Transcript
Cassie:
Hillary welcome back to another session of Infrequently Asked Questions.
Hillary:
Thank you, Cassie. Delighted to be here.
Cassie:
So today we’re going to talk about the question, what is the cheapest share class for my clients? So as we get ready to delve into this question, my first thing I want to ask is: why is it important for advisors to consider share classes when building portfolios for their clients?
Hillary:
Well, I think one of the main, one of the main things you need to be looking at here is really what’s best for my client. We’re fiduciaries to our clients and so we want to make sure that we are giving our clients’ portfolios that whereby we’re reducing fees as much as possible while providing great risk adjusted returns. And the SEC has a really big focus on this right now, especially with proper share class selection. There’s been a lot of litigation and some lawsuits and administrative proceedings against firms that have improper share class selection. And certainly when you go through an SEC audit, one of the first things that they’re going to ask you for is how did you determine which share classes are best for your client account? You need to be able to have a really good answer for that when the SEC comes knocking at your door for that particular question, because there are quite a few, administrative issues with improper share class selection and some hefty fines surrounding that for firms that aren’t abiding by the correct procedures.
Cassie:
So I guess the other thing I’m pulling out, I’m hearing you say is you really need to have a process. It needs to be a documented process. It needs to be a consistent process. So this is not something where you just make up a different portfolio for each person you’re using different portfolios and different share classes and you don’t have some kind of documented process to go along with that.
Hillary:
Correct. Yeah, I mean, when it comes to the SEC, really, in order to show that you have a prudent process in anything, it has to be documented and consistently followed. And so they’re going to ask for things such as what calculations did you use to arrive at using this share class over this share class for these client accounts? You need to be able that during those audits.
Cassie:
Well, so in my history as an advisor, of course, I’m familiar with A shares and B shares and C shares, but I never really fancied myself a portfolio manager. So that was not ever my thing. I was always really focused on educating clients, growing the business. But I know there are a lot of folks out there who are really interested in building portfolios. So the question is, what is the cheapest share class to use for my clients?
Hillary:
Well, unfortunately, Cassie, that answer is, it depends. It seems like I never give an easy answer on these videos because there’s a lot of things that go into, you know, figuring out the best share class for clients. And so I think a lot of advisors right off the bat, they think, well, I should just always use institutional share class. It has the cheapest embedded expense ratio, and therefore it’s the cheapest all in cost for my clients. And that’s just not true. You really need to dive into all of the facts surrounding how you’re going to use that fund in your portfolios and to really make a good determination. So I think it might be good if maybe I walk you through an example of what that would look like. So if you’re looking at fund “A” that has an institutional share class, maybe the expense ratio is 75 basis points, and then they also have another share class, maybe it’s called an investor share class, and it’s embedded expense ratio might be 100 basis points.
So a lot of advisors would automatically assume, well, the 75 basis fee fund is cheaper. So in terms of best share class selection, that’s what’s best for my clients, but fail to take into consideration all the other factors that have to go into the mathematical computation of what’s actually best for my client. So for example, say that fund was going to be a 10% allocation of a portfolio and say with your custodian, it costs you $25 to trade it every time. Well now you have a $25 ticket charge, you’re putting on top of it. And if you rebalance four times a year, that’s going to be a hundred dollars a year to trade it. So on a $10,000 position, you’re at $100 in trading costs, which is a 1% fee. So 1% plus 75 basis points is 175, whereas the higher embedded expense ratio fund with a 1% fee is likely free to trade at the custodian.
So you really have to do all the math. You have to consider, you know, how am I using this in the portfolio? Is it something I’m going to trade often when I rebalance? Is the client putting in a lot of deposits into the account or taking a lot of cash out of the account whereby I’m going to be trading this account more often? Because the SEC really looks at what’s the all in cost to the client. And you need to be able to justify that. And many times you are able to justify having a fund within your portfolios that may have a higher embedded expense ratio, but after you do all the other math involved, add all the other fees that are going to be accumulated to that client, as you trade and rebalance that account over time, it can be cheaper to go with what’s called non-transaction fee fund within your portfolio. So it takes a lot of math. I have a huge spreadsheet on every single fund that we use in our portfolios. I update it several times a year, of what’s the proper share class selection. And certainly once you’ve hit a certain breakpoint on accounts, say accounts $500,000 up or $300,000 up, your share class selection is going to change for that client. And so then you have to change your portfolio allocations to account for that.
Cassie:
So we’re talking about this in terms of wanting to have the best for our clients, the lowest cost, but I mean, when the SEC comes to do an audit, I mean, are they really, are they going to really look at it in this detail?
Hillary:
They have, for me. So, I’ll just say it that way. I have been asked in the last SEC audit I was through, to provide documentation of all these accounts and how proper share classes were selected and to really make that determination. And, they really liked how I was doing it in terms of, making an assumption of how often it would be traded, the all in cost for the client, and then deducing which share class to select from there. And again, it’s really being able to show a process to the SEC or, any other, type of regulatory body that could come in. You need to be able to show a process that what you did was prudent and you’re trying to do what’s best for the client. I mean, certainly there’re always assumptions going into this. You may not end up rebalancing four times a year. It may be slightly more costly to do it one way than another, but there is some leeway there. It’s really just, what is your overall process and does it make sense from a mathematical perspective?
Cassie:
Great. All right. Well, I think sometimes as advisors, we think, well, it’s not come up yet. So, I’m in good shape for now, but I guess you’re in good shape until you’re not.
Hillary:
Exactly.
Cassie:
So, yeah. So if this is something that you’ve not really thought about before, we invite you to reach out to us to talk about portfolios, how share classes are considered when putting together portfolios. And of course, if you decide you don’t want to be doing all of the math behind this, and you would like to outsource that, Hillary can be your Chief Investment Officer and you can use the portfolios that she’s put together through LightPoint™ Portfolios. So if you’d like to know more about that you can email me at Cassandra@beaconwealth.com and as always, I welcome your feedback and any questions that you have that you’d like us to talk further about and infrequently ask questions. Thanks for your time, Hillary.
Hillary:
Thank you.
Cassie:
Have a good day and God bless.