Fight the Good Fight Against Fees, Tax Inefficiency
Everyone knows there is no such thing as a free lunch, but in investing you often have to pay for a lot more than just lunch, and the lunch you get may not be what you expected. In particular, the fees associated with the investment management process tend to be high, making it hard to beat a passive market index, and the product you receive is almost inevitably highly tax inefficient, making after-tax market outperformance even less likely.
Here is a great piece by Ken French on the subject of active management fees: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1105775
The game of financial intermediation begins with framing. Consider how fees are framed by money managers: fees are expressed as a percentage of assets under management. Take an actively managed stock fund with an annual expenses on the order of 1.5% of assets under management (the so-called “expense ratio”). At first glance, this may not seem like a large number. Yet, if we scale such fees against a rate of return earned, they can appear dramatically higher. If your return is, say, 5% (and in a world of ultra-low yields that’s not bad), then a 1.5% fee is a full 30% of the return generated. Intuitively, to us anyway, that seems like an excessive portion of what may be a generous estimate for near-term stock market returns. In fact, Wes mentioned to me a while ago that his retirement plan offered the PIMCO bond fund at 70 basis points for the fixed income option. The yield on the fund was around 100 basic points, which means 70% of the return was eaten by fees. Aye, carumba!
Taking a step back, what is it exactly that you are buying for this 1.5% fee? The answer, at least for most people, is that you are paying to outperform the market. But in order to even match the market, the active manager has to therefore outperform the market by 1.5%. Is that easy to do, or hard to do? Here’s a back of the envelope perspective. A recent Morningstar study tracked 682 actively managed funds in the large cap, value/growth blend category over a 10-year period, and calculated the standard deviation of returns at 1.52%. This is practically identical to our typical 1.5% fee. This suggests that a fund must generate performance that is a full standard deviation above the mean in order to match the market, and the standard normal distribution suggests that about 84% of funds will fall below this threshold, meaning 16%, or about one out of six, will match or exceed this one-sigma figure. One out of six. Think about rolling a dice and coming up with a six. You never get one when you need it, right? So investors are paying this 1.5% fee in order to get exposure to this longshot 1 in 6 chance they will beat the market. That’s just nuts. The vast majority of investors will lose this bet. But wait, it gets worse. We are just considering the expense ratio – we could also assess the effects of taxes, as well as trading commissions, which are not reflected in the expense ratio.
For investors as a whole, returns decrease as motion increases.
– Warren Buffett
French estimates that the average turnover of actively managed funds, based on total assets, is over 200%. Why are turnover rates so high? Perhaps the main reason is that managers believe they can beat the market by trading more often. Portfolio turnover is a subtle beast, as it destroys returns in two ways.
First, there are taxes – federal, state, and local. Turnover generates a return-killing blend of long and short-term realized capital gains. It is safe to say that the average actively managed fund is highly tax inefficient, and the higher the rate of turnover, the greater the tax inefficiency. Second, all the trading involved while turning over the portfolio 2X per year also increases the costs of managing the fund through trading and transaction costs. The SEC does not currently require commissions to be factored into expense ratios, but the numbers can be comparable, with commissions/impact/spread costs totaling 100+ basis points per year, or more.
Another related category of expense that can be reflected in commissions: the particularly odious “soft dollars,” which involve hidden costs. Soft dollars are payments made by means other than the payment of “hard” dollars (cash). A quick example will make the point. Let’s say your money manager wants five new Bloomberg terminals. One way for him to get them is to simply pay for them himself, out of the fees he is charging you. But we know he doesn’t want to do that, since he would rather buy himself a Porsche. A second way is for him to pay for them, and expense them to you directly. But he doesn’t like that option either, since you might object. Therefore another attractive way for him to proceed is to make an opaque soft dollar arrangement with his brokerage firm. It works like this. He says to the brokerage, “I will direct all of my trading to your firm over the next six months, if in return you let me use five of your Bloomberg terminals.” The manager gets the Bloomberg terminals, and the broker gets a bunch of trading commissions that more than offset the cost of the terminals, and the investor loses–a Wall Street Love Story in the making.
Again, if the money manager pays cash, there is an entry on the books, and the manager has to either a) pay for the terminals himself, or b) disclose and expense them out to the investors. In this example, if the manger uses soft dollars, he can avoid disclosure, and simply pay by directing business to his broker or paying slightly higher commissions. The bottom line? The new Bloomberg expense gets buried in trading costs, and the investor foots the bill even though they can’t directly see it.
Then there are sales charges, with initial, deferred and redemption fees, as well as penalties for not maintaining a minimum balance, or market timing. You couldn’t dream this stuff up if you were a Hollywood writer. We could go on, but we are starting to feel ill talking about all these fees.
We look to a money management heavyweight, David Swenson, for a synopsis of the all-in effects of all these various fees:
A miniscule 4 percent of funds produce market-beating after-tax results with a scant 0.6 percent (annual) margin of gain. The 96 percent of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8 percent per annum.
-David Swenson, CIO of the Yale University Endowment
We roughly approximated that perhaps 1 out of 6 funds could beat the market after a 1.5% management fee, but when we add the effects of taxes, commissions and other expenses, David Swenson estimates that ratio falls to perhaps 1 out of 25. Holy schnikes!
Still think fees aren’t completely out of control, on average? We had our minds completely blown away by this recent news piece, which describes how many mutual funds are beginning to hold….wait for it…ETFs in their portfolios. Yes, you can now pay that 1.5% expense ratio for the privilege of having your fund manager pick for you the right ETF, which of course has its own separate fee, leaving you paying fees on fees. As an astute market observer puts it in the article: “It’s just being lazy. Buy stocks. It’s what people are paying you for.”
At the end of the day, what sensible investors should seek are a few very simple things. Minimal expenses. High tax efficiency. Transparency. Intelligent investment process. It’s not that hard. It is reasonably argued that mutual funds, in the aggregate, are a tremendous disservice to the investing public, because of the factors discussed above. Unfortunately, you as an investor are on your own to navigate your way through dangerous financial straits, and avoid the fees and turnover that can sink your ship. The task can be daunting, but knowledge goes a long way. Stick with Turnkey and we’ll try and increase your knowledge base. Snake oil can be a great product, but we’d prefer you avoid it whenever possible.***
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