Thursday, July 24, 2008

New Investment Management Paradigm

I have been approached by the gurus at Rainbox Portfolios to be one of their premier portfolio managers. It is definitely a tempting idea, and could be a new way to invest, but I'm just not clear how viable it really is, especially for smaller investors. Here's how it works:

I would operate and maintain what amounts to a live portfolio and research platform. For a monthly subscription fee, the client would have access to Smug research reports and live updates on portfolio changes. This might appeal to the DIYer who isn't entirely sure how to DIY. Every time Smug gets a trade signal from the green trading model, you get the trade signal too, in the form of an email indicating a price to buy (with a cushion), number of shares, and cost information. The only thing left for you, the client, to do is to place the trade as indicated.

This appeals to me on a few levels. Firstly, there is no bias for portfolio size. If you have a $10,000 portfolio or a $1,000,000 portfolio, your fee structure is exactly the same: the monthly subscription fee plus the cost to trade, which you can control. For instance, I prefer using optionsXpress for some of my accounts. The trading cost is $14.95 per trade regardless of size of the trade (though bigger accounts can get lower per trade costs) and there are no annual fees. I haven't found any hidden fees yet, either, in my time using them, so all in all, I'm satisfied.

Assuming your self directed accounts are in the $15/trade ballpark, which most of them are, here is a look at what portfolio size corresponds to what annual fee. As you would be making the trades yourself, I built in a cushion for "hassle" and "time to trade" as follows (all values are annual):


Hassle Cost: 0.45%
Time Cost: $28.00
Trading Cost: $14.95
Annual Fee: $0.00
Turnover %: 50%
Assets: 12
Growth Rate: 5.00%

Annual Fee Breakdown:

Fee $2,500 $5,000 $7,500 $10,000 $20,000 $30,000 $50,000 $100,000
$7.50 11.38% 5.69% 3.79% 2.84% 1.42% 0.95% 0.57% 0.28%
$10.00 12.53% 6.26% 4.18% 3.13% 1.57% 1.04% 0.63% 0.31%
$12.50 13.67% 6.84% 4.56% 3.42% 1.71% 1.14% 0.68% 0.34%
$15.00 14.82% 7.41% 4.94% 3.71% 1.85% 1.24% 0.74% 0.37%
$17.50 15.97% 7.98% 5.32% 3.99% 2.00% 1.33% 0.80% 0.40%
$20.00 17.12% 8.56% 5.71% 4.28% 2.14% 1.43% 0.86% 0.43%
$25.00 19.41% 9.71% 6.47% 4.85% 2.43% 1.62% 0.97% 0.49%

You can see why this becomes incredibly appealing to DIYers with $30K or more invested in the portfolio. If I were to set the subscription fees at what I consider my midpoint (Rainbox suggests a $20/month fee, but that seems steep to me), $15/month equivocates to an annualized 1.24% expense ratio. That's in the ballpark of most mutual funds, only you're not obligated to make any trade you don't like. If your portfolio is bigger, in the $50K - $100K range or beyond, the savings are exponential. At some point, the cost of a "professionally run" portfolio decreases to below ETF levels, and eventually to almost negligent non existent levels. It offers complete control with investment manager research and advice. My expense ratios are higher than Rainbox's in part because I added in the "hassle" and "time cost" of managing your own portfolio. The "time cost" assumes trades take about 7 minutes each and your time is worth roughly $20/hour. The "hassle cost" component assumes you get the trade email and wait to trade for 5 days, either due to laziness, busy-ness, vacation, or any reason at all. It makes the assumption that for every day you wait to trade, you lose about 0.15% in profit. That's a fairly big assumption, as you could actually avoid losses by waiting, but adding it as a component makes it a more realistic model of how the subscription service would work.

Want to know the kicker? If you paid no one and totally self directed, a $20K portfolio costs you roughly 0.99% annualized fees using the assumptions above. That's why online broker houses exist and seem so cheap - they are actually making fair sums of money off small accounts. An account of $10K with 50% turnover and 12 assets costs you about 1.98% per year - on the high end of just buying and holding a mutual fund! So here's a look at the same chart above, only the numbers reflect the excess cost of subscribing (as in, how much you are actually paying for a "management fee"):

"Management Fee" Breakdown:

Fee $2,500 $5,000 $7,500 $10,000 $20,000 $30,000 $50,000 $100,000
$7.50 3.44% 1.72% 1.15% 0.86% 0.43% 0.29% 0.17% 0.09%
$10.00 4.59% 2.30% 1.53% 1.15% 0.57% 0.38% 0.23% 0.11%
$12.50 5.74% 2.87% 1.91% 1.43% 0.72% 0.48% 0.29% 0.14%
$15.00 6.89% 3.44% 2.30% 1.72% 0.86% 0.57% 0.34% 0.17%
$17.50 8.03% 4.02% 2.68% 2.01% 1.00% 0.67% 0.40% 0.20%
$20.00 9.18% 4.59% 3.06% 2.30% 1.15% 0.77% 0.46% 0.23%
$25.00 11.48% 5.74% 3.83% 2.87% 1.43% 0.96% 0.57% 0.29%

At the mid price point of $15/month, the equivalent management fee is only 0.86% for a $20K portfolio. That's not too shabby, considering most management fees run between 0.50% and 1.00% for mutual funds, and up to 2.00% for hedge funds. The nice part is, as the portfolio size increases, your management fee decreases!

So how do I get paid? The subscription fees go to me, though there are expenses I would incur in utilizing the service. For one, I incur the credit card processing fees, plus a 25% commission fee to Rainbox. Here's how much I would make based on subscriber accounts:

Smug Income Breakdown:
Subscription ACCOUNTS
Fee 1 5 10 25 50 75 100
$7.50 -$47.54 -$6.10 $23.21 $105.12 $239.64 $373.82 $507.93
$10.00 -$45.72 $3.01 $41.41 $150.63 $330.65 $510.34 $689.95
$12.50 -$43.90 $12.11 $59.61 $196.13 $421.66 $646.86 $871.98
$15.00 -$42.08 $21.21 $77.82 $241.64 $512.68 $783.38 $1,054.00
$17.50 -$40.26 $30.31 $96.02 $287.14 $603.69 $919.90 $1,236.03
$20.00 -$38.44 $39.41 $114.22 $332.65 $694.70 $1,056.42 $1,418.05
$25.00 -$34.80 $57.61 $150.63 $423.66 $876.73 $1,329.45 $1,782.10

The breakeven is pretty low at 5 accounts for all but the cheapest subscription price. In fact, if I charged only $0.99/month, I'd only need about 40 accounts to barely break even after costs.

It sounds excellent in theory to me as a way to a.) create income for Smug and tap into a wider audience, and b.) allow investors to make their own choices at a minimum of cost. A new paradigm, right?

Well, I'm not entirely sure. First of all, the likelihood of DIYer's paying for advice is low, and the likelihood that online readers would subscribe and have $30K+ to invest solely in Smug's models is even lower. Rainbox is in beta form right now and actively soliciting managers (like me) to not only give it some credibility, but to help launch it successfully. The question I have is: will it work? I've set up a poll to the right side, I'm wondering how much you, the interested green investor, would be willing to pay for a subscription service like this? Nothing? $1.00 per month? $20.00 per month?

Comments and criticism appreciated, I'm looking to make a decision whether or not to offer the service in the coming weeks. Look out for more green commentary in the next few days, and a profile of the environmental services ETF, EVX.

No comments: