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Tag Archives: bonds

Keeping It Real – The Impact of Fees, Taxes and Inflation

Real Stock ChartWhat’s more important to investors than real returns? 

In a previous note (Leaving Money on the Table) we wrote about the impact of taxes and fees on net strategy returns. Our focus was more conceptual and we highlighted the highly customized nature of after-tax portfolio management advice.

Some of our readers, however, remembered empirical work we had done a number of years back using broad US stock and bond market returns. We decided to update our previous research on the effect of taxes, fees and inflation on the real return to investors.

Our methodology is simple.  By necessity we employ some simplifying assumptions regarding fees and taxes. We use S&P 500 and US Government Ten-Year Note returns from the end of 1982 to the end of 2015.

We subtract three levels of “costs” from gross returns:

  • Management Fees
  • Taxes (short and long-term)
  • Purchasing Power (inflation)

Real Stock ReturnsReal Bond Returns

 

 

 

 

 

 

 

The results are eye opening and a timely reminder of the drag on investment returns.  A lot of investors would be surprised to see the extent of this drag on their portfolios but in the real world the results may actually turn out to be even worse. 

Why? For one many investors pay high fees on their portfolios and ignore the tax efficiency of their strategies.

While not as sexy as a discussion of strategy returns or smart beta minimizing the extent of the cost drag from fees, taxes and loss of purchasing power is an important part of sustained wealth creation

 Management fees on portfolios should be scrutinized for value add.  Portfolio management has a cost. Index strategies are now available on most market segments in equity and fixed income markets at low cost but the combination of strategies and overall asset allocation still needs to be managed.

Jack Bogle has been talking about the importance of controlling fees for years and investors as a group may have become recently more fee sensitive especially as the realization sinks in that we are most likely going to be living in a low return environment for the next decade.

Paying high fees in a low return environment would certainly impair wealth accumulation targets.  Paying fees commensurate with value add should be the goal of investors.

As Benjamin Franklin once said, taxes are as certain as death and as such the best that one can do is minimize the tax bite of investment strategies. Tax loss harvesting, low portfolio turnover, proper strategy selection, and legal deferment of taxable events are elements of a coherent well-designed tax minimization strategy.

Finally, a huge drag on net real returns has been the loss of purchasing power. While inflation in recent years has been below historical norms the loss of purchasing power can best be thought of as an almost invisible downward pull on wealth creation efforts.

Not all investment strategies behave in the same manner in the face of inflationary forces.  Properly aligning investment strategies to the expected inflationary environment is an important component of minimizing the deleterious effects of a loss of purchasing power.

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Eric J. Weigel

Managing Partner, Global Focus Capital LLC

Feel free to contact us at Global Focus Capital LLC (mailto:eweigel@gf-cap.com or visit our website at https://gf-cap.com to find out more about our asset management strategies, consulting/OCIO solutions, and research subscriptions.

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

Beyond the Fog of Daily Capital Markets

foggy-mountains-1503271-1279x1926As an active manager one of the toughest psychological tasks is to invest for the long-term but have to deal with the daily noise and chatter of the markets.  The unrealistic expectation of having superior performance over all measurable holding periods leads to behavior often inconsistent with the goal of prudent long-term capital accumulation.

Given the volatility of capital markets a lot can happen over the short-term that over time gets washed away and becomes a mere blip on the radar. Conversely, other things that in the hustle and bustle of the markets seem minor turn out to be much more impactful over the long-term.  Empirical research shows that returns typically are more volatile in the short-term than warranted by changing fundamentals.  The net result is a lot of noise that dissipates once investors take a longer term view.

Taking a Step Back.  In recent years we have started thinking that stepping back a bit and watching the whole landscape unfold perhaps gives us a better sense of what really matters.

As archaic as this may sound to a high frequency trader in our research we have started focusing more on looking at company and capital market fundamentals over longer time periods.  Looking for example at year by year annual company financials gives us a better sense where business fundamentals are going.  Same with broad capital market relationships at the asset class level.  Aggregating annual periods to look at secular trends gives us another way to process information in a manner that may seem old-fashioned but that hopefully removes some of the noise.

Shifting our Focus toward Long-Term Performance.  We recently put together heat maps of annual performance for a variety of capital market breakdowns.  We looked across the major asset classes as well as within each asset class.  The results were revealing in each case.  We found a lot of surprises especially when looking at cumulative returns over the last ten years!

In this note I will share the heat map for the ten major asset classes used in our asset allocation strategies.  The returns for 2016 are as of January 22.  All returns are in US dollars and correspond to commonly used indices.

2015 ASSET MIX HEAT MAP

What We Expected:

  • Lots of variability from year to year – this we expected. After all this is the point of creating a heat map.
  • We did not see a lot of relative mean reversion over one or two calendar years. Again this was expected given the strong empirical evidence that momentum persists for up to three years. We did not see a lot of “going from worst to best” or vice versa.
  • Not all higher risk categories outperformed lower risk assets – this we expected given the hits suffered by equity-oriented assets during the Financial Crisis. For example, US bonds have out-performed international equity investments over the last ten years.  Needless to say this was achieved with much lower volatility.
  • US stocks had below average ten-year returns. The annualized return on US Large Caps (S&P 500) was 7.7%, more than 2% below historical averages. US Bonds (Barclay Aggregate) also had below average returns compared to history.

What Surprised Us?

  • A big surprise was the extremely poor performance of commodities (COM) – down 48% over the last ten years. For most investors the promise of uncorrelated returns to the stock market has come at a very high price.  Bye-bye commodity super-cycle!
  • I was also surprised by the 2X out-performance of US stocks compared to international equity indices. Some was due to currency but not all. There were major geographic performance differences over the last ten years.
  • US REITS (RE) edged out US large cap stocks by a slight margin over the last ten years. We expected a larger margin of out-performance but we had forgotten that in 2007 REITS were a precursor to what would happen during the Financial Crisis.
  • Emerging Market Debt proved to be a revealing surprise with a 97% total return. Pretty close to US equity market returns and vastly superior to international equities. Much lower volatility too.
  • The 91.7% return to the 60% S&P 500/40% Barclay Aggregate portfolio. The balanced portfolio lagged the S&P 500 by only 0.59% on an annualized basis but with much lower short-term volatility. Not bad for such a simple portfolio.

Insights to Share:

  • The short-term noise in the capital markets can obfuscate long-term secular changes as well as disproportionally focus the mind on events that over the long-term have little to no significance.
  • Expect lots of variability from year to year in terms of performance but over longer-term periods asset values will converge toward the fundamental drivers of return – income generation, growth and valuation.
  • To reinforce the previous point, a lot of capital market volatility is just noise and should be ignored unless there is a change to fundamentals.
  • Simple strategies such as the annually rebalanced 60/40 portfolio can prove sometimes incredibly effective at managing through the daily fog of markets
  • Effectively distinguishing noise from fundamental signal is the key goal of capital market research. Capital markets are always evolving but the fundamental drivers of return and associated risk should be the backbone guiding your perspectives.

Sincerely,

Eric J. Weigel

Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

A Marriage of Necessity but with Benefits

1000785262One of the key underpinnings of modern-day investing is the concept of diversification.  Adding assets to a portfolio will almost universally lower the overall volatility of a portfolio assuming that the correlation between the investment in question and the portfolio is lower than one.  As the correlation falls the greater the drop in the volatility of the portfolio, i.e. the greater the diversification benefit.

Investors often fret about the lack of diversification opportunities in capital markets.  The sentiment is especially pronounced during equity market selloffs such as what we have experienced this year.

Investors have been often discouraged by the high correlations observed among investments in the same asset class.  For example, the early day (70’s and 80’s) arguments for increasing exposure to international equities hinged on the portfolio diversification benefits accruing from the low correlation between US and international stocks.

Sometimes expectations need to be re-adjusted. Unfortunately, as US investors increased their exposure to international investments and both US and foreign domiciled companies became more globally integrated the net result was a significant upward drift in correlations and a loss of diversification benefit.

The same story can be told about emerging market and even domestic small-cap investing.  Investors looking for significant divergent behavior among equity sub-asset classes have been generally disappointed.  Our latest estimates of the correlations of the S&P 500 to US Small Caps, International Stocks and Emerging Market Equity are all north of 0.7.

CORR TO US STOCKSThe long-term performance of these equity sub-asset classes will naturally gravitate towards their fundamental value, but over shorter holding periods the pull of the broad equity market factor will be unmistakable.  Style, market cap and sector membership are secondary to what happens to the broad equity market.  The market effect dominates.

