Last week was a slow week ahead of this holiday-shortened week. Data points were few and far between; I’ll discuss the more important points in the Focus Market section of the report.
Given that it’s slow on the news front, let’s take a step back and ask two questions from 30,000 feet:
What’s your objective for investing?
Why do you put capital at risk in the financial markets?
Some of you are investing for retirement while others are already in retirement. Some are investing to pay for college or to buy a house. But no matter what your motive for investing is, the ultimate goal is the same, wealth creation.
Let's be honest, you're not reading this report just so you can get by. But some of you might chime in, “I don’t need to create wealth, I’m already wealthy, I just want to hold on to what I have.”
Well, unless you're interested in having the purchasing power of your present wealth cut in half over the next 20 years due to inflation, then you’re going to need to create some wealth. That statement is true whether you’re currently worth $1 million, $5 million or even $10 million.
So while we're all after wealth creation regardless of our place on the ladder, where do we differ? The two greatest differences across investors are:
The annual rate of return that is acceptable
The level of day-to-day involvement you want to have
Each person reading this will have to decide the answer to these two points for themselves. I would caution you against setting any goals that require a consistent annual rate of return greater than 10-15%.
I would also caution you against implementing a process that has you glued to a computer monitor 7.5 hours a day or waking up at 2 am to see how the Asian markets are trading.
Once you've decided how involved you want to be and what rate of return you want, then you can decide how to put money to work. The most common options are:
1. Hire a financial advisor or planner,
2. Invest in mutual funds
3. Invest in a private fund manager(s) – this can include hedge, private equity, real estate, etc.
4. Do it yourself
5. Some combination of the above
I’m going to focus on 2, 3, and 4 but before I do, a quick note. Do you notice that at this point, I haven’t said one thing about setting a benchmark like the return of the S&P 500?
I’m not sure where this idea got started but it makes absolutely no sense. This idea of judging the success of an investment strategy or the success of a given calendar year based solely on outperforming a basket of stocks is completely irrelevant to wealth creation.
The only benchmark you need to be concerned about is how well your strategy did compared to the rate of return you wanted to achieve. Period. If you still believe that outperforming the S&P is the only way to judge success, let me ask you two questions.
In 2008, the S&P lost almost 40% of it’s value, if you’re account lost 33% of its value would you have felt successful? You outperformed the S&P by 700 basis points during a crisis!
The reality is yes, you outperformed the S&P but you lost 1/3 of your wealth in 12 months. Let’s flip the scenario and say that the S&P is up 40% in a given year and you gain 33%, is that a failed year for you? If it is, then you need to educate yourself on historical asset returns.
If you gain 33% in a single calendar year, you should tip back a Big Gulp full of your favorite adult beverage and appreciate every basis point of that return.
But I digress, back to evaluating options 2,3, and 4. When evaluating professional asset managers, including mutual funds, hedge funds, private equity, there are two questions that you need to answer:
1. What are the NET returns of the fund in question? When I say 'net' I mean net of all fees (management, distribution, transactions, incentive allocation) and taxes.
2. How much risk does the manager typically take to earn those returns?
The risk of a particular fund is very easily quantified through any one of a hundred different metrics. However, the embedded fees of a fund can sometimes be a bit more difficult to pin down, especially in mutual funds.
Private funds are required to provide investors with a set of audited financial statements each year within 90 days of the year end. These statements spell out all of the fees associated with investing in that particular fund. It’s interesting to me that there are net worth and income requirements for investors to be able to invest in the these types of funds that provide so much transparency.
However, mutual funds, which are available to everyone with a 401(k), bank IRA or brokerage account don’t have the same requirements. But that’s a conversation for another day.
In order to understand the true costs of a mutual fund you have to evaluate the distribution and transactions costs of the fund. The distribution costs can be determined by looking in the prospectus but the transactions costs or the commissions paid for trading are more difficult numbers to determine.
Popular sites like Morningstar, don't include distribution or transaction costs in the total return calculations for mutual funds. For example, the RS Growth Fund, managed by the RS Investment Management Co.
Morningstar says that the expense ratio of the fund is 1.37%. The 10-year return of the fund is 7.81% and the 15-year return is 5.13% per year. The reality is that the total annual fees for this fund are closer to 2.8% per year or double what Morningstar says.
The distribution costs of this fund are 30 basis points a year and the transactions costs are an additional 1.15% per year. If you account for the total fees, it cuts the 10-year return down by 15% and the 15-year return down by 30%.
There are several sites that will provide you with this information and it's worth the extra time to educate yourself as the true costs of investing in a particular fund. Private fund managers, specifically hedge fund managers have been getting a bad wrap for both underperforming the “market” and for charging high fees.
You know how I feel about judging ANY manager or strategy against an arbitrary benchmark like an index, so I’ll leave that alone.
As for fees, here is my personal belief. If a manager or strategy is giving you the rate of return you desire net of fees and taxes, then who cares how much the fees are costing you?
If you find a manager capable of delivering your needed rate of return fairly consistently year in and year out (I’m not talking Bernie Madoff here) then why wouldn’t you be willing to pay that manager more?
Renaissance Technologies is a multi-billion dollar hedge fund firm that has delivered net returns in the area of 35% a year for the last 15 years. They charge a performance fee close to 50% of all profits. That might seem outrageous on the surface but don’t their returns justify the fee?
However, if you're fee conscious, I guess you could always put your money in the RS Growth Fund, pay 2.8% a year in fees and earn 3.7% per year for the last 15 years instead of 35% per year. I think you see my point.
Any strategy or manager is only as good as their net returns and the risk they take to earn them. Continue to focus on what matters and exclude everything that does not.