Diversify, Invest Passively, and Avoid Taxes! Invest Passively??? posted 2/17/09

 

In case you don’t know who Peter L. Bernstein is let me tell you that he is my favorite economic and investment sage.  I have known Peter for over forty years and have subscribed to his letter, Economic and Portfolio Strategy for as long as I can remember. You can subscribe yourself at www.peterlbernstein.com.  Believe me, it’s worth the price if you are a serious investor.  You also would enjoy his books, which have long held an esteemed place in the investment world.

 

Peter occasionally calls on his friend Mark Kritzman, President and CEO of Windham Capital Management and on the faculty of MIT’s Sloan School to contribute to Economic and Portfolio Strategy . In a recent issue, he wrote “Rules of Prudence for Individual Investors”.  So what are these rules?

           

Rule 1:   Diversify

            Rule 2:   Invest Passively

            Rule 3:   Avoid Taxes

 

Rules 1 & 3 appear as incontrovertible, even though we all tend to dismiss them from time to time.  And Kritzman points out that simple correlations between asset classes are not sufficient evidence that a portfolio has achieved diversification.  Correlations should be conditional.  For example, when both international markets and U.S. stocks produce returns greater than one standard deviation above their mean, their correlation is -17%.  But when both markets produce returns greater than one standard deviation below their mean, their correlation rises to +76%

 

But what about Rule 2?  Can active investors be convinced that giving up the task they most enjoy, the choosing of individual securities, is the best thing for their investment health? We are all well aware of the relentless drive of my friend Jack Bogle, founder of the Vanguard Group, to tell investors that low cost indexing is the best investment strategy.  We nod in patient agreement then turn and go happily about the very activity he eschews: stock picking. What a great sense of victory it provides us when we make good money in a stock! Or choose an industry that does very well.  And who doesn’t tend not to tell others about our mistakes.  Why would we consider investing in funds that are passively managed?

 

Well, Mark Kritzman analyzes a recent paper by Barras, Scaillet and Werner (BSW) called False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas (downloadable from the Social Science Research Network, which you can join free). The study examined returns of 2,076 mutual funds. Without burdening you with their statistical procedures, here are their conclusions as stated by Kritzman:

 

·       75% of funds had zero alphas, meaning that their active excess returns just covered their costs.

·       The number of skilled funds, in which alpha exceeded costs was statistically indistinguishable from zero.

·       24% produced negative alphas, that is, their expenses were in excess of their active returns.

·       From 1989 to2006, the fraction of skilled managers (whose returns exceeded costs) declined from 14.45% to 0.6%. BSW attribute this to an increase in unskilled managers who nonetheless charged high fees.

 

BSW define alpha as active gross return (return in excess of market return) minus costs, with costs defined as management and administrative fees, and transaction costs.

 

As if these conclusions are not enough of a black eye for active management, Mark Kritzman notes they ignore taxes, a matter of great importance, at least for the individual investor.

 

Kritzman lives in Massachusetts, where his effective combined state and federal marginal tax rate is 20% on dividends and long-term gains, and 47% on short-term gains.

 

The higher the portfolio turnover, the more the realized gains and the higher the tax bill.  So low turnover is the investor’s friend. Low turnover also involves transaction costs, which can be considerable.  And where do you get low turnover?  Index funds.

 

Kritzman says, “Perhaps you still cling to the quixotic belief that you can identify actively managed funds that will generate sufficiently large alphas to overcome the drag imposed by their incremental fees, transaction costs, and taxes.”  If so, take a gander at the table below, constructed by Kritzman as a Massachusetts resident:

 

     

Investment Options

           
 

                  Index  Fund              

 

  Mutual Fund

    Hedge Fund

           

Expected Return

10.00%

 

13.50%

 

19.00%

Dividend Yield

1.50%

 

1.50%

 

0.00%

Std. Deviation

16.00%

 

16.00%

 

16.00%

Turnover

4%

 

95%

 

200%

Transaction Costs

0.40%

 

0.40%

 

0.40%

Long-term Gain Rate

20%

 

20%

 

20%

Short-term Gain Rate

47%

 

47%

 

47%

Dividend Tax Rate

20%

 

205%

 

20%

Management Fee

0.07%

 

1.40%

 

2.00%

Performance Fee

0.00%

 

0.00%

 

20.00%

 

You might quibble with some of these assumptions, but for now stay with me.  Kritzman, using a ten-year horizon, then simulated portfolios using the above assumptions 1,000 times and liquidated the portfolios at the end of the period.  This is the result:

 

 

                                           Simulated Returns Net of Expenses

           
 

Index Fund

 

Mutual Fund

Hedge Fund

           

Gross Return

10.00%

 

13.50%

 

19.00%

Transaction Costs

0.02%

 

0.38%

 

0.80%

Taxes

1.64%

 

3.90%

 

5.42%

Management Fee

0.07%

 

1.40%

 

2.00%

Performance Fee

0.00%

 

0.00%

 

3.17%

           

Total Expenses

1.73%

 

5.68%

 

11.39%

Net Return

8.27%

 

7.82%

 

7.61%

 

 

Again, quibble with the methodology if you must, but the point is very clear, as stated in Kritzman’s conclusion:

 

“Net of all expenses including taxes, a typical mutual fund must generate an alpha in excess of 400 basis points to produce more wealth than an index fund, and a hedge fund’s alpha must exceed 1,000 basis points to beat an index fund. These estimates rise to 430 and 1,100 basis points if we extend the horizon to 20 years.”

 

But, you say you can pick the good mutual funds and hedge funds, and not simply settle for the “typical”?  Good luck!

 

 

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s