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THE RISK MANAGER
Advanced Thought Leadership for Your Money®

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  • Aaron Kolkman

MVO PART VI: Optimize Beyond the Index - After Fees


Optimize Beyond the Index – After Fees

As mentioned in the previous edition of The Risk Manager, index/passive investing is optimal by default: it offers investors the full risk and full return of the relevant marketplace. Active management, however, can be the answer to optimizing beyond the index. Consider the following data, which illustrate a global, multi-asset-class investment model and index.

Portfolio Optimization Data

Fee Analysis

The passive investor shown pays no management or advisory fee, identical to the index/benchmark. The active investor pays a management fee of .84% and advisory fees of 1.25%. Advisory fees include asset allocation and optimization, as well as quarterly re-balancing.

Observations

The passive investor receives the index risk/return, while the active investor does not. In our example, the active investor. instead received a lower return on a 3 and 5-year historical basis, and a greater return on a 10-year basis (a full market cycle) – after fees. Total risk (measured by Standard Deviation) was lower across the board. The combination of risk and return – the Sharpe Ratio– was superior across the board, for the active investor. The greatest contributor to this increase in Sharpe Ratio was substantially lower risk in each time period.

Conclusion

In summary, the passive investor will be optimized in terms of what the market bears for risk and return – no better, no worse. The active investor can either 1) beat the index on returns, or 2) beat the index on risk-adjusted returns. If the advisory firm can achieve a superior Sharpe Ratio, their services should be seriously considered. If not, an indexed approach may be preferable. Either way, the portfolio plays a supporting role to a comprehensive plan – a plan dependent upon consistent investment results.

The Risk Manager delivers intelligent, actionable content related to managing primary financial risks throughout the Life Cycle of Wealth. It can assist the reader in applying advanced financial concepts to a given situation with a well-informed and financially conservative viewpoint. The ultimate purpose of this work is to bring the reader less uncertainty and a greater ability to achieve life goals.

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## Not an offer to buy/sell any securities; not a financial planning engagement.##


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