Floor Plans

IFA's Approach to Minimizing Cash Drag

Floor Plans

One of the least advertised benefits of being an Index Funds Advisors, Inc (IFA) client is the continuous effort that our portfolio management team makes to give our clients the best investment experience possible. Much of this effort comes in the form of holistically evaluating all of our choices when determining how to help clients achieve their portfolio management goals by reviewing trading costs, taxes, and tracking error relative to the IFA Index portfolios. Any one of these is probably worthy of a short novel by itself, but today, the focus is on our desire to minimize cash drag in the portfolio. Here's a simple definition of cash drag:

Cash drag = excess cash × return on foregone investment

For example, if an advisor holds 1% excess cash over what is appropriate for management fees, monthly withdrawals, etc., and assuming the long-term expected return of the advisor's portfolio is 9% , then 0.09% is the annual amount of expected return forgone by not using a strategy designed to reduce cash drag. Regardless of which numbers you use, there's value in monitoring transaction costs and cash drag. At IFA we try to eliminate as much cash drag as possible by holding only 2.5 quarters worth of management fees in cash. For a client who pays a 0.9% advisory fee, the targeted maximum cash held would be 0.56% of the portfolio, and the average cash held over the long-term would be about 0.34%.

So, doesn't this mean that you'll be paying more transaction costs to replenish the cash?

The short answer is - not exactly!

Every time we rebalance, tax loss harvest, buy, sell, or have a cash inflow or outflow, not only will we replenish the 2.5 quarters of cash, but we will hold a 5.5 quarters worth of management fees in a no-transaction fee S&P 500 fund used as part of our US Large Cap Blend allocation.  This fund can be bought or sold without paying trading commissions to the custodian. This has two significant impacts:

1) It saves the client trading costs, which can significantly add up over time, and

2) Instead of leaving investable assets in cash, it affords the opportunity to earn money in low cost index mutual funds. In other words, those assets are working for our clients.

Now this all sounds nice and well, but what's it actually all worth? Well, if we look at the ending monthly values of these no transaction fee funds over the last calendar year (2012), and multiply them by the monthly returns of the IFA US Large Company Index (an equivalent fund to the S&P 500 funds used by IFA), we can get an idea of what this strategy is putting back into our client's pockets by investing this money rather than leaving it in cash.

 

Month No Transaction Fee
Fund Values1
IFA Large Company Dollar Contribution
Jan-12 $9,319,429 4.44% $414,197
Feb-12 $9,685,677 4.26% $412,156
Mar-12 $9,583,637 3.35% $320,915
Apr-12 $10,103,096 -0.63% $(63,656)
May-12 $10,113,007 -6.07% $(613,742)
Jun-12 $9,675,644 4.13% $399,937
Jul-12 $9,843,103 1.40% $137,473
Aug-12 $10,169,495 2.20% $224,121
Sep-12 $10,653,336 2.58% $275,193
Oct-12 $10,231,250 -1.85% $(189,134)
Nov-12 $10,164,534 0.63% $63,813
Dec-12 $10,061,420 0.85% $85,114
      $1,466,388

 

That's over $1.4 million dollars that went back into our client's pockets by being invested in no transaction fee S&P 500 funds.

Last year (2012) was a better than average year for the S&P 500, with a return of 15.82% based on the IFA US Large Company Index. Historically, from 1928 through the end of 2012, the annualized return for the S&P 500 was 9.10%, which is a good proxy for an expected return going forward.

We only touched on cash drag today, but there are several costs similar to what I've mentioned thus far that IFA considers in its portfolio management process. At the end of the day, all of the value added to investors' portfolios by managing and mitigating cost adds up to an advisor's true worth. Here is an illustration:

 

Advisor's Management Fee (%)

- Behavioral Cost Savings (%)

- Cash Drag Savings (%)

- Tax Cost Savings (%)

- Transaction Cost Savings (%)

- The Value of Being able to Sleep at Night (%)

 = True Advisor Fee (%) (Hopefully, a value added rather than a cost)

 

 

The comments and feedback of Thomas Allen and Jay D. Franklin, CFA, FSA are greatly appreciated.

Disclosure:

1The "IFA No Transaction Fee Fund Values" are composed of the values of SWPPX, SVSPX, FUSEX, FUSVX, & PEOPX managed by IFA as of the ending day of the previous month for the 2012 calendar year. Any month with inflated numbers due to the funds being using for Tax Loss Harvesting were excluded and the average fund values for the previous and next month were used instead. The data for both Adjusted and Unadjusted is available upon request.