Getting Rich in a Poor Market, Part VI
In a low return environment, investors need to do things differently if we want to have any hope of growing our capital. Many of these different things – the ones I’ve already talked about – have to do with playing offense in a smarter way. We’ve examined using more aggressive asset allocations, taking greater advantage of the premium for illiquidity, focusing more on alpha than beta, and searching for opportunistic investments. But to prosper in a low return world, we will also have to play smart defense, which brings us to the issue of investment costs.
The subject of investment costs is a broad one. It encompasses investment advisory fees, fees we pay to money managers, commissions and marketing expenses (like the disgraceful 12b-1 fees charged by many mutual fund companies), trading costs, taxes, even volatility, since excess volatility is a “cost” that slows the growth of our capital.
Investment costs matter, and the harm they do to our portfolios compounds over time. A $1 million portfolio paying 0.50% per annum in expenses (50 basis points, or ½ of 1%) will have its terminal value reduced by $100,000 over 20 years. Doubling those fees to 1% per annum causes the damage to triple to $300,000.
Given the sensitivity of investment outcomes to the expenses incurred, you might suppose that, in an environment of persistently low returns, the sensible approach would be to minimize investment costs across the board. And, indeed, many investors are already moving in that direction, hiring low-cost robo-advisors, investing almost exclusively in low-cost index funds (which also exhibit low turnover, minimizing taxes), eschewing more expensive asset classes like hedge and private equity, and so on.
But note that this approach renders moot virtually all the important offensive techniques we’ve discussed. Robo-advisors are cheap, to be sure, typically charging 15 to 50 basis points while the average financial planner charges almost 1.5%. But all they do is set up your portfolio and rebalance it now and then. That’s terrific in a high-return world, but it’s suicide in a low-return world. A robo-advisor won’t implement an aggressive asset allocation, won’t invest in illiquid investments, won’t produce alpha, and will have no clue how to search for opportunistic investment ideas.
A better approach – indeed, an essential approach in a low-return environment – is to optimize investment costs. We want to pay enough to gain access to the offensive tactics we need to employ in such a world, but we don’t want to pay a penny more than necessary to accomplish that objective.
Thus, we certainly don’t want to pay an advisor 1.5% per annum, but we also don’t want to reduce our advisory fees to the point where we’re forced to work with brain-dead, Internet-based algorithms. We want to keep money manager fees reasonable relative to the returns they are generating, but we don’t want to index our way into impecunity. (No, there’s no such word, but there should be.) We hate paying 2-and-20 (2% management fee plus 20% of the profits), but if that’s the only way to get access to illiquidity premia, so be it. In short, we don’t want to be pennywise and dollar-foolish.
So how much should we pay? What’s the magic number that will optimize our investment expenses? The honest answer is, “It depends.” But since that’s a copout, let’s do the math.
Suppose that, in a low-return world, a traditional, globally diversified investment portfolio will produce, net of its 1% all-in costs, about 3% per annum. And let’s suppose that if we employ all the offensive strategies we’ve discussed we can expect to add another 2% to 3% per annum to our portfolio returns. Theoretically, then, we could add 1% to 1.5% to our annual investment costs and still be ahead of the game.
But in the real world, we know that the extra return we seek is uncertain. Two to three percent per year extra return seems like a reasonable assumption, but it’s possible that our strategies or managers will disappoint. Meanwhile, the extra costs we incur are known, fixed and certain.
If it were me – which it could well be; investment advisors also have to make hard decisions about their portfolios – I would think about it like this. In a normal world a capital preservation-oriented, globally diversified portfolio might net us six or seven percent, for which we would pay 1%. If we are willing to pay 15% of our return under normal conditions, then we should be willing to pay at least that much to get ourselves out of low-return quicksand.
Specifically, if we are aiming to add 3% per year to our returns, we might be willing to pay roughly 50 basis points on top of what we are already paying, bringing our all-in costs to 1½%. It sounds high, and would be high under ordinary circumstances. But when your financial health depends on breaking out of a persistent low-return trap, it’s a bargain. And you can take that, more or less, to the bank.
Next up: Waking Up on the Wrong Side of History