It is customary for money managers and other such financial advisors to state their views on the market for the year ahead. Some even provide a list of surprises that are not in the consensus but could have an outsize impact. These thoughts are usually interesting but fraught with the implicit dangers of divination, as “it is very difficult to make predictions, especially about the future.” We are going to take a different approach, rather than trying to evaluate possible scenarios for the next twelve months, we will remind you of three things that should be top of mind for investors and savers at all times.
The three enemies of wealth accumulation
Taxes, inflation, and management fees are the three horsemen of the Apocalypse for investors. The best strategy to maximise long-term investment returns necessarily starts with the optimization of your portfolio for taxes. We do not provide tax advice but you should carefully explore the tax implications of different investment products.
Protecting your portfolio from inflation is more complex. Generally, but not always, fixed income does not perform well in an inflationary environment. Some believe that real assets such as real estate should perform better, as leases and rental contracts generally have annual inflation adjustments. But this is helpful only up to the point where an inflationary environment starts impacting economic activity negatively and thus vacancy rates. In addition, higher refinancing costs will impact the bottom line and higher discount rates will dent valuations. Some industries perform better than others in an inflationary environment, thus certain industries will also perform better in the stock market. Commodities may be a source of protection. Over long periods, US broad equity indices have beaten inflation. That is not the case in other stock markets.
Fees and expenses is the problem area where it is easier to make good progress. Investors pay management fees in the belief that the manager they have selected has an especial ability to beat a benchmark over long periods. If only life worked like that! Academic and industry research conclude unassailably that most portfolio managers in liquid markets, such as large capitalization US stocks, are unable to beat their benchmark over time, after fees. For most, the underperformance is largely explained by the fees and expenses of their funds.
Even if a few managers outperform, it would be very lucky to choose the right manager for the next 5 or 10 years, especially if you keep in mind that past performance is not only not a guarantee of future success but more likely is a guarantee of future underperformance, as most index outperformance may be attributed to the prevalence of the manager’s style.
When you’re hot, you’re hot, and when you’re not….
When a particular style is hot, let’s say Value, then Value biased managers outperform Quality or Growth managers as well as the broad market. Those same managers may underperform for long periods when the leadership in the market changes to another category. Thus over very long periods very few managers beat the S&P 500. There are other reasons that make the Index a formidable opponent, such as survivor bias and the winner takes all outcomes in technology categories. Some managers will outperform, but determining who those managers will be is a very complex problem to solve ex ante. Therefore most people are better off investing in very low cost indexed funds or ETFs.
The savings in fees over time make a huge difference. If you were to save $10,000 per year during your working life of forty years and the S&P500 were to return its 50 year Compound Annual Growth Rate of 10.61%, you would start your retirement with $5,227,570. A slight underperformance of just 61 basis points per year would leave you with just $4,425,952 or 15% worse off.
There are more reasons to pay for ability in fixed income markets, especially in high yield. New issue access is far more important for returns in this market. Duration and credit exposure choices will also make a difference. Choosing a manager with all the necessary resources may justify paying their fees going forward, as has been the case historically.
Alternative investment fund managers typically charge significantly higher fees. There are two broad categories: liquid and illiquid strategies. Hedge funds are included in the former category while buy-out, growth, private credit, real estate or infrastructure funds comprise the latter.
Academic research suggest that long-term hedge fund returns are not compelling, as they are close to LIBOR for the industry as a group. This is perhaps not surprising as investing in financial markets is a zero-sum game. Research on buy-out funds’ returns concludes that they have similar returns to the S&P500, although with far less volatility, which is a much desired feature. Clearly, the choice of managers is the key to success in these asset classes and one of the few areas where financial advisors could add a lot of value were they not conflicted because of access to capacity or distribution agreements.
How to cut the pie
Asset allocation is one of the most important investment decisions, thus many people pay their bankers an advisory fee. Banks have complex asset allocation models that usually reach very similar conclusions, which are then overlaid on the risk tolerance and financial objectives of individual customers. All their computations can be summarised with a simple rule of thumb, for most people the allocation to equities should be 100 minus their current age. For very wealthy people who often think about their legacy to heirs, foundations, and charities allocations close to 100% in equities may be optimal.
One thing one should always keep in mind is that the interests of financial advisors and their customers are often misaligned. Did your advisor tell you to go into cash in the fourth quarter of 2021 or at least to sell all your fixed-income exposure? If the answer is no, your advisor is probably not telling you today to reduce your deposit balances to a minimum either and use the proceeds to buy T-bills or a money market fund. At much lower rates, it did not matter much where you parked your liquidity, at current rates it is crucial to get remunerated on cash balances.
How to make your banker very happy
In spite of several rounds of rate hikes, most financial institutions are getting away with not paying anything for deposits. Once again they are exploiting the asymmetry of information with their customer. While your liquidity makes no money your bank is printing money, financing its loan portfolio priced at current market rates at zero-cost. Your banker is laughing all the way to the bank. Oh wait! She is at the bank already. Don’t be a chump.
In the euro zone some banks are selling principal-protected funds and held to maturity fixed-income funds. The former is a source of high fees to build a simple portfolio consisting of a zero coupon strip of a bond and a call option on an index. The latter is disingenuous to say the least as you may also buy bonds and hold them to maturity and not pay management fees. These are some of the pitfalls you must avoid on the road to financial success.