Maserati, Miu Miu, and Managed Funds

They say you get what you pay for. You’d be forgiven for thinking this philosophy applies to investing. It’s a schoolboy error – however nothing could be further from the truth.

Over the years, multiple studies have proven that costs depress investment performance over long periods of time.

There are two types of costs, 1) portfolio turnover costs, and 2) ongoing investment management costs

Portfolio Turnover costs

Portfolio turnover is basically how often a portfolio manager buys and sells stocks. When it happens too often, they rack up extra costs for investors. The costs are hidden, rarely disclosed to investors, and they’re crippling to a portfolio’s return.

The table below shows just how much portfolio turnover could be costing you. A global equities fund with a turnover of 100% is costing you 1.70% pa. You now need to make this back, plus more, in order to stay ahead. Not an easy assignment.

Here’s what portfolio turnover looks like (a little old I know), and how it’s increased over time through trading via actively managed funds.

Stock picking organisations “renting” rather than “owning” businesses in the stock market are at a massive disadvantage. The more you trade, the higher your costs. The higher your costs, the lower your return. Capiche?

Let’s move on.

Ongoing Investment Management costs

To set the scene, here’s the average cost of actively managed funds and corresponding index funds and ETFs.

Source: Vanguard

Not only are you behind the eight ball with higher transaction costs, you must contend with higher investment fees (also known as expense ratios).

Vanguard have a great calculator on their website (click here), which shows you how much money has been kept and how much money has been lost over time based on different expense ratios. I’ve run two scenarios:

1) A portfolio with an expense ration of 1.25%, which results in 68.7% of returns captured over 25 years.

2) A portfolio with an expense ratio of 0.50%, which results in 86.3% of returns being captured.

This is hard dollars. Lost.

Wrapping up

  • Higher costs can significantly depress a portfolio’s growth over long periods.
  • Costs create an inevitable gap between what the markets return and what investors actually earn—but keeping expenses down can help to narrow that gap.
  • Lower-cost mutual funds have tended to perform better than higher-cost funds over time.
  • Indexed investments can be a useful tool for cost control.

Unlike Maserati and Miu Miu, expensive managed investments are not cool, stylish, sexy, or impressive.

Here’s What Happens When Markets Crash

Eight years ago, the US and Australian stock markets slid 55.65% and 53.95% respectively, all within a 15 month period. Your $1,000,000 share portfolio would have been worth around $450,000. Here’s what it looked like (click for larger image):

Source: Thomson Reuters

Investors were liquidating their portfolios and piling into cash as there was no end in sight. Fear and uncertainty were at an all time high, even though the duration of this bear market was shorter than the average.

In fact, by the time the market bottomed out in 2009, investors were selling down their share portfolio at the fastest pace in over a decade. Precisely at the worst time (click for larger image):

The ‘pros’ were giving in too. In 2009, global fund managers’ allocations to the share market relative to other asset classes were at an all time low.

Humans are an irrational bunch. We tend to think in certain ways that lead to systematic deviations from good judgement.

Here’s what happened next. US stocks climbed a whopping 255.44%, and Aussie stocks up (a mere, relative to the US) 82.79% (click for larger image):

Source: Thomson Reuters

With the stock market at all time highs, and having lasted for so long, we’re hearing commentators and investors question the market’s ability to push any higher.

The current bull market has lasted around 8.1 years, making it the 5th longest bull market since 1926. Although it feels like it’s the longest, right? In fact, it’s also 5th not only in it’s duration, but also in magnitude.

Since 1926, the average bull market has lasted around 8.9 years, with an average cumulative gain of 468%. The current bull market has gained around 255%.

What’s interesting from the chart below, is how dominating the blue shaded areas are relative to the orange (bear markets). The average bear market has lasted 1.4 years with an average cumulative loss of 41% (click for larger image):

I thought it would be interesting to see the stats for the Australian share market, so I ran the numbers and have summarised in the table below:

Of the 351 months since 1980, the Australian stock market has been up 220 periods (63% of the time), and down 131 periods (37% of the time).

Source: Returns 2.0

If you then extend your time horizon to a rolling 5 years, since 1980, the Australian stock market has only ever seen 1, 5 year period of negative returns. It began in 2007 and fell on average -4.27% pa for 5 years. Every other 5 year rolling period has seen the Australian share market return a positive number with an average return of 11.52% pa (click for larger image):

Source: Returns 2.0

Even after one of the greatest crisis in history, if you had simply held course, here’s what your portfolio would have looked like. A $1,000,000 investment at the peak of the stock market would be worth $1,325,000 today (click for larger image):

Source: Returns 2.0

Whether this market will collapse tomorrow, or in 12 months from today, nobody really knows. What is certain however, is that there will be another collapse, and that you’ll be told that it’s different this time (it’s unlikely to be). In the end, it’s completely out of our control.

Design and construct your portfolio today as if the market will crash tomorrow. Because that is when your true emotions will flourish. How tolerant are you to volatility and risk. What is your investment horizon. How patient and disciplined are you. These will all be challenged. Your actions from these emotions, are all in your control. What the market does is not.