Posted on: January 9, 2014 by Martin Curiel, CFA in Investments
2013 was a great year for the capital markets – the S&P 500 Index returned over 32%! It’s heaven for stock investors – many feel richer, smarter, and more risk seeking. Some will brag about their great investment picks in 2013; others will shower their financial advisors with praise for being so “smart” and “giving” them such high returns. But it is the good times that often mask the bad deeds and portfolio inefficiencies. Calculating what we call the “Underperformance Fee” is a good way to judge truly how well an investor did. Underperformance Fees can be calculated overall or by individual strategy. In this article, we would like to introduce this concept, which is not well understood by many individual investors but is one of the largest drags on wealth creation. We will argue that Underperformance Fees are very common and likely to persist due to efficient capital markets, presence of high fees, and risk of bad money management.
Albert Einstein once said:“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
Most investors generally understand the power of compounding. For example, if one divides 72 by the expected interest rate (or investment return), one can calculate approximately the number of years it takes to double an investment (e.g., earning 8% annually doubles your money in about 9 years). Compounding is indeed a powerful force, but it can also work against the investor, particularly when it comes to fees. For example, paying an extra 2% annually in fees can result in a loss of 43% of one’s ending value of investable assets (assuming 8% gross annual return and 30 years investing).
It is true that fees charged by money managers, financial advisors, and other players in the industry are an inherent part of investing. It is impossible to participate in the capital markets free of charge. The best scenario one can hope for is to understand how fees work and to minimize them as practically as possible.
In the world of investments, a fee is something that reduces one’s potential investment return. It doesn’t really matter if the fee is explicit, implicit, spelled out, hidden, or packaged beautifully. It has the same effect: systematic destruction of wealth for the investor.
At MYeCFO, we define an Underperformance Fee as the opportunity cost incurred from investing in a certain product and/or strategy. The key word is “opportunity cost.” In our experience, many investors look at the return on their respective investments in absolute terms. We often hear comments such as “My mutual fund returned 20%, which is great! That is better than the money sitting in my savings account.”
We believe such analysis is flawed. A more appropriate way to judge investments is to do so in relative terms. The idea is that by investing in a product/strategy, the investor is making a choice between one product/strategy and other alternatives. For example, if an investor chooses to invest in John’s Mutual Fund, then the investor is implicitly saying that John’s Mutual Fund will be better than other mutual funds of similar risk/return profiles. For example, if John’s Mutual Fund invests in small-value companies domiciled in the U.S., then the investor should expect it to outperform all other mutual funds that invest in small-value companies domiciled in the U.S.
To answer the question, “How well did my investment do?” it’s important to judge the investment against the appropriate benchmark. For example, investing in John’s Mutual Fund is implicitly stating the following: “John has skill. He can pick the ‘best’ small cap value stocks in the U.S.” Therefore, the opportunity cost of investing in John’s Mutual Fund is investing in ALL small cap value stocks that exist in the U.S.
One could look at an index such as the CRSP US Small Cap Value Index to compare John’s Mutual Fund. However, given that it is impossible to actually invest in an index, we recommend using something we refer to as the Most Efficient Investable Product (MEIP) that would give an investor exposure to the entire universe of small cap value stocks domiciled in the U.S. In this case, one could use Vanguard Small Cap Value ETF (Symbol: VBR), which has an expense ratio of 0.10% and attempts to replicate the CRSP US Small Cap Value Index.The Concept of Underperformance Fees
Underperformance Fees summarize the opportunity cost in real terms. The following equation can be used:
= [Return of Investor’s Portfolio or Strategy] – [Most Efficient Investable Product]
For example, if John’s Mutual Fund returned 20% and the MEIP returned 25%, then the investor paid 5% in Underperformance Fees (20% – 25% = –5%). On a $1,000,000 investment, this represents $50,000 in “extra fees.” It is irrelevant that the investor did not actually write a $50,000 check; the Underperformance Fee has made a permanent reduction in her wealth. In years like 2013, many investors will ignore relative returns or will think the Underperformance Fee is not significant given the high absolute return values.Underperformance: A Nearly Guaranteed Outcome
Looking at the equation above, one can argue that the Underperformance Fee could conceivably be negative; in other words, the return of a particular portfolio or strategy could exceed its respective MEIP, and therefore would be an Outperformance Benefit rather than Underperformance Fee. However, the odds of consistent and long-term outperformance is unlikely for the following reasons:
Of course, every investor’s holdings will be different, and it is conceivable that some investors will achieve an Outperformance Benefit consistently, either at the portfolio level or the strategy level. Many investors, however, will end up paying an Underperformance Fee.
At the end of the day, for individual investors, theory is of little value. What matters most is what actually took place within their respective holdings. The table below is a sample list of efficient products that can be used to benchmark particular exposures. This is not exhaustive, but it provides a good sample that investors can use to measure how well their strategies did.
|Most Efficient Investable Product (MEIP)*
|2013 Investment Return
|Vanguard Total World Stock ETF (VT)
|Schwab U.S. Broad Market ETF (SCHB)
|Schwab U.S. Aggregate Bond ETF (SCHZ)
|International Developed Markets
|Schwab International Equity ETF (SCHF)
|Schwab Emerging Markets Equity ETF (SCHE)
|iShares Gold Trust (IAU)
*By listing the products shown, we are not making any investment recommendations. The MEIP is simply what we recommend as a benchmark to compare with other strategies. See disclosures at the bottom of this article. **Based on published gross expense ratios or equivalent.Conclusion
Fees are a necessary part of investing, but their effect on wealth destruction should be thoroughly understood. Investment-related expenses – “fees” – represent a systematic transfer of wealth from our families to members of the financial services industries. Although it is impossible to avoid all fees, it is important to be aware of the various categories of fees and to recognize that even if they are implicit and/or challenging to determine, they exist, and they have a similar effect on wealth creation. Underperformance Fees represent the opportunity cost of investing, and they are likely to occur because of an efficient capital market, the presence of high product and advisor fees, and the risk of bad managers.
In the year 2013, when most stock markets performed extremely well, it is easy to lose sight of the importance of relative returns. We recommend investors use the MEIP list we provided and find others that are relevant to their respective situations to judge the performance of their own portfolio or strategy. We would also be happy to help with that or any other fee analysis.Happy New Year!
Disclosures: Non-deposit investment products are not FDIC insured, are not deposits or other obligations of MYeCFO, are not guaranteed by MYeCFO, and involve investment risks, including possible loss of principal. The information contained in this article is for informational purposes only and contains confidential and proprietary information that is subject to change without notice. Any opinions expressed are current only as of the time made and are subject to change without notice. This article may include estimates, projections, and other forward-looking statements; however, due to numerous factors, actual events may differ substantially from those presented. Any graphs and tables that make up this article have been based on unaudited, third party data and performance information provided to us by one or more commercial databases or publicly available websites and reports. While we believe this information to be reliable, MYeCFO bears no responsibility whatsoever for any errors or omissions. Additionally, please be aware that past performance is no guide to the future performance of any manager or strategy, and that the performance results displayed herein may have been adversely or favorably impacted by events and economic conditions that will not prevail in the future. Therefore, caution must be used inferring that these results are indicative of the future performance of any strategy. Index results assume re-investment of all dividends and interest. Moreover, the information provided is not intended to be, and should not be construed as, investment, legal, or tax advice. Nothing contained herein should be construed as a recommendation or advice to purchase or sell any security, investment, or portfolio allocation. Any investment advice provided by MYeCFO is client-specific based on each client’s risk tolerance and investment objectives. Please consult your MYeCFO Advisor directly for investment advice related to your specific investment portfolio.