The same applies within other asset classes.  For example, in fixed income markets the most significant pull comes from the interest rate on sovereign bonds.  Other factors such as credit are often secondary in explaining return movements. Again the market effect dominates especially over shorter holding periods

So where does that leave investors looking for a little zig when their portfolio zags? The answer is so simply and obvious but the message is often ignored.  Bonds, bonds and more bonds.  In recent times investors have shown a strong dislike for fixed income especially in light of the low prevailing interest rates.The same applies within other asset classes.  For example, in fixed income markets the most significant pull comes from the interest rate on sovereign bonds.  Other factors such as credit are often secondary in explaining return movements. Again the market effect dominates especially over shorter holding periods

From a prospective return perspective we agree, but, in our opinion, investors are forgetting about the diversification benefits of bonds.  Bonds (especially high quality) represent the most direct and least expensive form of portfolio risk reduction available in todays’ markets.

Our current estimates of the correlation of US stocks to high quality domestic and developed international debt markets are south of -0.3. Ok, correlations have been lower in the past, but they have also been higher. In fact the average correlation of US stocks and bonds over annual holding periods is indistinguishable from zero.

ROLL CORR STOCKS BONDS

Is it a free lunch?  No, not given the low interest rates on bonds today, but compared to the costs of using other forms of portfolio protection plain old bonds seem to offer the lowest opportunity cost with the lowest execution risk. The way we look at it is that the below normal yields are the premium you must pay to protect your portfolio.

Let’s look at a simple case using a portfolio composed 60% of the S&P 500 and 40% of the Barclays Aggregate. We are assuming that stocks have a volatility of 16% and bonds of 6% (these are currently our long-term normalized estimates).

The benefits depend on the volatility of stocks and bonds as well as their degree of co-movement. Historically, the correlation between stocks and bonds in the US has been about zero.  Under such a scenario, the 60/40 portfolio would have a volatility of 9.9%.

60 40 VOL

There have been long periods of time, however, when the correlation has actually been positive. Stocks and bonds moving in the same direction either up or down.  Let’s assume a modest correlation of 0.2. Under such a scenario the diversification benefits still accrue but at a lower rate.  The 60/40 mix now exhibits a volatility of 10.4%.

What happens when the correlation between US stocks and bonds is actually negative?  The simple answer is that the diversification benefits are significantly enhanced.  Let’s assume a correlation of -0.2.  This estimate is in line with our current estimate from our proprietary multi-asset class model.  Now the 60/40 portfolio has a volatility of 9.4%, a full point lower than the earlier case.

Why stop there? Let’s push the envelope and assume a stock/bond correlation of -0.6.  Quite dramatic for sure but not out-of-bounds from previous capital market experience.  Now the benefits are further enhanced with the portfolio exhibiting a volatility of 8.4%

The role of bonds should be seen from the perspective of the total package of benefits. Historically, the role of fixed income has been income generation, but in today’s environment investors should focus as well on the diversification benefits created by mixing bonds with equity-like assets.

Bonds (especially high quality) represent the most direct and least expensive form of portfolio risk reduction available in todays’ markets. Incorporating bonds into the mix will be especially important in risk on/off markets such as those we expect to prevail over the next few years.

Let us hope that the marriage between stocks and bonds which at times has been a bit awkward remains beneficial as we transition into a low capital market return environment.

Sincerely,

Eric J. Weigel

eweigel@gf-cap.com

Managing Partner and Founder of Global Focus Capital LLC

 

DISCLAIMER: NOTHING HEREIN SHALL BE CONSTRUED AS INVESTMENT ADVICE, A RECOMMENDATION OR SOLICITATION TO BUY OR SELL ANY SECURITY. PAST PERFORMANCE DOES NOT PREDICT OR GUARANTEE FUTURE SIMILAR RESULTS. SEEK THE ADVICE OF AN INVESTMENT MANAGER, LAWYER AND ACCOUNTANT BEFORE YOU INVEST. DON’T RELY ON ANYTHING HEREIN. DO YOUR OWN HOMEWORK. THIS IS FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSIDER THE INVESTMENT NEEDS OR SUITABILITY OF ANY INDIVIDUAL. THERE IS NO PROMISE TO CORRECT ANY ERRORS OR OMISSIONS OR NOTIFY THE READER OF ANY SUCH ERRORS

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