Actively managing a portfolio requires buying and selling securities with the goal of managing risk and outperforming passive benchmark portfolios. Clients are correct to question the number of trades that are being made in their portfolio in pursuit of this objective. After all, one trade can generate several trade acknowledgments from our custodians, and each trade acknowledgement shows the brokerage commission charged for each transaction. Clearly the cost of trading has a negative impact on total portfolio return. As we approach year-end and Pinnacle’s investment team continues to generate commissionable transactions in our managed accounts, it might be helpful to analyze the cost of brokerage commissions relative to our ability to implement our active management strategy. Trading activity is often a consequence of how Pinnacle portfolios are positioned relative to our benchmarks. When portfolio asset allocations are neutral, meaning that the overall mix of risk and non-risk assets is close to portfolio policy, then trading activity tends to be higher than normal. To put it another way: If you are invested in Pinnacle’s Dynamic Moderate Growth strategy, where the benchmark allocation to risk is 60% equity and 40% fixed income, and the portfolio’s current allocation is close to 60-40 based on the investment team’s current view of market risks and opportunities, then the only way to outperform the benchmark is either through sector rotation or security selection. Both sector rotation and security selection can result in more rather than fewer transactions being executed in our portfolios. Pinnacle DMG accounts are currently 63% invested in risk assets (domestic stocks, international stocks, and commodities), which is 3% more than the benchmark weighting of 60% risk assets. Yet current portfolio volatility is 20% to 25% more than the benchmark. Clearly sector rotation can have an impact on portfolio risk and reward. It is worthwhile to compare recent trading activity to prior years to see if there is anything unusual about this year’s amount of transactions. In fact, this year is looking similar to prior years as shown below in this analysis of transactions in our DMG portfolio strategy:
The eighty transactions in the DMG model this year are significantly more than the 58 trades in 2012, but still less than the 94 transactions in 2011. Since 2010 there have been four months with no trading activity and thirteen months with ten or more trades. There is no seasonal trend to trading activity, which is driven by changes in market conditions and reflects Pinnacle’s incremental approach to changing the asset allocation of our portfolios. While the incremental approach results in more transactions in Pinnacle accounts, it also provides a measure of safety for our clients, as making small allocation changes tends to reduce the possibility of a large asset allocation mistake.
Unfortunately, analyzing the number of transactions in Pinnacle portfolios is not as simple as counting the number of trades in any one of our strategies. That is because most Pinnacle clients own securities in more than one account, and often a simple transaction results in trades being executed in multiple accounts. Joe Zimmerman, Pinnacle’s trading specialist, reports that approximately 11% of Pinnacle clients have only one managed account. Our best ‘back of the napkin’ guess is that each Pinnacle client owns on average three different separate accounts that make up their managed account group, and that the total number of trades for an average client, based on a quick review of several multiple account groups, would be 25% more than the total shown above. To be very conservative, let’s assume the average Pinnacle DMG investor sees 50% more than the total of trades in any single account group, or 120 trades (80 trades x 1.5) transactions in their total portfolio each year. That may seem like a lot of transactions… but trading activity should be viewed in the context of what it costs to trade versus the benefits of adding sector rotation and security selection to our arsenal of portfolio management tools. So what is the cost? Again, let’s guestimate to come up with some numbers. First let’s assume the cost of each trade is $9.00, which can vary depending on the custodian. Next, let’s recognize that not all trades are commissionable trades using ETFs. In fact, some trades are no-transaction fee mutual fund transactions that cost nothing, while others are mutual fund trades that cost $25. If we use a reasonable and conservative guestimate that 10 of the 120 trades this year were no-load mutual fund transactions, and if we assume that the cost of trading is $9 per trade, and we execute 110 commissionable trades in an average portfolio group of three accounts, then the total cost of trading is $990. If we translate trading costs into percentage of returns, we can analyze the cost of transactions for different size portfolios.
|Account Size||Trading Cost $||Trading Cost %|
While the dollar cost of brokerage commissions is the same for all portfolios, smaller accounts have higher brokerage fees as a percent of account size than larger accounts. A $750,000 portfolio comprised of three different accounts with 110 commissionable trades in the total account group would have estimated brokerage commission costs of 0.13% (0.13% of 1%) of the portfolio value. In other words trading costs represent a 0.13% drag on portfolio returns. As the portfolio value increases the result of our trading activities becomes even less significant relative to returns. For a $1 million portfolio, brokerage commissions are a 0.10% drag on returns while a $3 million portfolio has a 0.025% drag. It is worth noting that a recent study by Edelen, Evans, and Kadlec found U.S. stock mutual funds average 1.44% in transaction costs per year. These costs, which are difficult to measure and are not included in the mutual fund’s published expense ratio, include brokerage commissions, market impact cost (a large fund can actually move market prices in a large transaction), and spread cost, or the difference between bid and ask prices. Compared to a mutual fund, our transaction costs, ranging from 0.13% to 0.025%, look quite reasonable. Notably, Pinnacle’s recent decisions regarding portfolio selection have resulted in a high percentage of the portfolio being invested in ETFs versus mutual funds. While the ETF trades result in higher transaction costs, they also result in a much lower expense ratio for the account as a whole. So instead of paying an expense ratio of 1% or more in many mutual funds, clients pay ETF expense ratios that are in many cases less than 40 basis points. If we invest $20,000 as a 2% position in a $1 million portfolio, and the trade requires a buy and a sell of ETFs, and the client has a multiple account group so the factor is 1.5%, then the total trades would be 3 (1 buy + 1 sell x 1.5) and the brokerage expense would be $27 assuming the client pays $9 per trade. The savings for buying the ETF versus a no-load mutual fund (assuming a mutual fund with a 1% expense ratio and an ETF with a .35% expense ratio) would be $200, minus a $70 ETF expense and a $27 brokerage commission, resulting in $103. While it can be exasperating for clients to see the $27 charge on their trade acknowledgment, in most cases the choice of investing in a security that generates a brokerage commission actually represents a significant savings. There is no question that portfolio cost, in all of its forms, creates a headwind to the total return we earn for our clients. Those expenses include Pinnacle’s portfolio management fee, the expense ratio of the underlying securities in the portfolio, and transaction costs. Clients are correct to question how transaction costs impact total return, especially when Pinnacle executes a block trade that seems to create a blizzard of trade acknowledgements in a client’s in-box. Our analysis shows that transaction costs due to brokerage commissions do not have a significant impact on our portfolio returns and that the cost of buying and holding far outweighs the costs of brokerage commissions.
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