Portfolio Analysis: A $960,598 Trust Dragged Down by Cost

Deciding how to invest inherited money can be difficult. It's hard to make the right investment choices when emotions are running high. So what do we do?

Do we stick with the same investments we inherited or do we go with something else? If our relative was already working with a financial advisor before he or she passed, do we continue with that relationship or do we try someone different? These questions are nearly impossible to answer without a full scale analysis of the inherited portfolio.

My latest portfolio report card is for TBM in Austin, Texas. His father left him and his sister around $960,000 in a family trust. After a few years of lackluster performance, he finally decided to have his inherited money analyzed and graded.

TBM asked me to take a look and here's what I found: His family trust consists of 21 mutual funds, five exchange-traded funds, one exchange-traded note and is managed by a financial advisor.

What kind of portfolio report card grade will TBM get? Before I assign him a final score, let's examine the critical elements of the portfolio.

Diversification. Adequate diversification is all about having your money divided across all of the main asset classes. Admittedly, I was impressed with TBM's portfolio diversification.

TBM's trust account has exposure to all of the major asset classes, including domestic stocks through the iShares S&P 500 Index ETF, international stocks through Dodge & Cox International Stock Fund, commodities through Credit Suisse Commodity Return Strategy Fund, bonds through Pimco Total Return Fund, real estate through SPDR Dow Jones International Real Estate ETF and cash. His portfolio even holds exposure to other, often missed areas, such as preferred securities and emerging market bonds. Well done on diversification.

Risk. The risk characteristics of a portfolio -- regardless of whether it's inherited money or not -- should accurately reflect the risk character of the living person (or beneficiary). This is an important point, because some people (usually stubborn trustees) have the misinformed view that the money should be invested according to the risk tolerance of the dead bequeather.

Around 20 percent of TBM's portfolio is concentrated in risky emerging market debt and individual municipal bonds. The overall asset mix is 49 percent bonds, 35 percent stocks, 7 percent real estate, 6 percent other and 3 percent percent cash.

Cost. TBM's advisor fees over the past year (from August 2013 to August 2014) were $8,363. The income mutual funds like the Principal Preferred Securities Fund charge another 0.43 percent to 0.75 percent on average. And although his portfolio owns a few low cost ETFs, through the iShares S&P 500 Index ETF, Vanguard REIT ETF and iShares MSCI Emerging Markets Index ETF, most of money is parked in higher cost funds. I estimate the overall fee and cost structure of TBM's portfolio, including advisory fees, ranges from 1.5 percent to 2 percent annually.

In the context of a bond portfolio like this, elevated fees are a death blow. Why? The performance return from bonds tends to be much lower versus stocks, making it harder to play catchup. It's sad and shocking to find so many financial advisors don't take deliberate steps to minimize investment costs for their clients. TBM's portfolio doesn't do well at minimizing cost.

Tax-efficiency. Aside from $107,000 in two individual municipal bonds, TBM's portfolio is not constructed in a tax-efficient manner. Generally, income portfolios held in a taxable account with heavy exposure to bonds, like this one, won't be very tax-efficient. But on the equity side, TBM's trust holds too many active funds with high turnover and annual distributions that weigh down the portfolio tax-wise.

Performance. TBM's portfolio gained 4.9 percent ($44,100) from August 2013 to August 2014. Over that same time frame, a portfolio of index ETFs matching his asset mix returned 8.3 percent, with blended expenses of just 0.20 percent.

TBM's subpar performance says almost everything we need to know. Portfolios that do poorly at minimizing cost and cutting taxes will suffer the consequences of disappointing performance.

Summary. The final grade for TBM's portfolio is C. The only area where it shines is in diversification. Unfortunately, this one positive quality is overshadowed by too many other structural weaknesses.

The C grade indicates this portfolio has major flaws that prevent it from achieving a satisfactory grade of "B" or higher.

For a fixed income portfolio, I would characterize TBM's investment costs as wholly unacceptable. Clearly, his subpar performance of less than 5 percent over the past year versus an 8.3 percent gain for a similar indexed portfolio is not good.

Hopefully, TBM will be motivated to fix the weaknesses within his portfolio and get back on track.

Ron DeLegge is the founder and chief portfolio strategist at ETFguide.com. He invented the Portfolio Report Card to help people understand the strengths and weaknesses of their investment portfolios so they can make better choices. Ron is also a radio host of the Index Investing Show and author of "Gents With No Cents: A Closer Look at Wall Street, its Customers, Financial Regulators and the Media."

Ron DeLegge is a blogger for The Smarter Investor. You can read his articles at ETFguide.com, listen to his radio show, the Index Investing Show, and read his book "Gents with No Cents: A Closer Look at Wall Street, its Customers, Financial Regulators, and the Media" (Half Full Publishing Group, 2011).