by WWM | Jul 26, 2017 | Investor Profile
Previously we considered how one’s risk tolerance and phase in one’s life cycle impact an individual’s investment strategy.
It is also very important to assess your unique investment objectives and constraints.
Today we will look at one’s investment objectives.
I like to categorize objectives (and constraints) by both time horizon and priority. Time can be grouped as short, medium, or long term. Priorities may be deemed low, moderate, or high.
If you require $20,000 for your wedding in 1 year, that is likely a short term, high priority objective. Planning to buy a brand new (mid-life crisis) sports car in 20 years may be a low priority, long term objective.
While we can go through every permutation, today we will aggregate into 5 groupings. All individuals share these common categories, however the specific objectives within a category will be unique to each person.
Emergency Funds
Although not really an investment goal, it should be an objective to maintain adequate liquidity to deal with any emergencies that may arise. Think of this an an extremely short term, very high priority objective.
I suggest that you hold approximately 3-6 month of basic living costs in liquid funds.
This should provide protection against short term emergencies such as job loss, personal injury, damage or loss of personal property such as your vehicle, or any other unplanned event that will drain your resources.
Liquid funds includes cash and cash equivalent assets. Savings accounts, money market funds, short term term deposits, etc. Assets that can be converted to cash very quickly and at no penalty to you for so doing.
Also, assets that are extremely stable (i.e., very low volatility and therefore low risk), yet have better return upside than simply hiding the cash under your mattress.
I would recommend money market or other funds to hold your liquid assets. These latter funds include certain low risk bond and equity funds, exchange traded funds, capital protection funds, to list a few examples. The keys being that you are able to sell them rapidly at little or no cost on disposal. Also, when you need to sell, the investment will be stable in price and not subject to wide swings (i.e., volatility or risk). This limits the use of equity funds or longer duration bonds.
I would also recommend brokerage accounts that provide money market interest rates on cash balances. Often these are termed, “sweep accounts.” They are useful and offer better rates than bank savings accounts.
I would not recommend holding many of your liquid assets in bank savings or chequing accounts. These accounts tend to pay very little or no interest on cash balances. And even with cash, you should try and get some sort of return.
Near-Term High Priority
This category reflects major goals whose time horizon is relatively short.
Examples may be a new home or vehicle, paying for your education, or even a trip if it is extremely important to you.
As the time to the goal is close, you want to increase the certainty of the investment’s return. You should invest in low risk, stable investments that provide a relatively known result.
Cash or cash equivalents would fall into this area. Short term bonds may also be useful investments. In certain situations, other funds may also be appropriate.
It is important to try and match the maturity of your asset to the expected date of the expenditure.
For example, you have $25,000 on January 1. On July 1, you must pay that amount as principal on a new home. You want to ensure that money is safely available when due. If you invest the money in a 1 year term deposit, you may not be able to liquidate on July 1 without penalty. However, if you invest in a 6 month term deposit, the investment will mature at the same time the money is needed.
If you invest in a higher risk equity fund, the value on July 1 may be greater than or equal to the $25,000 investment. But there is also a higher probability that it will be less than the $25,000 due to the volatility of the asset. If this occurs, you may need to forego the home purchase.
Be sure to match the asset risk-return profile and timing to your objectives.
Long-Term High Priority
This category reflects critical objectives whose time horizon is a long ways off.
An example would be in achieving financial independence at age 65. Another might be to buy a lake house or a winter condo in Florida by the time you are 50.
Because of the long time frame, you have the ability to ride out the ups and downs of highly volatile investments. This allows you to invest in assets that have relatively high risk and (therefor) greater expected returns.
The longer time frame also allows you to invest in less liquid assets. If you are currently 30 and are planning to buy a ski chalet by age 45, you have 15 years to work with. As the date approaches you can find a beneficial time to sell.
Compare that to only investing at age 44 for the chalet by 45. With very limited time, you cannot afford to hold volatile or illiquid assets that may not be disposed of, on time or at a profit, in one year’s time.
Remember, the longer the time frame, the greater the risk you can endure in your investments.
Yes, within reason, that is.
