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Volume 12, Edition 35 | December 4 – December 8, 2023

Expenses: A Hidden Drag On Performance

Doug Walters, CFA
All investments have expenses; their creators have to get paid somehow. However, not all expenses are created equal and investors should ensure they know what they are paying and are getting benefits that justify any extra hidden costs.

Contributed by Doug Walters, David Lemire, Max Berkovich, Eh Ka Paw

The best things in life may be free, but investments generally are not. You may not always see their cost, but they are there, quietly dragging on your performance. For this reason, we include “expenses” in our evidence-based guiding principles. Knowing what to look for and ensuring you get value for that cost is essential to successful long-term investing.

One evening, I attended an event where attendees went around the room, introducing themselves and their businesses. One participant said she worked as a financial advisor, and the great thing about the firm was that they “don’t charge their clients anything.” Sounds like a great business model… give your services away for free! But of course, they are charging their clients, potentially a lot, and likely through hidden fund expenses… and probably mutual funds issued by their own company. Sounds like an egregious conflict of interest to me.

The fees can come in many forms. Brokers, for example, might sell you funds with a front-end “sales load” (a fee paid upfront to purchase the shares). These can be over 5%. The most basic fees are those internal fees that cover management and administration (the fund providers do have to get paid, after all). These are often referred to in terms of an “expense ratio.” You can look up any fund online and find its expense ratio. This tells you how much of your investment will be paid out in fees each year. A 1% expense ratio on a $10,000 investment equates to $100 a year. That is a significant drag on performance that the investment manager needs to overcome.

We typically use exchange-traded funds (ETFs) as their expense ratios tend to be lower than the mutual fund peers (although that gap is shrinking). For a basic fund like Vanguard’s S&P 500 ETF (VOO), the expense ratio is currently just 3 basis points (or .03%).

But, investors should not seek just to minimize fees. Instead, it is important to be “fee aware.” If you know you want exposure to something basic like the S&P 500, then the cheaper options from reputable fund providers may do the trick. But if you want something more sophisticated, more work must be done. We practice factor investing as Strategic. So, when we want exposure to, say, a value fund, we will not just look at fees but also whether the funds are giving us the right type of value exposure and whether or not any extra expense we may pay for that access is giving us the extra performance we are seeking. Performance after fees is what matters.

Vanguard1 estimates the average value of moving to lower-cost funds to be 30 basis points per year. That is a meaningful number but underestimates some of the worst cases we’ve seen come through our doors, with expense ratios in excess of 1.5% and private investments with outrageous “2 and 202” agreements that have not paid off.

Avoiding a few tenths of a percent of performance drag may not seem like much, but it adds up over time. When taken in combination with the potential benefits of our other guiding principles, it could mean the difference between achieving your great life vision… and not.

Previous articles on our guiding principles can be found here:

1. “Putting a Value on Your Advisor: Quantifying Vanguard’s Advisor Alpha®,” Vanguard, July 2022
2. We did not dive into the world of alternatives here. “2 and 20” is a common hedge fund expense structure where they charge 2% (ie. 200 basis points) and the also take 20% of the profits. That creates a huge performance hurdle to clear which is why so many alternative investments prove not to be worth the cost.

$5.9 trillion in money market funds is a concerning trend

According to the Investment Company Institute, a record amount of money is parked in short-term cash vehicles as of the end of November. Investors have been flocking to money market funds, CDs, and high-yield savings vehicles thanks to high short-term interest rates and bank teaser rates. While these rates are great news for your short-term liquidity needs, we see an alarming trend of investors moving portions of their long-term investments into these vehicles. As we discussed in previous Insights editions, Time to Go Long and The Risk of De-Risking, this can be a harmful move. We’ll dive into this in more detail next week. In the meantime, think twice about moving your longer-term investments to short-term vehicles whose attractive yields can vanish overnight.

Headline of the Week

Santa Recharging?

Sticking with the Santa theme from last week, it looks like Santa had to head back to the North Pole to reload the sleigh after such a strong and early start to his rally in November. With the foggy start to December, it might make sense to put some fresh batteries in Rudolph’s nose.

The November job’s report should help lighten the fog around Fed policy. Jobs were in line with economists’ forecasts at 199,000, and the unemployment rate ticked lower to 3.7%. This report is largely viewed as finishing off the prospects for any further rate hikes. Easing labor shortages (in many sectors) should help alleviate wage pressures which figures heavily into Fed thinking. The soft-landing thesis continues to gather momentum. One main caveat or implication from the employment report is that continued strength in labor markets has the potential to trigger an adjustment for when rate cuts start. This re-pricing could help explain some of the fog thus far in December.

The Week Ahead

Inflation and Central Banks take center stage next week, with interest rate setters in the US, UK, and the European Union all gathering ahead of the holiday.

Cheers or Jeers!

The bond markets have decided that rates don’t need to go higher. As a matter of fact, they expect them to go lower next year. Now, it’s up to the three biggest central banks to face the markets.

  • The higher-for-longer narrative central banks have tried to communicate has received very aggressive pushback from investors and, more remarkably, a small but growing group of central bankers.
  • In 2024, markets are pricing in a less aggressive scenario of rate cuts from The Bank of England (three) than the European Central Bank (five).
  • Bank of England’s Governor Bailey came out to push back on the assumption that the Bank of England is looking to cut rates.
  • Expect very cautious language from the policymakers next week, especially since Bailey has no press conference.
  • ECB’s Lagarde also must temper the markets where rates are expected to fall starting in March.
  • With Europe’s inflation still running at 3.6% year over year, Lagarde needs to get the market to act cautiously.
  • The Federal Reserve is facing a market penciling in four cuts next year and is expected to have a fresh projection of rates (the dots).
  • Chairman Powell will have to navigate the questions at the press conference with finesse to not ruin the holiday season.

Inflation

On the eve of the Federal Reserve meeting, the Consumer Price Index (CPI) will be unveiled and is widely viewed as a proxy for how the members of the rate-setting committee will feel.

  • With CPI flat last report, a negative print this time can juice rate cut expectations and maybe move some predictions of a start to as early as the first quarter of 2024.
  • Headline CPI is expected to edge down to 3.1%, but a two-handle would be sweet!

Get Lit!

Happy Hanukkah! Chag Semeach!

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