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© 2018 by The Discerning Investor.

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Investing: Why Costs Matter

Managing costs, fees and commissions is paramount to create the best odds for strong long-term portfolio returns.



Managing costs, fees and commissions we pay to brokerages and financial institutions, is critical to maximizing our investment returns. Unlike investment returns and volatility, costs is the one area we have absolute control over. Good thing for all retail investors, online brokerage fees have come down substantially since the deregulation of brokerage commissions, and advent of Charles Schwab and other discount brokerages. Many online brokerages now offer low fixed fees per trade, such as Interactive Brokers' US$1.00 per 100 shares, or SAXO’s 0.12% of trade value.


Trading through a personal stock broker is much more expensive, as is purchasing investment products from banks’ financial advisers. Personal stock brokers typically charge anywhere from 0.25% to 0.75% per trade (both buy and sell), while financial advisers typically charge 1.00% to 5.00% per fund investment (buy only, sell is free). For fund investments, annual expense ratios which are paid by investors, typically range from 1.5% to 2.5% per year, and primarily covers management, administrative, operating and marketing fees. With fees that high, it is important to know the value you are receiving from such services, and its implications on your investment returns.


For the purposes of this analysis, we will exclude products other than equities and equity funds, offered by stock brokers and banks respectively. And assume all investments are in U.S. large-cap stocks, to ensure apples to apples comparison.


The value of paying more


Personal stock brokers – Professionals that watch the market daily and receive updated analysis from the brokerage’s analyst teams. They then translate that knowledge into buy and sell calls for their investors, hoping that their investors can reap good short-term returns, and reinvest the proceeds with them. A knowledgeable and astute broker can help clients build exposure in promising stocks and reap quick profits.


Financial advisers – Client advisers at banks that market various deposit, investment and insurance products. They leverage their bank’s research teams to provide client recommendations and craft custom client portfolios, in line with clients’ risk appetites and goals. A discerning financial adviser can raise client awareness on financial markets and help build robust, diversified portfolios.


Fund Management Companies – Typically third-party asset management companies that manage investors’ monies in line with specific guidelines and strategies. Examples include Schroders, Aberdeen and First State. They have dedicated teams of analysts and portfolio managers performing fundamental research, portfolio stress-testing and trading. Good fund managers can generate superior risk-adjusted returns to their peer group, and potentially beat their benchmark indices over extended periods. While retail investors typically purchase mutual funds (unit trusts) through banks’ financial advisers, they can be purchased through online platforms such as fundsupermart which charges 0% upfront commission. Because online platforms are cheaper to maintain, and they still receive trailer fees from fund management companies (typically up to 50% of management fees on AUM), it can be very lucrative business.


The non-cost flaws of these services


Conflicting interests – Brokerages and banks earn a substantial portion of their revenues in the business from trading and sales commissions, which are a percentage levied on customers’ invested assets, not profits. This incentivizes them to persuade customers to trade stocks or switch funds as often as possible, regardless of the impacts to their portfolios. To increase firms’ profitability and meet public investors’ quarterly expectations, senior management teams have set high sales targets for personal stock brokers and financial advisers, removing those that fail the mark. Because sales targets come before everything else, advisers spend most of their time prospecting clients’, and may neglect building their financial market knowledge, potentially leading to poor advice and little value-add.


This situation has led many private bankers to leave their banks for external asset managers (EAM), where interests are better aligned with clients. At the retail and mass affluent levels, turnover is exceptionally high, as advisers who cannot hit their targets are let go.


Portfolio tax - Fund managers face a different kind of challenge. As compensation is determined by Assets under Management (AUM), they are incentivized to grow their funds. However, when funds get large and serve institutions and financial advisers, the chances for superior performance shrink. They tend to over-diversify and too closely track their benchmark indices, since these investors dislike under-performance twice as much as they like out-performance.


C. Thomas Howard, director of research at AthenaInvest, a Denver-based research company calls these three burdens of fund managers, “the portfolio tax”. “The bigger the fund, the worse the performance,” said Howard, “the more you track an index, the worse the performance, and the more you over-diversify, the worse you do. But fund companies have incentives to do what makes them money and pursuing them means hurting a shareholder’s chance of getting a superior return. Fund companies are okay with that.” In his research, he finds that 80% of equity-fund managers are great stock pickers that beat their benchmarks, until the burden of fees and costs (including “the portfolio tax”) come into play.


Quantifying costs and their impact on portfolio performance


We now turn to quantifying the costs and value-add needed to justify engaging the services of brokers and financial advisers, over simple index investing. To achieve this, we will make some assumptions on expected future market returns using the CAPM model, calculate broker / adviser portfolio net returns after factoring in the additional costs, and compare the difference between the two to determine the shortfall. (Since portfolio turnover occurs throughout the year, costs are calculated by taking the average of beginning of the year’s market value of the portfolio and its end of year value before fees, multiplied by the fees as a percentage of portfolio) We then calculate the per year net returns after costs, and the excess returns per year required to match the benchmark index.


For the purposes of our analysis, we will group financial advisers and fund management companies together, since in Singapore, mutual fund distributions are largely concentrated in banks. To ensure apples to apples comparison, we will only compare equity index fund investing, broker trading and bank-advised equity fund investments. Additionally, we ignore the availability of leverage facilities.


