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Instutional Asset Class Funds Help You Benefit from Asset Class Investing


Have you taken a good look at institutional asset class mutual funds? They offer attractive features, not the least of which are lower operating expenses and less turnover, which can cut both costs and taxes.
 
Institutional asset class funds invest exclusively within, and are intended to mirror the performance of, a particular asset class. An asset class is a grouping of investments whose risk level and expected returns are similar. Large-cap stocks, real estate securities, and emerging markets stocks are just a few examples of asset classes.
 
In the past, the minimum investment required by institutional asset class funds was often in the millions of dollars, effectively keeping these funds beyond the reach of all but the wealthiest investors. Today, however, many of these funds offer significantly lower minimum investment levels, and the funds are available to all investors through fee-based financial advisors.
 
Let’s take a closer look at the major attributes that attract investors to institutional asset class funds.
 
 
Lower Operating Expenses
 
All mutual funds and separately-managed accounts have expenses that include management fees, administrative charges and custody fees. These fees are quantified as a percentage of assets.
 
According to Morningstar, the average annual expense ratio for all retail equity mutual funds is 1.45 percent. However, the ratio for institutional asset class funds is typically about one-third the ratio for retail equity mutual funds. All other factors being equal, lower expenses lead to higher rates of return.
 
 
Lower Turnover Resulting in Lower Cost
 
Most investment managers do a lot of trading, believing that this adds value. The average retail mutual fund has a turnover ratio of 85 percent. This means that, on average, 85 percent of the securities in the portfolio are traded over a 12-month period. This represents $85,000 of traded securities for every $100,000 invested.
 
Higher turnover is costly to shareholders, because each time a trade is made, there are transaction costs, including commissions, spreads and market impact costs. These hidden costs may amount to more than a fund’s total operating expenses if the fund trades heavily, or if it invests in small-company stocks for which trading costs are very high.
 
Institutional asset class funds keep turnover at lower levels than do retail mutual funds overall, because institutional investors seek a specific asset class return with as low a cost as possible.
 
 
Lower Turnover Resulting in Lower Taxes, Too
 
If a mutual fund sells a security for a gain, it must make a capital gains distribution to shareholders. The reason is that mutual funds are required to distribute 98 percent of their taxable income, including realized gains, each year in order to stay tax-exempt at the corporate level. These funds distribute all their income annually, because no mutual fund manager wants to have his or her performance reduced by paying corporate income taxes.
 
In one study, Stanford University economists John B. Shoven and Joel M. Dickson found that taxable distributions have a negative effect on the rate of return of many well-known retail equity mutual funds. They determined that a high-tax-bracket investor who reinvested the after-tax distribution ended up with an accumulated wealth-per-dollar-invested of only 45 percent of the fund’s published performance. An investor in the middle tax bracket realized just 55 percent of the published performance.
 
Because institutional asset class funds have lower turnover, they have significantly lower taxes.
 

Consistent Investing in a Targeted Asset Class
 
Most financial advisors agree that the greatest determining factor of the performance of your investments is your asset allocation, a term that refers to the way your money is distributed among various asset classes. Your asset allocation can go a long way toward helping you achieve your goals for investment performance – but only if the investments in your portfolio maintain your intended asset allocation.
 
Each institutional asset class fund carries a mandate to stay fully invested in the asset class that the fund was created to represent. For this reason, by investing in such a fund, you are better able to maintain your intended asset allocation.
 
At Grand Wealth Management, we utilize institutional asset class funds from Dimensional Fund Advisors as well as traditional low-cost index funds from Vanguard and Fidelity. If you'd like to explore the benefits of institutional asset class investing, give us a call.
 
 
 
This article is adapted from our white paper, The Informed Investor: Making Smart Investing Decisions in Today’s Volatile Market.


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