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December 16, 2009
As an investor, it can be easy to miss the forest for the trees. Fads, convoluted investment products, and the daily noise of the financial media distract us when we should be focusing on the basic principles that are the overwhelming determinants of long-term success. Unfortunately, ignoring the following four fundamental investment considerations can lead to apocalyptic returns.
Fees
High fees can be a threat to achieving competitive investment returns. Most investors are logically focused on net-of-fee returns, but over time, exorbitant fees are often the very cause of sub-par performance.
According to a 2007 speech by John Bogle, the 80-year old founder of The Vanguard Group, the average equity mutual fund expense ratio in 1977 was about 1.0%. In 2008, three decades later, the average fee for a U.S. stock fund had escalated to 1.6%, according to Morningstar.
Albert Einstein is quoted as saying, “The most powerful force in the universe is compound interest.” On the surface, this 0.6% fee differential may seem minimal, until you consider the effect of compounding. For example, let’s review two hypothetical equity mutual funds that each generates before-fee annual returns of 8%: Fund A carries a 1.0% fee and Fund B charges 1.6%. At the end of 20 years, if you began with a $500,000 investment, Fund B’s higher expenses would have destroyed over $200,000 of value.
Investors in individual securities should also contemplate trading costs. Thanks to the advent of online trading, ordinary investors now have the ability to trade individual stocks and bonds at reasonable costs. However, excessive trading can still rack up substantial expenses without actually improving performance, which takes us to our next headwind.
Turnover
Turnover is an indicator of how frequently managers buy and sell assets within a portfolio. According to William Harding, an analyst with Morningstar, the average turnover ratio for managed U.S. stock mutual funds is 130%. In other words, the average manager of a 100-stock mutual fund would sell and replace every stock, then liquidate 30 of the replacement stocks, all within a year. Viewed another way, the fund holds each stock for an average of just over 9 months.
This represents pure short-term speculation, not true investing, and should be a point of caution for mutual fund investors. When purchasing shares of a high-turnover mutual fund, it is nearly impossible to identify what you are actually buying. Rather than getting a diversified basket of sound long-term investments, you end up with a faceless trading vehicle.
Most mutual funds are under intense pressure to consistently keep pace with the broader market. If a fund experiences a few months of lackluster performance, investors will often withdraw their money in favor of competing managers. This leads many funds to a short-term mindset that drives high turnover and poor performance.
Taxes
Frequent trading can also drive taxes higher, further deteriorating “take-home” returns in taxable accounts. And the higher the turnover, the greater the damage from taxes, because short-term capital gains, or the price appreciation of stocks sold after being held less than a year, receive worse tax treatment than long-term capital gains.
“The Securities and Exchange Commission says more than 2.5 percent of the average stock fund’s total return is lost each year to taxes, significantly more than the amount lost to fees. The tax bite varies from zero percent for the most tax-efficient funds to 5.6 percent for the least efficient,” according to a 2003 article from Bankrate.com. Once again, if you apply the impact of compound returns over many years, the results can be devastating.
Many investors do not realize that capital gains can occur even in a year when a fund loses value. Typically, as funds incur losses, shareholders head for the doors and force fund managers to sell long-held positions to meet redemptions. For example, the Dodge & Cox International Stock Fund, a popular fund with a solid long-term track record, incurred over $1.50 per share in capital gains distributions in 2008, a year in which the fund lost almost half its value.
Market Timing
According to the folks at The Motley Fool, a popular investment website, “It’s not timing the market that’s key, but rather the amount of time you’re in the market.” In fact, Nobel laureate William Sharpe found that market timers must be right an incredible 82% of the time just to match the returns realized by buy-and-hold investors. Nevertheless, that has not stopped people from trying.
The Motley Fool calculates that between 80% and 90% of the returns realized on stocks occur between 2% and 7% of the time. To further illustrate this phenomenon, The Motley Fool also reports that, “Using data from Bloomberg, American Century Investments looked at the period from 1990 to 2005 and found that a $10,000 investment would have grown to $51,354 had you just sat tight from beginning to end. However, if you had missed the best 10 days in that 15-year period, your returns would have dwindled to $31,994; if you had missed the best 30 days, you’d be looking at a mere $15,730.” Not only do these statistics explain the temptation to make a quick profit, but they also illustrate the dangers in missing the relatively few trading days that contribute the bulk of positive returns.
Former U.S. President Theodore Roosevelt once said, “With self-discipline most anything is possible.” By undertaking disciplined research to avoid high fees, unnecessary turnover, excessive taxes and misguided market timing, investors will stay on the path to reaching their investment goals.
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