Resources/Weekly Insights

Volume 13, Edition 32 | November 30 - December 6, 2024

Expenses: The More You Pay the Less You Get

Doug Walters, CFA

This week we continue our focus on our Guiding Principles with a deep dive into Expenses which can be a hidden drag on performance over time.

Contributed by Doug Walters, David Lemire, Max Berkovich

You get what you pay for. So goes the saying. But in the world of investing that phrase takes on new meaning, where paying more may mean getting less. For this reason, we have made Expenses one of our Guiding Principles. It seems logical to minimize fees, but the choice is a little more nuanced than that. And before you can start that process, you first need to find those, sometimes, hidden fees that are a drag on your portfolio performance.

Why Hidden Fees Matter

Whether you are buying an ETF, mutual fund, or private investment, there are fees. You may not see them, but they are there. Afterall, the issuer and manager of the fund needs to get paid somehow. For funds, they usually come in the form of an “expense ratio.” This is a percent fee deducted directly from the performance of the fund. For example, if the investments within a fund were up 10% in a given year, and the fund had a 50 basis point (ie. 0.5%) expense ratio, your return would be 9.5%. You never directly see the fee, which is why we refer to it as hidden.

Fees can be low, like 3bps, or very high, like 150bps or more. Many studies have been done on these fees. In a 2016 report by Morningstar¹, they looked at the universe of mutual funds and calculated what percentage of them both survived and outperformed their category group. They compared those results across different expense ratios. The 20% of funds with the lowest fees had a 62% success ratio. The 20% with the highest fees had only a 20% success ratio. So, in a way, you get what you pay for. The less you pay, the more you get!

Sometimes you can reduce fees without changing funds. We are always on the lookout for these share class exchange opportunities for our clients. The same fund can come in different “classes” and these classes can have different expenses. Perhaps you rolled over funds from a 401(k) to an IRA. You may have only had access to one fund class in the 401(k) and now have access to a cheaper one in your IRA. You can exchange it with no tax implications.

A Nuanced Decision

At Strategic, we keep costs in check for our clients, through the use of relatively low-cost ETFs. The embedded expense ratios across our suite of strategies range from just 5bps to 15bps. With that said, our goal is not simply to minimize the expense ratio. Rather it is to optimize the after-expense total return. We are more than willing to pay a little more expense, for the expectation of higher returns.

The multifactor funds we use at the core of our portfolios are a good example. Academic research shows that “factors” like High Quality, Good Value, Price Momentum and Small Size tend to outperform over time. While there is no guarantee that this trend will continue in the future, we find the academic research compelling and are willing to accept a few more basis points of expense to own these funds.

Expense Reductions in 2024

Our strategies started 2024 a bit more expensive than they are going to end the year. Part of that reduction has come from action we have taken to exit our core fixed income holding (at 20bps) in favor of funds with an expense of 4bps. Our goal here was in part tactical, but in part to reduce an expense that we determined was not likely to be justified going forward.

A few basis points here or there in expense may not seem like much, but it can add up over time, particularly as returns compound. Each of our Guiding Principles attempts to find these opportunities to potentially tip the performance scales in our clients’ favor. Next week we discuss Taxes.

1. Morningstar, “Predictive Power of Fees: Why Mutual Fund Fees Are So Important”, May 2016

Our Guiding Principles

PATIENCE: Focus on the long-term to fully benefit from market returns.
DIVERSIFICATION: Enjoy the best free lunch in finance.
FACTORS: Identify market segments with a propensity for outperformance.
REBALANCING: Systematically and opportunistically, buy low and sell high.
EXPENSES: Avoid the hidden costs that quietly erode performance.
TAXES: Manage the inevitable burden for successful investors.
BEHAVIOR: Learn to get out of the way of your own worst enemy.

62%

Success ratio of mutual funds with the lowest embedded fees

Morningstar found¹ that the cheapest 20% of funds survived and outperformed 62% of the time. The 20% with the highest fees had only a 20% success ratio.

Headline of the Week

227,000

No that’s not bitcoin’s price, at least not yet. This month’s job number got back on track relative to last month’s mildly disappointing number. Granted last month had a fair amount of noise in the data due to hurricanes and a Boeing strike. The report reestablished the hypothesis that the employment picture remains solid but is gradually softening. It also reinforced expectations for another Fed rate cut in a few weeks. The “Goldilocks” and/or “Soft Landing” stories remain intact with the path forward remaining challenging. Immigration seems a likely source for future “Headlines of the Week”, but we’ll wait to see how this potent issue impacts jobs as well as wage pressures in the new year.

The Week Ahead

The week before the final Federal Reserve meeting of the year. We get an inflation report and several rate decisions abroad to digest. The wild card could be an economic conference in China.

Consistent and Persistent

The Consumer Price Index (CPI) next week will offer a final look at inflation before the Federal Reserve assembles to make its final rate decision for 2024.

The past several inflation reports have come in-line with expectations, and we expect the same this time.
Expectations are that the CPI headline number will be another 0.2% monthly increase in inflation and the November-to-November inflation will be 2.7%.
Core-CPI, which excludes food and energy, is expected to be up 0.3% for the month and 3.3% year over year.

Cut It Out!

It is a full house for central banks waiting to cut rates next week.

Australia, Switzerland, Brazil, and Canada have rate meetings, but the biggest will be the European Central Bank (ECB).
Australia has a persistent inflation and a sputtering economy, with the double whammy, the odds say they will hold rates steady.
The Swiss National Bank on the other hand has sub-1% inflation, and markets are expecting a ½ a percent trim.
Canada is expected to keep the cut small at ¼ of a percent.
Brazil is speculated to be cutting by ¾ of a percent, this is after 2 rate hikes that brought the short rate to 11.25%.
The ECB has had a major member nation’s administration collapse and another on the cusp, with all the headwinds from political crisis’s economic sentiment has been dealt a blow.
While a ½ percent cut might help, current expectations are for a fourth ¼ of a percent move.

No Numbers

The Central Economic Work Conference in China is different than the two-session gatherings we usually hear about.

No numbers or targets get released; however, this will offer a window into what the central planners will target and prioritize in the new year.
The tone and change in language will hint to investors how the Chinese government will try to institute the long-awaited intervention to boost the economy, if at all.

About Strategic

Founded in 1979, Strategic is a leading investment and wealth management firm managing and advising on total client assets of over $2 billion.

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