For long time horizons, a wide range of investments are suitable. These include equities, bonds, real estate, and other exotic assets.
Asset classes that we will look at in the next couple of weeks.
Lower Priority
This category may have short, medium, or long time horizons.
These goals have some importance, but they are secondary to the ones discussed above. Usually they are nice to have achieved. But if they are not reached, it is not crucial to your existence.
These usually involve discretionary spending objectives. That is, expenditures that are non-essential or voluntary in nature. Examples include: charitable giving, vacations, buying a boat, non-critical business ventures.
With lower priorities, you can match the investment risk to the time frame as we did above.
Many individuals though, take a more speculative approach in investing for lower priority goals.
As the objective is less important to the individual, the investor may invest in extremely high risk assets in the hope of abnormal returns. If it is successful, great. If unsuccessful and funds are not available to meet the goal, its lack of attainment was not critical.
Entrepreneurial
This category involves entrepreneurial or money-making ventures and covers any time frame.
Portfolio diversification is usually not an issue in this category. Instead, investors tend to take an “all eggs in one basket” view to their entrepreneurial activities.
As you can expect, this is normally a high risk investment with the potential for high rewards (or total loss).
That sums up the categories of investor objectives.
In future, as you develop financial goals, try to determine which classification each one fits into. Then, develop appropriate investment strategies and tactics to attain each goal.
Next we will look at common investor constraints.
by WWM | Jul 20, 2017 | Investor Profile
We previously reviewed how an individual’s risk tolerance impacts investment behaviour.
While risk tolerance is a driver in one’s investor profile, so too are an individual’s unique personal circumstances. Where an individual is at different stages of one’s life greatly influences the risk/return decisions that are made.
Today we will review the Life Cycle view of wealth accumulation. It does not address all the unique issues facing you, but moves us in the right direction to create an effective investment plan.
Accumulation Phase
Accumulation occurs early in your career. When you initially enter the work-force and for the first few years afterward.
Because you are young, there is a long time horizon for investing. Time is extremely important. The longer money is invested, the reinvested income on that money actually contributes more to total growth than most other factors.
Although you are finally earning real money and have the capacity to begin saving, your net worth is likely quite small. It may even be negative if you have significant debt from student loans, home mortgage, or car loan.
During this phase, your priorities may be liquidity for emergency funds, paying down debt, buying your initial or larger home, starting a family, saving for your children’s education.
And yes, beginning to invest for long term growth and retirement.
While you may not have significant savings, starting to invest as early as possible is best. The longer your money can grow, especially if you reinvest the income (and the income on that income), the greater your wealth accumulation (and the less in total dollars you need to contribute).
We will cover this concept soon when we look as the power of compound returns. A very important topic.
That said, paying down existing debt saves significant interest costs. Usually being paid with after-tax disposable income. While beginning an investment program when young is useful, do not necessarily do so by not reducing personal debt.
As we shall also see later, avail yourself of any investment plans that defer, minimize, or avoid tax liability on returns. The longer assets grow for your benefit and not the government’s, the greater the ability to compound returns.
In considering suitable investments, you should focus on relatively high risk, high return, capital-gain oriented assets.
Why?
Due to the long time horizon, you have a greater probability of riding out the ups and downs of high volatility (i.e., high risk) investments that offer greater potential returns.
Consolidation Phase
Consolidation takes place during the mid-to-late stages of your career. While a lesser time horizon than in the Accumulation Phase, the years until retirement are still very long.
By now you have reduced your debt and related cash outflows to service both the interest and principal. Your income and cash inflows exceed your expenses and cash outflows.
During this phase, you should begin to generate more than sufficient savings with which to seriously invest for retirement.
As your time horizon is still long, focus should remain on relatively higher risk, higher return assets.
But as you move through this phase and the time horizon starts to shorten, there should be a progressive shift to lower risk (i.e., less volatile) investment options.
Spending Phase
Spending commences at retirement as employment or business income ceases or slows.
Your debt is gone, your children grown and not needing support, and your required expenses should not be extensive.
Without a salary, income will be derived primarily from your investments and, possibly, pension. As a result, you want to increase the certainty of your returns by investing in lower risk investments.
