The Potential Pitfalls of DIY Portfolio Management
Since most of the hard work that goes into managing our portfolios is not apparent to an outside observer, some prospective clients ask, “Why don’t I just manage my own portfolio?”
There's more to it than meets the eye.
These days anyone can buy mutual funds or ETFs and build their own portfolio. But here are some things to consider before going down that path.
Fund Selection
Selecting building blocks for your portfolio takes skill and experience. Yes, anyone can buy funds, but choosing the right ones is not as easy as it looks.
First, you must decide whether to use actively managed funds, passively managed funds, or a combination of both. In any case, you need a disciplined process for selecting them.
Active managers have a hard time beating their benchmarks after fees, and past performance is not a reliable way to select them. More often than not, today’s winners are tomorrow’s losers.
In their SPIVA Scorecards, Standard & Poor’s (S&P) regularly tracks the performance of active managers. As of June 30, 20231, S&P found that over the preceding year, 72% of all domestic equity funds had underperformed their benchmarks after fees. Over the preceding five years, 89% had underperformed. Over the preceding 10 years, 90% underperformed.
Active managers that outperformed in one period were not necessarily the ones who outperformed in subsequent periods. S&P found that less than 1% of the domestic equity funds that were in the top quartile of performance for the one-year ended June 30, 2018 remained in the top quartile over the ensuing five one- year periods.
Selecting passively managed funds seems like it should be easier, but there are still important decisions to make. For example, which index do you track? Not all US large cap index funds track the same index. Not all US small cap funds track the same index. Which should you choose? Performance will vary depending on your selection.
Passively managed funds have widely varying expenses. For example, some funds that track the S&P 500 Index have management fees of 0.05% or less, while others charge over 1%. Choosing one versus the other could either cost or save you hundreds of thousands of dollars.
Passively managed ETFs also differ in terms of their “liquidity.” Liquidity is measured in terms of the magnitude of an ETF’s “bid/ask spread”—that is, the difference between the amount you receive when you sell the ETF and the price you pay when you buy it. Building a portfolio with ETFs that are more liquid (i.e. have a smaller bid/ask spread) can save you money over time.
Selecting either active or passively managed funds calls for a review of the reputation and stability of the firm offering the fund.
Every year, dozens, if not hundreds, of ETFs are closed down.2
Combining Funds
Once you have selected the building blocks you want to use in your portfolio, you must decide how to combine them to give you the outcome you desire.
First you must decide how you will allocate the assets in your portfolio among the various “asset classes” that make up the investment universe. For example, how much will be allocated to stocks, how much to bonds, and how much to other asset classes?
Maybe you want to build a portfolio with 60% allocated to stocks and 40% allocated to bonds. How much will you allocate to US stocks and how much to international stocks?
How much will you allocate to developed markets and how much to emerging markets?
How much will you allocate to small-cap, mid-cap, and large-cap stocks?
How much to growth stocks? How much to value stocks?
How much will you allocate to Government bonds and how much to corporate bonds?
Do you know how to combine the different building blocks to target the long-term returns you need? Do you know what that target is?
Do you know how to combine the building blocks to limit portfolio volatility to a tolerable level? Do you know what level of volatility is tolerable for you?
Do you know how to build a broadly diversified portfolio so that declines in the value of some portfolio assets are minimized or offset by smaller declines or gains in others?
Rebalancing
Once you have selected the appropriate building blocks and decided how to allocate them, you should adopt a rebalancing strategy.
As securities markets rise and fall, the allocation of the investments within a portfolio will change. For example, after several years of a rising stock market, the 60% stock/40% bond portfolio that you wanted might have shifted into a 75%/25% portfolio.
You will need to develop a regular program for monitoring your portfolio and periodically resetting or “rebalancing” it to the allocation that is right for you.
Taxable Portfolios
Managing portfolios to reduce taxes for taxable investors requires another level of skill and effort.
Taxable portfolios are often constructed and managed differently than non-taxable portfolios. This may involve using different building blocks, like municipal bond funds, that aren’t subject to Federal tax. Or it may mean investing in more “tax efficient” asset classes.
Managing taxable portfolios also presents the opportunity to engage in “tax loss harvesting.” This is a practice that involves intentionally selling positions that have declined in value in order to realize, or “harvest,” a loss in the current tax year.
If you are going to do-it-yourself, you will want to develop a regular program for monitoring and harvesting tax losses to reduce your annual tax bill.
- Lazzara, C., Ganti, A., Gioia, D., & Stoddart, G. (2023). SPIVA® U.S. Scorecard. S&P Global. https://www.spglobal.com/spdji/en/documents/spiva/spiva-us-mid-year-2023.pdf
- https://www.etf.com/etf-closures
The information contained herein does not constitute investment advice or a solicitation. This article is for dissemination of general information only. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. Investments are not guaranteed and are subject to investment risk, including possible loss of the principal amount invested. Past performance is no guarantee of future results.