If you needed surgery, would you seek out the surgeon who charged the least? Would you trust your child’s care to the babysitter with the lowest hourly rate? If you are like me, the answer to these questions is a resounding NO. Like any rational person, you would seek the surgeon with the best patient outcomes or the babysitter with the glowing recommendation from trusted friends.
The reason I bring these ridiculous questions up is that when it comes to the money management profession, it seems that the focus of investors has shifted away from the performance of a manager toward the amount of fees the manager charges. While fees are important, this shift is not rational.
So, how did the spotlight shift from the end result to how much it costs to get there? Well, in the investment world, managers are judged on their performance relative to a predetermined benchmark. For example, if a client has given a manager a mandate to invest solely in U.S. stocks, common benchmarks could be the S&P 500 or the Russell 3000 indices. Over the years, the managers with the ability to beat the benchmark would attract more clients and could charge more for their services. Those managers who underperformed had a tough time keeping clients and could not charge a premium for their services.
More recently, the inability to outperform has led many large money managers to solely utilize a product known as an exchange-traded fund (ETF). In fact, ETFs have become so explosive that, since their introduction in the U.S. just over 20 years ago, the industry has grown to over 2000 funds and $3.99 trillion in assets (Investment Company Institute, July 2019). ETFs are a security that tracks an index, a commodity, or a basket of assets like an index fund, but trades like a stock on an exchange. The major benefit of ETFs is the ability to achieve a diversified portfolio of securities at a low cost and, in many instances, with adequate liquidity. Since the security tracks an index, you can expect to receive the performance of the index less the trading cost and fees. This means that if you solely invest in ETFs, you will always underperform the benchmark.
My point is that if your goal is to minimize fees while receiving consistently below benchmark performance, ETFs or “index investing” may be right for you. If, on the other hand, you care about maximizing the performance of your investment, judging a manager based on net of fee performance would be more effective. After all, if a manager can beat the benchmark by 1% per year net of fees and expenses (assuming similar risk), it shouldn’t matter how much you pay them because you would be better off. How much better off? If you gave a top notch manager $100,000 to invest in U.S. stocks 10 years ago and they beat the S&P 500 index by 1% net of fees per year, you would have $32,398 more in your portfolio.
When it comes to your investment portfolio, selecting a manager with a proven track record of beating benchmarks net of fees may leave you with more money over the long run. If you have selected a low-cost investment, compare your results over the last 10 years with the returns generated by the top performers. After all, a manager who truly adds value over the long run is generally worth more than they charge for their services.
According to Bloomberg LP, S&P 500 Index’s 10 year annualized return ending 8/31/19 was 13.45%. $100,000 x ((1+.1345)^10-1)=$253,219.77. 1% extra return or 14.45%/year results in $100,000 x ((1+.1445)^10-1)=$285,618.60 or $32,398.83 more.
Daniel Lippincott, CFA is a senior tax sensitive manager/director of investment personnel for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, NY 14534 (585) 586-4680.
This Market Commentary is the opinion of Karpus as of the date written and is for informational purposes. While reasonable care has been taken to ensure that the information herein is factually correct, Karpus makes no representation or guarantee as to its accuracy or completeness. The information herein is subject to analysis of the market at the time of publication and is subject to change without notice. It should not be assumed that correlations based on our analysis of historical returns will persist in the future. This information is included for informational purposes only and reflects the opinion of Karpus. It should not be assumed that any security discussed will prove to be profitable or that the investment decisions we make in the future will be profitable or will equal the performance of any security discussed herein. This information should not be considered a recommendation to purchase or sell any particular security.