One mistake made in this phase is to place too much reliance on low risk investments. Low risk assets will result in low returns that may not be adequate to meet your retirement goals.
Also, if returns are not linked to inflation, you may find your real returns worse than expected. At times, even negative. If this occurs, you may be unable to meet your retirement objectives.
A second mistake is to underestimate retirement needs. Yes, you are retired and many of your work related expenses vanish. And yes, with the kids gone, the mortgage paid, etc, many other traditional costs also disappear.
But these will be replaced by increased travel and entertainment costs. Expenditures you may not have made to such an extent previously. These are not “required” expenses. But if you do not factor in these additional costs when planning, it may be a very boring retirement.
In today’s world, you could easily retire between 55 and 62, yet live until over the age of 90. That means you may need retirement income for a at least 35 years.
If all your assets reside in low risk, income generating investments, you may be hard pressed to cover all your needs and objectives until death. With a still lengthy time frame, you may want to keep a portion of your wealth in assets with higher growth potential. Then, with each passing year, continue to slowly shift into safer assets.
Gifting Phase
Gifting is the final stage in your life. Hopefully a long, long ways off for you.
In this stage, you possess more assets than you need until the end of your life.
You begin to gift your wealth to others. This may include family members, but more and more people are becoming involved in philanthropic activities. These include direct donations to charitable or educational institutes. Also, some people set up trusts and foundations with their wealth to contribute directly to their charitable objectives.
Takeaway Thoughts
One takeaway is investments that may be prudent for you in one stage of your life, may not be best in another stage.
In your 20s, it may be appropriate to invest in mutual funds of emerging markets. These funds may exhibit relatively high risk but also offer potentially generous returns. But at 80, those same funds may make little sense in meeting your retirement objectives.
Conversely, at 80, a significant portion of your wealth may be in term deposits and short-term government bonds. This may be prudent in attempting to preserve your capital and generate steady cash flow. But at age 30, having a significant portion of your assets in cash equivalent investments likely is a poor strategy to follow.
A second takeaway is that your life cycle phase is based on your personal situation, not age.
You and a friend may both be the same age. But if he spent 10 years travelling the world as a scuba instructor and has just now completed a 10 year medical program, he may only be in his Accumulation Phase in his 40s. On the other hand, you started your career at age 22 and may have moved on to the Consolidation Phase by your 40s.
Age is not a determinant. Only your personal circumstances.
Getting married and having children while in your 20s may result in a significantly different investment program than for a single person also in their 20s. Life insurance may be one big difference.
A third takeaway is that you must focus on your own unique situation. What others are doing should have little, if any, impact on your investment strategy.
When listening to investment advice or strategies employed by others, always consider their personal situation and how it compares to your own before following their lead.
For example, a German friend tells you about a great potential real estate investment in Saskatoon, Saskatchewan, near where you live. The local market is hot and everyone believes the expected gains will be excellent. For her, it may indeed be a good opportunity. But if you already own a home in the community, a rental property in the same city, and a cottage at a nearby lake, it may not be a wise move.
This is because you may end up with too much exposure to the local real estate market (if you have not already done so) and/or possibly have invested too much in real estate as an asset class in general.
That gives you a few things to consider as you begin to address your own investment strategy.
Coming up, we shall look at common investor objectives and constraints.
by WWM | Mar 21, 2017 | Investor Profile
“What is Your Risk Tolerance?” asked a few questions to help determine your risk comfort level.
I want to flesh those questions out using a classic investor personality model, the Bailard, Biehl, & Kaiser Five-Way Model.
I am not a “fit in a box” guy. It is rare to find someone who is an exact match within any personality model. But understanding how your general tendencies impact your decision making is useful. Learning more about who you are as an investor will ease your shift to become a more unemotional, objective, and successful investor.
Investor Psychographic Models
Investor psychographic models can help investors determine their own risk tolerance.
Pyschographics refers to the description of an individual’s psychological characteristics. It attempts to classify investors based on their personality traits.
There are a variety of models in use today. I suggest you review a couple of models to better understand your own investor profile. In this post, we shall look at the Bailard, Biehl, & Kaiser Five-Way Model.