Assumptions


• Time Horizon: 20 years

• Initial Capital: $100,000

• Market Benchmark Index: S&P 500 (Most S&P 500 index ETFs have expense ratios ranging from 0.03% to 0.05%, we assume the median of 0.04%)

• Risk-free rate: 2.80%

• Equity Risk Premium: 5.00%

• Hence, expected returns per year: 2.80% + 5.00% = 7.80%


Variables


• Number of trades (portfolio turnover) per year – (Assuming the full $100,000 initial capital is sold 1 time throughout the year and reinvested into another stock or fund, this constitutes a portfolio turnover of 1)

• Trading and sales commissions %

• Annual expense ratio %


Table 1: Index Investing vs Personal Stock Broker (End of 20-year balance, initial capital of $100,000)


Table 2: Index Investing vs Banks' financial advisers (End of 20-year balance, initial capital of $100,000)


Table 3: Index Investing vs Mutual funds / Unit Trusts without bank commissions (End of 20-year balance, initial capital of $100,000)


Stock Brokers


With commission rates ranging from 0.25% to 0.50%, and portfolio turnover of 1 to 2 times, stock brokers need to achieve 0.48% to 2.06% excess returns over the market per year to justify their fees. With a concentrated stock portfolio, and good (perhaps even lucky) trade timing, this may not be unattainable. If you do find stock brokers with well-planned trading strategies and long-term track records of delivering excess returns, the odds aren’t weighed heavily against you. Unless you are charged commissions over 0.50%, or your broker over-trades.


From a risk-adjusted returns perspective as measured by the Sharpe or Sortino ratios however, things could look very different. Because broker-advised portfolios are typically much more concentrated (e.g. less than 20 stocks), they may be taking on too much single-firm risk, leading to more volatile portfolios which lack diversification benefits. You can track the returns and volatility experienced on your portfolio vs the relative benchmark index to measure your broker’s risk-adjusted performance.


Banks' Financial Advisers


Because you pay two layers of fees when you purchase Unit Trusts from banks – Sales commissions and fund expense ratios, this is where it can get ugly. In our best-case scenario, where you pay sales commissions of 1.00%, are invested in a fund with expense ratio of 1.50%, and the adviser only switches your funds once per year, the adviser and his selected funds must outperform the market consistently by 2.59% per year for you to match index returns. This is significantly more difficult than a broker outperforming by 2.59% per year, because large funds tend to mirror their benchmarks closely and hold diversified portfolios. Over the past 15 years ending Dec 2016, more than 90% of actively managed U.S. large-cap, mid-cap and small-cap funds did worse than the S&P 500, after accounting for fund-related fees.


In our median-case of 3% commissions, portfolio turnover of 1.5 times per year and expense ratio of 2.00%, it gets materially worse. If fund managers only reap the benchmark index’s return before fees, our returns per year is 1.05%, even lower than 2-year fixed deposit rates. To match the benchmark index’s return, the adviser and his selected funds must outperform consistently by 6.94% per year, a colossal achievement.


In our worst-case scenario of 5% commissions, portfolio turnover of 2 times per year and expense ratio of 2.50%, you might as well take your money to the casino, where your odds are better. Assuming fund managers only match the benchmark index’s return of 7.80% before fees, you’ll lose 5.19% per year, and your initial investment of $100,000 will end up 20 years later at $34,550. To match the benchmark index’s return, the adviser and his selected funds must outperform consistently by a staggering 13.81% per year, essentially requiring Warren Buffet of the old days manage your funds (his excess returns over the market has waned considerably in the last two decades).


Know your expectations and set yourself up for success


Understanding the implications of investment vehicle cost-structures on portfolio returns is critical to setting your expectations, whichever institution you decide to engage. If an adviser intends to charge you 3% in sales commissions in funds with expense ratios of 2.00%, and re-balance 1.5 times a year, he/she must be able to illustrate a track record of delivering consistent excess returns of 6.94% or more over the benchmark index’s return per year, before you pay attention. Additionally, ensure that the comparison is valid. For example, comparing previous recommendations into European small-cap funds to the S&P 500 index, when you are considering investment into U.S. Large-caps, is a poor gauge.


To take full advantage of the benefits of working with financial institutions, there is no substitute for sound financial knowledge and due diligence. Think of the benefits as a delicious pie, which is to be shared between the financial institution and investors. The profit-seeking nature of financial institutions drives them to take advantage of information asymmetry (that is the ignorance of average investors), to capture a disproportionately generous portion of the pie. By arming yourself with sound financial knowledge and conducting the required due diligence, you can achieve considerably better outcomes.


Simple rules of thumb include:


• Select brokers with a robust trading strategy and verifiable track record

• Select financial advisers who can clearly articulate their strategy for beating the relevant benchmarks.

• Negotiate for the lowest fees possible and prepare to walk if the numbers don’t add up

• Select funds that delivered superior returns and risk-adjusted returns (Sharpe and Sortino ratios) to the benchmark, are more concentrated and have greater tracking errors. You don’t want to invest in a fund that mirrors the market