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Obvious, Boring and Effective

In investing, a substantial performance advantage comes from things you can control: simple portfolio construction and low-cost funds.

Everyone wants to gain a performance advantage. Some try by placing bets on “smart” financial factors like value or momentum. Some like data-driven algorithms. Others swing for the fences with big macro calls.   

It’s certainly fun and intellectually stimulating and you feel so smart when your bets pay off. 

But there are more productive, albeit boring, ways to lock in a performance advantage. And to do it, you don’t have to guess correctly about the future or hope that history repeats itself. 

It’s simple. Keep your fees and expenses low. Every asset manager in the country knows this. But most don’t incorporate the idea into their investment processes. Why?  

  • People don’t appreciate how highly correlated low fees and good performance truly are 
  • People don’t appreciate the impact that fees and expenses have over time 
  • The industry is in love with complexity and complexity is expensive 

The Impact Is Huge

In 2010, Morningstar studied the relationship between low fees and performance. They found: “In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.” They also found: “Each 1% in additional fees eats up 28% of the ending value of an account over a 35-year span.” 

Vanguard did a study in 2015 that measured the effectiveness of different factors in predicting mutual fund performance. They found: “The ex-ante expense ratio separated poorly performing funds from better performing funds more successfully than all other metrics…” They also found a “1.27 percentage-point annual alpha difference between the lowest-quartile cost funds and the highest-quartile cost funds…” 

In another Vanguard study, they compared the returns of mutual funds in the lowest-cost quartile with funds in the highest-cost quartile in different asset classes over the 10 years ending in 2013. Again, the low-cost funds beat the high-cost funds in every asset class. 

Even a small difference in fees can make a big difference in the long term. Assume a client has a $100,000 account that grows at a 6 percent rate over 30 years. If the client pays 25 basis points in fees, they end up with $532,899. If they pay 90 basis points in fees, they only have $438,976 in their account. The difference is almost equal to the entire $100,000 initial account value.

You clearly don’t get more by paying more. This is somewhat counterintuitive. We are so used to associating high cost with high quality that we transfer this frame of reference to the investment world. But it just doesn’t apply here. 

The Fix Is Straightforward

Here’s how to incorporate this reality into your investment process. Keep a watchful eye on: 

  • the internal expenses of the funds and exchange traded funds in your portfolios
  • the fees charged by any portfolio manager you use to build the portfolios
  • ongoing trading and rebalancing costs incurred in managing the portfolios

Here’s how it works. Let’s say you have a client with a $300,000 account who needs a standard workhorse 60/40 portfolio. The average expense ratio for a balanced fund in the Morningstar database is about 87 basis points. Or you could build your client a perfectly good balanced portfolio with internal expenses of 6 basis points using ETFs. The difference is 81 basis points. 

Maybe you don’t want to build portfolios yourself so you hire a turnkey asset management provider, or TAMP, to do it for you. It might cost 50 basis points—some TAMPs charge even more. But there are TAMPs that will manage a $300,000 account for 25 basis points—some charge even less. Using the lower-cost TAMP can save your client another 25 basis points.

At our firm’s custodian, the transaction costs associated with setting up an 8-position portfolio using ETFs would be $55.60. The transaction costs associated with setting up a 16-position portfolio using actively managed funds would be $384. For the $300,000 client, the difference is about 11 basis points. (This doesn’t account for the bid/ask spread on the ETFs, which, for highly liquid ETFs, could amount to 1 or 2 basis points.)   

If you rebalance your 8-position portfolio annually and trade one-quarter of your positions, your annual rebalancing costs would be $13.90. If you rebalance your 16-position portfolio quarterly and trade one-quarter of your positions each quarter, your annual rebalancing costs would be $384. The difference is $370.10. That’s an annual difference of a little over 12 basis points. (Again, this doesn’t account for the bid/ask spread on the ETFs.)   

If you add it up, you could save your $300,000 client well over 1 percent per year simply by paying attention to things you can control. Saving 1 percent annually could fund years of additional retirement. That’s an advantage you get regardless of what happens in the markets.

Simple Is Beautiful

Focus on keeping your fees and expenses low. You do that by keeping things simple. 

It’s easy to build portfolios with many high-cost positions and trade them frequently. Some people might even equate the complexity, all the moving parts and the frequent activity as more sophistication. But it takes more effort and even more sophistication to build an elegantly simple portfolio. As Leonardo da Vinci said, “Simplicity is the ultimate sophistication.”

 

Scott MacKillop is CEO of First Ascent Asset Management, a Denver-based firm that provides investment management services to financial advisors and their clients. He is a 40-year veteran of the financial services industry. He can be reached at [email protected]

TAGS: Mutual Funds
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