The key to this model is that it focuses on two personality traits: investor confidence level and preferred method of action.
Investor confidence may range from being totally confident to being wholly anxious in investing abilities.
An investor’s method of action considers how methodical, analytical, and intuitive an investor is in his actions. One’s method of action may range from extreme carefulness or caution to being highly impetuous or reckless.
Confidence and method of action are plotted on two axes and investors are grouped according to their preferences. In this model, there are five possible investor profiles.
Guardians
Guardians are extremely cautious and anxious in their behaviour. Preservation of capital is paramount. Guardians are very risk averse and do not want to incur any monetary losses.
Often, older investors fall into this category. Older investors need to preserve their assets and usually want secure investments with a steady, stable income flow.
That said, new investors may also fall into this category. As knowledge and experience levels are very low, new investors may want to take a cautious and safe investment approach until they gain sufficient skill to move into riskier assets.
Guardians typically invest in government backed bonds or treasury bills, term deposits, preferred shares in public companies, and balanced mutual funds. Low risk of capital loss, but with little hope of significant capital gains.
Celebrities
Celebrities are investors who are anxious but, at the same time, are also impetuous. Not a combination that usually results in long term success.
Celebrities exhibit a crowd mentality and like to invest in the latest hot investments.
For example, if gold is in vogue amongst the media talking heads, Celebrities will invest in gold. Or if a friend at a cocktail party mentions some new biotech company, the Celebrity will want to purchase shares as well.
Whether the investment in question is potentially positive from an analytical perspective or whether it is appropriate for the specific investor are usually not considerations for the Celebrity.
Celebrity investors may be of any age group although I suspect more fall into the young or middle age groupings. This is because over time, Celebrities will not usually be financially successful following this path and move on to more structured investment approaches (or they will have lost all their capital).
Celebrities invest in a wide variety of assets, usually creating a haphazard portfolio. One that tends to be of higher volatility. The only common theme is that the investment is currently fashionable. That often excludes investments in plain-vanilla (i.e. boring) assets such as term deposits, treasury bills, and balanced mutual funds.
Can you just picture a Celebrity discussing his 90 day term deposit at the local bank when all his friends are raving about their shares of Albanian hi-tech companies? Neither can I.
Celebrities are prime candidates for getting caught in an investment bubble.
Adventurers
Adventurers are highly confident, but impetuous.
Adventurers are strong-willed individuals who may be entrepreneurs in their work life. Often successful in business, they expect that success will flow into other areas of their lives. The difficulty is that these individuals do not typically have the time nor the inclination to develop the necessary tools to also become successful investors.
As a result, Adventurers may act rashly and err in their investing decisions.
Adventurers are willing to take chances on their investments and readily consider higher risk assets that offer better potential returns. This would include smaller public or unlisted companies, real estate, venture capital, and derivatives.
Diversified portfolios are considered boring. Adventurers are comfortable investing a significant portion of their assets in one single investment.
Individualists
Individualists are strong willed and highly confident, but they act with care.
Individualists are very rational and analytical in their investing strategies. They understand the relationship between risk and return and take emotions out of their investing style.
Individualists are normally “do-it-yourself” investors, performing their own research and making their own decisions.
As they act with caution and not recklessness, Individualists make less fundamental investment errors than Adventurers.
Individualists invest in a wide variety of assets and develop diversified portfolios. They also tend to be contrarian in their approach and typically have an eye for value. Because of this, individualists may be able to avoid investment bubbles.
Professional investors normally fall into this investor category.
Straight-Arrows
By their vary nature, models tend to classify investors into extremes. In actuality, most investors fall somewhere in between the outer reaches.
Into this comes the Straight-Arrow classification. Where the “average” investor, who possesses some investment experience and knowledge, tends to sit.
Straight-Arrows do not clearly fall into any one category. There is overlap between the different classifications.
Straight-Arrows have some confidence. Not the total level of an Adventurer or Individualist, but substantially more than exhibited by the Guardian or Celebrity.
Straight-Arrows act in a reasonable manner, for the most part. They normally act in a prudent and careful manner, but are still prone to recklessness and following the herd at times.
