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How We Gain a Performance Advantage No Matter What the Markets Do – Part I

Scott's Column

Obvious and Boring

Everyone wants to gain a performance advantage by placing bets based on smart-factors, data-driven algorithms or macro-calls that purport to predict the future.  It’s certainly fun and intellectually stimulating to do this and you feel so smart when your bets pay off.

We think there are more productive, albeit boring, ways to lock in a performance advantage.  And you don’t have to guess about the future or hope that history repeats itself.

It’s quite simple.  You keep your fees and expenses low.  Every asset manager in the country knows this, but most don’t incorporate this idea into their investment processes.  Why?

  • people don’t appreciate how highly correlated low fees and good performance truly are
  • people don’t appreciate the impact that fees and expenses have on a portfolio
  • our industry is in love with complexity and complexity is expensive

The Impact is Huge

In 2010, Morningstar studied the relationship between low fees and performance.  They found: “In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.”  They also found: “Each 1% in additional fees eats up 28% of the ending value of an account over a 35-year span.”

Vanguard did a study in 2015 that measured the effectiveness of different factors in predicting mutual fund performance.  They found: “The ex-ante expense ratio separated poorly performing funds from better performing funds more successfully than all other metrics…”  They also found a “1.27 percentage-point annual alpha difference between the lowest-quartile cost funds and the highest-quartile cost funds…”

In another Vanguard study, they compared the returns of mutual funds in the lowest-cost quartile with funds in the highest-cost quartile in different asset classes over the 10 years ending in 2013.  Again, the low-cost funds beat the high cost funds in every asset class.

Even a small difference in fees can make a big difference long-term.  Assume a client has a $100,000 account that grows at a 6% rate over 30 years.  If the client pays 25 basis points in fees, they end up with $532,899.  If they pay 90 basis points in fees, they only have $438,976 in their account.  The difference is almost equal to the entire $100,000 initial account value.

You clearly don’t get more by paying more.  This is somewhat counter intuitive.  We are so used to associating high cost with high quality that we transfer this frame of reference to the investment world.  But it just doesn’t apply here.  We need to internalize this reality.

In my next blog post I’ll tell you the specifics of how we manage fees and expenses in our portfolio and give you an example of what a big difference this can make in the ultimate value of a long-term portfolio.  It is literally possible to fund multiple years of retirement with the savings gained by paying close attention to fees and expenses.  Find out how in my next post.