Diversified and low cost? I finally found the formula

My attempts to keep clients’ overall investing costs low, while also making sure they’re appropriately diversified, has been quite a journey. It’s taken me six years of trials, errors and research, but I think I’ve finally found the formula.

When I started my financial planning practice in 2013, I faced a dilemma: I didn’t meet the minimums of any custodian. Coming from an AUM structure, I wanted to provide clients with investment advice that mirrored the investment philosophy I had been taught. In not being able to manage their investments directly, I had to teach them how to invest on their own.

Initially, I encouraged clients to use ETFs, but regularly received questions about how to adjust purchases if share prices changed, or if bid-ask spreads were something to be concerned about.

To simplify the process, I suggested clients use passive-approach mutual funds, mostly with Vanguard. In this way I could advise them on dollar amounts to invest, and, as long as they were over the investment minimum, things went smoothly. But, as trading and ongoing expenses started rising, issues popped up if clients had accounts with Fidelity or Charles Schwab. In response, I adjusted the approach and used index funds native to that custodian.

But these models became cumbersome as well since I had various portfolios models for various custodians. If a client used multiple accounts across multiple custodians, my investment recommendations rarely looked simple.

In summer 2016, I joined the XY Planning Network and received access to TD Ameritrade without the need for a minimum asset base. With access to a custodian and being able to manage client accounts directly, my investment recommendations started to adjust back to a simpler, more holistic design.

Even so, I monitored client portfolios to make sure they hewed to the mantra of controlling and keeping costs and taxes as low as possible. Were investments as low cost and tax-efficient as they could be, while staying globally diversified?

One red flag was trading costs on mutual funds. Each time I bought and sold a Vanguard mutual fund on the TDA platform, it cost a client $24. It bothered me that even in years of mediocre performance, my clients could experience short- and long-term gain distributions solely based on activity inside the mutual fund itself. This led me to research ETF alternatives for these specific mutual funds.

Vanguard has designed its ETFs to be a sub-share of its mutual fund partner. This made it fairly easy to know what index the ETF would be following, and I could reassure myself it was not wildly different the mutual fund alternative. It helped that the ETFs —even though they mirrored the investments of the corresponding mutual fund — had a lower expense ratio. Additionally, trading these ETFs on the TD Ameritrade platform was then free for Vanguard ETFs (it’s now increased to $6.95/trade) so I was keeping the same investments for clients while decreasing their costs and taxable consequences.

Way back in 2007, I was introduced to Dimensional Fund Advisors. I learned how its strategy differed from a standard passive index fund and how it could add value to a portfolio. When I changed firms and then subsequently launched my own RIA, I missed being able to use them just like I could a regular fund company.

Fast forward to 2018. At a conference, I went through DFA’s advisor training to be able to use its mutual funds and be a DFA-approved advisor. But despite understanding and agreeing with many of the firm’s philosophies, I still used Vanguard ETFs for most positions. I believed there had to be some arbitrage between some Vanguard ETFs and its DFA mutual fund competitor.

That led me to look at long-term characteristics between asset classes, comparing Vanguard ETFs and DFA mutual funds. I decided that I would either have a Vanguard ETF as my main investment, with the DFA alternative being the backup in specific investment situations. If the DFA fund was more favorable after the research, then vice versa.

Through my research, I only found a couple of classes in which I was comfortable having a DFA fund as the front-runner: classes where pricing and performance arbitrage is more prevalent — emerging markets debt and equity — and global real estate. I found it hard to justify bringing in a strategic investment approach for U.S. equity allocations given how open and efficient our markets are. Even though long-term performance numbers were painted as beating the respective index, I factored in explaining the investments to my clients.

My clients like “boring and simple” because that’s how I sell my investing philosophy, but they also trust me to educate them on any changes. I led the client conversation by letting them know that their portfolios would be changing slightly and then described the process that led to the decision. Going through the DFA process had taken most of 2018, and I let them know the calls and conferences in which I had participated in bringing this new fund family to their portfolios. I explained the differences between Vanguard and DFA, and while some didn’t have too many questions, others were excited about adding DFA’s approach to their investments.

Now my client portfolios have a mixture of Vanguard ETFs — clients get excited when they see their investments are almost free — and a smattering of DFA funds where it makes sense from an allocation and tax perspective.

I’ll never stray from the passive investing approach, especially given how cheap ETFs are to use, and my clients have frequently thanked me.