A Straight-Arrow should be open to investing in a wide variety of asset classes.
And You?
Where do you fit into this Five-Way Model?
Ideally, as an investor, becoming an Individualist is the best case scenario.
For most people who are not professional investors, finding the time and energy to become an Individualist is not usually possible. For these people, becoming a Straight-Arrow should be the goal to best achieve one’s investment objectives.
Straight-Arrows can prosper relying on a structured investment strategy incorporating a passive asset management style.
Straight-Arrows also benefit when working with a professional financial advisor. Straight-Arrows have an understanding of investing and can work in partnership with a professional to develop and implement a prudent investment plan.
If you are currently more of a Guardian, Celebrity, or Adventurer, no worries at this time. By understanding the weaknesses of each category, you can take conscious measures to eliminate the deficiencies in your investor profile and move toward a more well-rounded approach.
I understand that changing basic personality traits may not be easy. Some people are naturally anxious while others are confident. Some are cautious, others are rash. It is all part of one’s inner make-up.
Over time, I hope you will see that a rational approach to investing is the best way to invest. If you do, that will provide you with greater confidence and the ability to take on a more measured course of action in your investing activities.
by WWM | Mar 16, 2017 | Investor Profile, Risk
In Standard Deviation Limitations, I noted that one potential weakness is human behavioural characteristics.
The risk tolerance of each individual is different. It is based on one’s experiences, desires, needs, objectives, and attitudes.
Understanding a person’s unique risk tolerance is critical. How investors view the risk and associated expected return of investments will guide their investment strategy. Everyone differs to some extent.
Today we will look at few questions that shape an individual’s perception of risk.
Consider how you perceive risk as we go through these questions?
Is risk the losing of invested capital?
For many, the thought of losing money is their greatest fear.
These investors typically consider the risk of losing money in absolute dollar terms as compared to the original cost of the asset. Some investors feel that money is only “lost” when the investment is actually sold. Others feel the pain even for losses that are not yet realized.
When we looked at risk, we saw that the greater the investment risk (i.e., standard deviation), the greater the volatility of the investment. That is, the greater the probability that the actual return would deviate from the expected return.
If you fear losing money, you might be more comfortable investing in extremely low risk assets. Sacrifice potentially higher returns for certainty, as well as minimizing the risk of actually incurring an absolute loss.
Is risk the unfamiliar?
Individuals often fear the unknown.
For investors, investments with which one has little or no knowledge of, or appear to be complex in nature, may be seen as riskier.
A good example is the writing of covered call options. Many investors have no experience dealing with options. The mechanics and even the terminology may be intimidating. If I suggested that they incorporate covered calls in their investment portfolio, most investors would be hesitant. Their uncertainty is internalized as increasing the investment risk.
But that is simply the perception. The reality is that covered call options can be an excellent tool within one’s portfolio. While not something I might recommend initially for investors, as investment knowledge and experience improves, one can see that certain options strategies are not risky nor overly complex to execute.
While it is fine to be cautious with unfamiliar investments, that does not necessarily mean they are more risky. Take a little time to learn about areas where you have no knowledge. You might find that the investment is not as risky, nor intimidating, as your initially thought.
Is risk being once bitten twice shy?
Individuals often view investments on which they have previously lost money as unattractive or riskier than they really are.
For example, you purchased 10 ounces of gold in 2012 at USD 1600 per ounce. The investment fell over time and you sold in 2015 for USD 1100 per ounce.
In 2017, you read that gold is recommended as a great mid to long term investment. Based on your prior experience losing money on gold, there is a strong probability you will find this new recommendation unattractive or high risk.
However, that unattractiveness or increased risk is merely a perception and not reality. Whether you gained or lost money on a specific investment in the past has no connection with how well you will do in the future.
Of course, I also meet investors who like to jump back in on investments they previously lost money on. Payback, they are due, karma, pick your reasoning.
Is risk not following the crowd?
Following the conventional wisdom and expert recommendations is usually comforting.
It is always good to find that others, especially experts, agree with your investing decisions. Or that your decisions are based on the consensus of many who may be “smarter” than you. If you lose on the investment, you can take some solace knowing that many others did so as well.
