. We will explain our investment philosophy and process, answer any questions you have, and analyze your existing portfolio, the details of which are always held in confidence, backed by our non-disclosure policy and Privacy Statement. As part of this analysis, we provide feedback on ways that we can improve the risk management of your investments, lower tax exposure, and lower investment costs. We also provide you with our regulatory form ADV Part 2, which details in plain english every aspect of our firm, including business practices, investment philosophy and fees. The initial consultation is free of cost, obligation, and pressure; our goal is to help you and provide the information you need to make an informed decision. We are available after the initial consultation for follow-up questions and dialogue, as much as needed.
As a Registered Investment Adviser (RIA), our fees for investment management are always fee-only, a tiered percentage based on the amount of assets we manage for you (.5% – 1%). We bill clients directly and do not receive 3rd party compensation in any form. We generally accept clients with investable assets over $100,000, with enhanced service levels for those with investable assets over $700,000, including a full financial plan and ongoing financial planning support, as outlined in our Financial Planning Solution.
INFORMATION DISCOVERY & BECOMING A CLIENT
Should you decide to become a client, we jointly execute an Account Agreement, outlining such items as our fiduciary duty to you and our non-disclosure/confidentiality policy. Then, we initialize our discovery process. We ask each client to fill out a series of online surveys that gives us, as investment managers, the information necessary to manage to your needs. Questions in the surveys cover subjects like personal information, goals, education needs, tax circumstances, and perspectives on risk.
As a firm, we employ the Socratic method of maieutics, allowing your input to, in large part, determine your investment path. We don’t claim to be omniscient about security returns or market movements, instead focusing on factors that we can manage according to your circumstances based on your input: the Investing Triumvirate – Risk, Taxes, and Costs.
Your input from this set of surveys gives us the foundation on which to compile your investment plan. We may reach out to you or your other professional advisors (tax accountant, estate attorney, etc.) for dialogue and clarification on certain points.
INVESTMENT POLICY STATEMENT
Once our discovery process is complete, we compile a written Investment Policy Statement (IPS), which outlines the parameters around which we will invest your capital, including risk and asset allocation, income needs, tax circumstances, types of securities, and any investment restrictions particular to your circumstances. The IPS also details any financial planning recommendations we have for you. It must be signed by both eBIS and you, indicating mutual agreement on all aspects of investment management and financial planning. This document acts as a guide for all of our implementation efforts, and can serve as a roadmap for meeting your financial goals. We will not deviate from the investment parameters established in it; we do not allow short term volatility in securities markets to influence your long term risk and asset allocation strategy, the primary driver of returns. Should your financial or life situation change, we can adjust your asset allocation, income needs, etc. by executing an IPS amendment.
Once signed and executed, we use the IPS to guide our investment implementation. The total implementation timeline depends on the complexity of your existing portfolio, but will be mutually agreed ahead of time. As part of the implementation of our investment model, we must transfer asset from your current bank(s) or brokerage firm(s) to our independent custodian. This process necessitates the execution of a number of brokerage forms signed by you and submitted for back office processing and transfer.
As an important note, assets over which we have discretionary authority and/or limited power of attorney (LPOA) are held at arm’s length from us at an independent custodian, which is insured by SIPC and regulated by FINRA. One of the mistakes investors can make is allowing an investment manager to take custody of their assets, giving said manager unfettered access to client funds. This situation played out infamously with Bernie Madoff and his firm, Madoff Investment Securities LLC, which custodied client funds in-house or at small regional banks that lacked regulatory oversight. Had the firm used a regulated independent custodian, the fraudulent ponzi scheme would not have been possible.
ONGOING INVESTMENT MANAGEMENT
Should you need periodic withdrawals or deposits of cash, we provide the means, through the custodial platform, to execute these transactions and manage the purchase or sale of securities as needed. This service includes management of Required Minimum Distributions (RMD) from tax-deferred accounts based on your age and required trust distributions, as appropriate.
We provide ongoing management of your investments through our Investing Triumvirate of risk, taxes and costs, as outlined above. This service includes continuous monitoring and management of our proprietary risk and tax models as applied to your portfolio.
We ask all clients to update us at least annually with information about their current circumstances, which we capture through an online survey. Any life changes can affect the management of one’s investments, so we ask clients to proactively contact us with any relevant information. Should your financial circumstances change, we will execute an amendment to your IPS and adjust your risk allocation and financial plan accordingly, if necessary.
REPORTING AND COMMUNICATION
Clients have on-demand online access to their assets through a 3rd party custodial platform and receive account statements, detailing all of their investment positions, at least quarterly. Detailed tax statements, including 1099s, are prepared annually by the custodian and made available for tax preparation.
Clients, and any interested parties designated by them, receive ongoing communication from eBIS through news releases, blog posts on investment topics, and email distributions concerning administrative items. In addition, we are available throughout the year to answer questions as they arise. We aspire to exceed your client service expectations and look forward to hearing from you.