Mutual funds are best for the core portfolio

Last week, we suggested that individuals can construct their Aspiration Assets using wealth managers who generate excess returns or follow near-pure alpha strategies.

In response to the article, a reader questioned us on the rationale of hiring wealth managers who generate near-pure alpha returns.

This article builds on the core-satellite framework to explain why it is optimal to hire wealth managers for alpha returns only. By logical extension, the article also shows why it makes economic sense for HNWIs to have a significant proportion of their exposure in mutual funds.

Alpha Managers

Mutual fund managers construct portfolios based on pre-defined investment mandates. Wealth managers come in two flavours — those who follow alternative strategies and those who follow investment styles as active mutual funds — but have a closer relationship with their clients.

If a wealth manager were to offer similar investment styles as active mutual funds, HNWIs may just as well invest in the latter.

The reason is that mutual funds charge only an asset management fee, while wealth managers also typically share a percentage of the profits on the portfolio. Yet, wealth managers offer a distinct advantage over mutual funds.

A portfolio manager's ability to generate excess returns is related to the assets under management (AUM), as AUM increases, the likelihood of generating alpha declines. This happens because the manager is employing the same alpha strategy on the same universe of assets with larger cash flow.

This pushes up the value of the assets over a period of time, reducing the excess returns.

A mutual fund may strive to increase its AUM, as its fees are a percentage of the asset size.

A wealth manager may choose not to increase her managed assets beyond a certain level, if she believes that increasing asset size may hurt her ability to generate excess returns.

Many HNWIs, hence, argue that wealth managers are better than mutual funds even if they follow similar investment styles.

We, however, believe that HNWIs would do well to hire wealth managers who follow alternative strategies. Our argument is based on the core-satellite framework.

Satellite Wealth

Every asset has two sources of returns — income return such as dividend or interest and capital appreciation. An asset's capital appreciation, in turn, is driven by two factors — market factor and company-specific factor.

Market factor is called the beta exposure and leads to market returns.

Company-specific factor leads to excess returns or alpha.

Now, an active portfolio will necessarily have both beta and alpha exposure. It is in fact typical of an active portfolio to have substantial proportion of its returns coming from systematic risk or beta exposure.

This makes an active portfolio a sub-optimal investment choice. Why?

Active managers charge twice as much fee as that of passive managers. And the investor typically pays active fee on the total portfolio even though it contains both beta and alpha exposure.

The question is: Why should an investor pay active fee for beta exposure when she can get the same exposure for half the cost?

The core-satellite portfolio addresses this issue. It separates the passive and the active exposure, thereby, optimising the fee on the overall portfolio. Individuals should, hence, buy index funds and broad-cap ETFs to get a low-cost beta exposure.

HNWIs may argue that they would rather hire a wealth manager to maintain their total portfolio.

It is, however, efficient for HNWIs to buy index funds and ETFs for reason besides the low-cost beta exposure — the alpha-beta separation forces them to actively seek wealth managers who follow alternative strategies such as private equity and hedge-fund replication and not those who follow mutual fund-like strategies.

Conclusion

We believe that individuals including HNWIs should use mutual funds and ETFs to build the passive component of their life cycle investment — ranging from children's education fund to retirement income portfolio. HNWIs would do well to hire wealth managers who follow alternative strategies for their satellite portfolio.

Such a core-satellite framework leads to distinct and optimal combination of alpha and beta exposure.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. He can be reached at >enhancek@gmail.com )

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