Taking contrary investment positions is more stressful to many individuals. Going against the tide may be seen as a risky proposition. After all, who are you to know more than everyone else?
For example, if the “talking heads” on the business channels are all recommending avoiding Canadian natural resource equities, it takes a bit of nerve to go out and buy shares in these companies.
Given the track record of many “experts”, I am not sure following their advice is often wise.
Investment bubbles are often the end result of following the crowd and engaging in “herd mentality”.
Is risk historically based?
Finally, investors often focus on the past when assessing risk.
Individuals consider historic returns when extrapolating into the future. While history can be a predictor of the future, it is the expected returns (and associated risk) that is more important.
Situations change, both good and bad, and that can impact the risk of an investment.
Consider a mutual fund whose mandate is shares in mining companies. Performance over the last 10 years averaged 15% and risk standard deviation was 4%. Well ahead of other funds in the same category. Based on past results you invest.
However, six months ago the fund decided to sell its investments in traditional mining companies and focus on higher risk companies in Africa and South America. Specifically, countries with less stable companies, young free-market economies, and inefficient markets. Unhappy with the shift in strategy, the successful management team quit. To save money, the fund company has the managers of their banking mutual fund take over management of the mining fund.
Although historic risk was 4%, these recent factors will significantly increase risk levels in the near future.
Data comforts investors in their decision making. And it should. But if you rely too much on the past, you might err in the future. Historic statistics are only applicable if the circumstances in which they occurred are still relevant going forward.
That is why in every mutual fund prospectus you will see “past performance is no indicator of future results.” Or similar.
How did you respond to these questions?
The answers will help you arrive at your personal risk tolerance level. This will guide you as to investments you are comfortable to invest your capital in.
Do you fear the risk of a real loss? Or do you take (hopefully, calculated and prudent) risks to attain potentially higher returns?
Do you avoid the unfamiliar? Or are you an adventurer who seeks out new investment ideas?
Does a prior loss in an asset class or investment cause you to shun them in future? Or is it a chance for revenge?
Do you get comfort relying on experts and the consensus or do you prefer going against the flow?
There are no “right” answers. How you see risk is based on your life history.
However, while risk tolerance levels are unique to each person, I would like to influence each of you to some extent.
I cannot do much about your personality, life experiences, investment objectives, personal constraints, etc. And how they all impact your risk tolerance.
However, I hope to show you that it is best to take a view of risk with as little emotional involvement as possible. That by improving your base investment knowledge and learning what questions to ask, you can become more objective in your decision making.
I fully realize that this is a challenge for almost all individual. But if you can develop a more disciplined approach to investing, you will be in better position to succeed over the long run.
by WWM | Jan 16, 2017 | Portfolio Construction
Over time, we will look at the debate between active and passive asset management.
What each term means. In general, should you actively or passively invest? Are there exceptions to the general rule?
Today I want to briefly highlight an article I read in the Financial Times. A subscription is probably necessary to access the story, but I will cover the key points below.
Active Global Equities Outperform
The Financial Times article is entitled, “Study finds active global equity funds outperform”.
Very interesting given that it is very difficult to impossible for active managers to consistently outperform market benchmarks over extended periods. There are some exceptions, yes. But, in general, I would not expect to see actively managed global equity funds outperform their passive benchmarks.
But if the Financial Times headlines that, it must be correct. Sell all your index funds and get into actively managed. Unfortunately, if you read past the headline and opening paragraph, it is not that clear cut.
Many “Studies” Desire Pre-Ordained Results
According to the study,
actively managed global equity funds outperformed the market by between 1.2 per cent and 1.4 per cent annually on average between 2002 and 2012.
I will not impugn this study and shall accept their results.
But it is worth pointing out a problem I have found with “studies” in many instances. Something you should keep in mind any time someone claims something, especially an unconventional finding.
In this study, why choose only a sample period from 2002 through 2012? Did active fund management not exist before 2002? Yes it did, in case you were wondering. Why end in 2012 for a study that is just being published now? 4 years to assess and collate?
