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Concept Three: Employ Asset Class Investing

Almost all investors would benefit by using institutional asset classes. An asset class is a group of investments whose risk factor and expected returns are similar. Originally, institutional asset class funds were not available to the great majority of investors. Often the minimum investment for these mutual funds was in the millions of dollars, effectively keeping them beyond the reach of all but the wealthiest investors. That was their goal because these funds were for institutional accounts, such as large pension plans.

There are four major attributes of institutional asset class funds that attract institutional investors:

1. Lower operating expenses
2. Lower turnover resulting in lower costs
3. Lower turnover resulting in lower taxes
4. Consistently maintained market segments
We'll look at each one in turn.

1. Lower Operating Expenses

All mutual funds and separately managed accounts have expenses that include management fees, administrative charges and custody fees. These are expressed as a percentage of assets. According to the Globe and Mail, the average annual expense ratio for all retail equity mutual funds in Canada is 2.81 percent. In comparison, the same ratio for institutional asset class funds is typically only about one-third of all retail equity mutual funds. All other factors being equal, lower costs lead to higher rates of return.

2. Lower Turnover Resulting in Lower Cost

Most investment managers do a lot of trading, thinking that this adds value. The average retail mutual fund has a turnover ratio of 83 percent. This means that, on average, 83 percent of the securities in the portfolio are traded over a 12- month period. This represents $83,000 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 have significantly lower turnover because their institutional investors want them to deliver a specific asset class return with as low a cost as possible.

3. Lower Turnover Resulting in Lower Taxes

If a mutual fund sells a security for a gain, it must make a capital gains distribution to shareholders because mutual funds are required to distribute 98 percent of their taxable income each year, including realized gains, to stay taxexempt at the corporate level. They 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 found that a hightax- bracket investor who reinvested the aftertax 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.

4. Consistently Maintained Market Segments

Most investment advisors agree that the greatest determining factor of performance is asset allocation— how your money is divided among different asset categories. However, you can only accomplish effective asset allocation if the investments in your portfolio maintain consistent asset allocation. That means your funds need to stay within their target asset classes. Unfortunately, most retail funds effectively have you relinquish your control of your asset allocation. On the other hand, because of their investment mandates, institutional asset class funds must stay fully invested in the specific asset class they represent.

Fortunately, these institutional asset class funds are now available to investors through fee-based financial advisors. You can gain the same advantages that previously only large institutional investors received.