Quarterly Investment Commentary
Continuing a similar pattern to last quarter, US markets reached new highs only to pull back in the last few weeks of the quarter in response to news from the Federal Reserve. It’s been a tale of two Feds. Last quarter the Federal Reserve spooked markets by indicating their intent to end future asset purchases. However, at their September meeting they reversed course and announced that they would continue the stimulus because Fed Chairman Bernanke and his colleagues were not pleased with the recent sluggish economic data releases, higher interest rates and fiscal uncertainty. Markets were initially driven higher by the Fed’s surprise announcement, but the euphoria wore off, and markets retrenched in response to the debt ceiling debate in Congress.
US large companies ended the quarter +6.0%, while small company stocks ended +10.2%. Despite experiencing some significant yield changes during the quarter, bonds finished up 0.5%. Municipal bonds were the topperforming bond sector (+2.2%), driven by reduced supply and renewed investor demand.
The US economy continues to be stable and is experiencing slow but steady growth. US corporations reported solid earnings while amassing huge levels of cash, almost $1.5 trillion, which is the highest level since the 1950s. Meanwhile, consumers continue to show modest but increasing spending. Housing remains additive, as sales of single-family homes increased 7.9% in August. However, higher mortgage rates may weigh on future demand.
Outside the US, emerging and foreign developed markets experienced improving economic results that pushed the stock markets up as well. China reported 7.5% GDP growth and improving export and manufacturing data. The Eurozone appears to be recovering from a recession after reporting positive 2nd quarter growth after six consecutive quarters of contraction.
Looking forward, all eyes will be on the change in leadership at the Federal Reserve from Ben Bernanke’s to current nominee, Janet Yellen in January. Expect more headlines on this topic in the coming months. Also, as this letter goes to press, the Federal government remains shut.
Q3 2013: Why Fees Matter
Over the last few years, investors have enjoyed double digit returns in the equity markets. When markets are up, investors often don’t pay as much attention to investment expense ratios, since worrying over fractions of percents doesn’t seem as meaningful when returns are positive. However, we strongly believe that it always makes sense to pay attention to the cost that it takes to obtain investment returns. This quarter we will explore how the usuallywise adage that “You get what you pay for” is wildly false in the world of investments.
Background: What are manager expense ratios?
Like any business, investment firms incur costs to operate and must make a profit in order to stay in business. In the case of mutual funds, expenses include management fees, marketing fees (called 12b-1 fees), administrative fees, and operating costs. In order to compare costs for different mutual funds, the financial press has coined the term “expense ratio,” which is calculated by dividing a fund’s total fund expenses by its asset’s under management.
Although investors don’t actually write a check for mutual fund expenses, the expenses are deducted from the overall net assets of the fund, so the costs directly reduce investment returns. Expenses vary by asset class and investment style. Typically, expense ratios are higher for equity managers than for fixed income managers. Similarly, it costs more to hire investment professionals to actively pick stocks (“active strategies”) than it does to passively hold all of the stocks in an index (“passive strategies”). The table at right provides a summary. As you can see, the differences are meaningful.
To the point: Why should you care about fees?
There are few factors in the investment markets that are predictable, at least in the short run. Manager expense ratios are an exception. These costs can be reasonably predicted ahead of time, and we know for certain that these fees will negatively impact returns, whether markets are up or down. Costs detract from the amount of money you have available to spend and enjoy your life. Looking at the long-term impact of managers’ fees tells a very clear story. Let’s consider $100,000 invested with manager A and manager B. Both experience the same 6% return, but manager A’s expense ratio is 1.4% and manager B’s is 1.0%, a difference of 0.40%. Over 30 years, the difference in fees adds up to nearly $50,000.
It is obviously extremely important to pay attention to costs, since even a relatively small expense margin can add up to a big amount over time. Paracle believes it is our responsibility to be careful stewards of our clients’ resources and to incur only the investment expenses that are reasonable and worthwhile. We conduct careful research in all areas of the portfolio to evaluate this.
Decision #1: To Be Active or Not To Be Active?
We have already established that active strategies are more expensive than passive strategies. Managers who pursue active stock selection strategies often advocate that they expect to achieve returns in excess of a passive strategy by an amount that not only covers their expenses, but also provides investors with a positive benefit. But is this true?
You would think that paying a manager to carefully select specific stocks with positive characteristics would be rewarded with higher excess returns relative to passive strategies, but are they rewarded in reality? In order for a manager to outperform a passive strategy, they must select specific stocks from within the index that perform better than the average stock in the index. To do this successfully they must process readily available public information differently than the masses and apply unique insights. There are many factors that impact their ability to do this, and the reality is that not all active managers get it right consistently.
This issue of whether active managers are likely to outperform is such an important evaluation that it is our starting point for determining the types of investment strategies that we will pursue for our clients in each asset class. If we determine that active managers are not likely to outperform consistently, or if their margin of outperformance is historically small, then we pursue an index strategy. (The topic of these asset class studies, passive investing nuances, and alternative index investing is a topic of its own and the subject for an entirely different newsletter.) For our purposes here, suffice it to say that it does not always make sense to pay for an actively-managed strategy. Buying an index strategy is one of the most effective ways to reduce portfolio expenses, and we do this wherever we believe that it makes good sense.
Decision #2: If Active, Then What?
Let’s shift gears and focus on active managers. We have established that only managers with unique insights and a disciplined, repeatable process will add value, but where do we go from there? What fee level is reasonable for an active manager, and are there managers who are worth higher fees? Academic studies consistently indicate that high manager fees are associated with inferior performance. For example, the Financial Research Corporation found that low-cost funds deliver above average performance in all the examined periods. Vanguard has also completed studies comparing funds with the highest and lowest expense ratios between asset class categories, and they too found that the low cost managers outperformed the high cost ones. We performed our own study and, no surprise, reached the same conclusion. The imbedded table highlights two asset classes where Paracle believes there is benefit to active stock selection: Foreign Developed Large Companies and US Small Companies. In both of these asset classes, managers who outperformed the index had lower expenses than their average peer. Based on the relationship between low fees and better-than-average performance, we aim to select managers with a long-term record of positive outperformance versus their market benchmark index, a repeatable investment process, and lower-than-average fees.
We take our responsibility for the stewardship of your resources seriously. Across all areas of the portfolio we select strategies that we believe strike a reasonable balance between expenses and expected performance. Furthermore, within each asset class we select specific managers who maintain expenses below the average expenses for their category. The table below summarizes the expense ratios for Paracle-selected managers in equity and fixed income asset classes and compares them to category averages.
Boiled down, the weighted expense ratio for Paracle’s model equity portfolio is 0.54% versus 1.37% for the average equity mutual fund, a savings of 0.83%, or $8,300 annually for every million dollars invested. Similarly, Paracle’s taxable fixed income portfolio expenses are less than half of the average fees for taxable fixed income mutual funds; and our municipal fixed income portfolio’s fees are one-quarter of the average expense level for municipal bond funds.
We are cognizant that in addition to underlying manager expenses, you pay Paracle a retainer fee for the services that we provide to you. Providing access to high quality investments and saving money on investment fees is just one way that we strive to add value. There are several other practical ways that we endeavor to earn the fees that you pay us including:
- Identifying an asset allocation that balances the needs for growth and protection
- Rebalancing at appropriate times
- Tax sensitivity/awareness
- Time savings
- Providing education to protect you from investor mistakes
Covering these topics in appropriate depth is beyond the scope of this newsletter, but will likely be touched on in the future. In the meantime, please let us know if you have any questions on this quarter’s topic and our approach to managing investment expenses.