Watch for studies that rely on things like sample size, time period, or makeup of the participants to drive the results. In general, the larger the sample size or time period the better. Or with “makeup”, consider a poll of US voters that has a sample of 85% Democrats to 15% Republicans. You may not get a representative set of responses of the US as a whole.
The same holds true for sampling investments. You always want samples that represent the overall population as best as possible.
Again, not saying there is anything intentional here, but it raises questions. Especially given that it is very difficult to consistently beat benchmarks over longer periods.
Always view “studies” with a healthy degree of skepticism.
Investor Costs Impair Performance
I am not going to hammer the findings too much as active management can outperform in gross returns. Sadly, you – the investor – never receive gross returns. For the active managers’ services, you pay an annual management fee, plus associated costs. Your return is net of fund costs and fees.
You may have also paid a sales commission when you bought the fund. That adds to your cost structure.
This study found that active management can outperform on a GROSS basis. The study does not calculate excess returns on a NET basis. That is, the actual return that you receive. When you factor in management fees that investors pay in the real non-academic world, that 1.2% outperformance significantly shrinks.
I do not know the exact shrinkage as I do not know the specific funds assessed. But it would not surprise me if the management fees and related costs eroded the excess return to zero of worse.
The article points out that “pension funds and other big investors typically pay fees of around 0.75 per cent.” Then helpfully adds, “Retail investors often pay higher fees.”
You, gentle reader, are a retail investor.
Investopedia gives a quick breakdown of typical fund expenses that lower investor returns. Investopedia estimates that, “The average equity mutual fund charges around 1.3%-1.5%. You’ll generally pay more for specialty or international funds, which require more expertise from managers.”
If that is the average equity fund, and international funds tend to cost even more, then that 1.2% excess return in an actively managed global fund disappears quickly.
Note that active management tends to result in higher administrative and transaction costs than a passive fund. Because active funds are more “active”. Also, many international funds have higher expense ratios for a variety of reasons (regulatory, lack of transparency, inefficient markets, etc.). We will cover this in time.
Realize that your net returns (i.e., your actual performance) may be materially different than gross.
Selection Bias
Another topic to delve into at a later date. But an issue with studies of this sort, so I will briefly touch on it.
The authors looked at 143 global equity funds. Now there are more than 143 actively managed global equity funds out there, so first question is how did they choose the ones they did? Did they pick the top performers, bottom performers, etc?
If you let me look back at 10 years results, I might be able to put together a portfolio of stocks with Apple, Amazon, Under Armour, SalesForce, etc. If you ask me to put together a portfolio for success in the next 10 years, I will have less certainty.
Second, and a huge issue with mutual funds, is funds that are no longer in existence. This study chose funds that were around for all 10 years of the study. That means funds that ceased to exist during that period were not included in the results. As you can imagine, the main reason for a fund ceasing to exist is due to underperformance. Weak funds lose investors (and their capital) and usually go out of business over time. By not including low performing funds in the sample, you skew results upwards.
Think back to your school days. 30 students in class. Mid-term exam, 10 students get 80%, 10 get 50%, and 10 get 20%. Overall class average is 50%. But the lower tier students all decide to cancel the class. Same class, but instead of a 50% average, now you only have 20 students who average 65%. Simply by weaker students dropping out, the overall average rises.
Same thing with funds. Never forget that when reviewing longer term performance data.
All the Media Clickbaits
The Financial Times is not TMZ or a dodgy website that lures viewers through very enticing headlines. Yet today, everyone uses headlines to attract readers.
Even staid financial newspapers or magazines are in the business of bringing people to their sites. That leads to headlines and short blurbs that may not be 100% accurate. Do not automatically assume that what you see in the first paragraph totally agrees with the actually contents. Make sure you read things in total.
These things tend to annoy me a great deal (hence the blog post). One, they tend to be incorrect or misleading. That confuses non-professional investors and leads them to make poor choices. Two, it takes me (and other financial advisors) time to correct this misleading information with clients.
Over time, and in some sort of proper order, we will get into the themes raised in this post. The active versus passive debate being the big one. But we will also take a look at fund fees and expenses and problems with reported performance data.