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

What’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)

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.

If you would like to read our full report please fill out the information below and hit the Send button

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

Should Inflationary Expectations Be So Sticky?

Capital markets have brought lots of surprises this year. Two developments especially – recovering commodity markets and a falling US dollar – have important implications for future consumer prices.

Capital market participants do not seem overly sensitive to these two developments in terms of expectations of future inflation. Commodity prices are for the most part an “input” into the type of goods and services consumed. The US dollar on the other hand acts as a translator of value between goods produced abroad and domestic consumers.

Recent consumer price changes have been muted in the last few years. Monetary authorities in the US as well as abroad seem particularly troubled by the prospect of deflation and have in some cases even resorted to the use of negative policy rates to revive growth.

The April 14 BLS Report on the CPI-U estimates year-over-year inflation at just 0.9%. This number is welcome news after near zero inflation for most of 2015, but still lags the historical norm of 3% annual inflation by a wide margin.

A quick glance at the latest report provides interesting clues. Two of the four main categories of consumption categories – Food, Energy, Commodities Less Food & Energy, and Services – exhibit price depreciation over the last year.

The biggest deflationary force has been the Energy category with a 12.6% price drop. The other deflationary category is Commodities Less Food & Energy with a -0.4% year-over-year price change.

Federal Reserve members seem concerned with the possibility of deflation in the US, but what about market participants? We evaluate two measures – the breakeven rates from TIP prices measuring the expected inflation over the next 5 years (orange line) and the so called 5-over-5 rates measuring inflation expectations five years from now over the next five years (green line). To provide context we also illustrate the rolling year-over-year CPI-U inflation.

Capital market participants are expecting an uptick to inflation, but in light of this year’s commodity price increases and the depreciation of the US dollar do these expectations need to be revised? Yes, the market implied inflationary expectations seem low in relation to the resurgence in commodity prices and the depreciation of the US dollar.

Where do we see inflationary expectations heading to? Our research based on our econometric model of 5 year inflationary expectations calls for steady but moderate upward revisions.

The latest market-based estimate of 1.61% is expected according to our model to rise to 1.7% by the end of Q2 and to 1.9% by the end of the year.

We are not expecting a huge bump up yet in inflationary expectations in large part due to the fact that rising commodity prices and a depreciating USD have only been in place for a short period of time.

Many strategists are still skeptical that these two trends have legs. Our view is that even if there is no further change for the remainder of the year inflationary expectations have been too low and will slowly drift up.

What are the implications for investors of slowly rising inflationary expectations? For now the more direct impact for investors of rising commodity prices and a falling US dollar is being felt through the rise of previously unloved sectors such as Energy and Materials as well as the revival of Emerging Market Equities.

The transmission mechanism from higher commodity prices and changes in the value of the US dollar to actual inflation pressures is not immediate of for that manner always straightforward as many other forces such as demographics and the overall health of the global economy come to bear.

Rising inflationary expectations would according to our risk management methodology benefit holders of risky assets such as equities, commodities and real estate. Safer assets such as bonds would suffer as we would expect higher inflationary expectations to translate to higher nominal interest rates. The effect would obviously be greater the longer the duration of the assets.

Click here to download the report: Should Inflationary Expectations Be So Sticky

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

Feeling a Bit Deflated This Year?

With the rough start to 2016 most investors are feeling a bit deflated. Not only are most asset classes in the red but now there is even talk about the dreaded D word – Deflation.

In this report we look at deflationary conditions around the globe and the likelihood that such forces persist over the foreseeable future.

We share our thoughts on the issue of negative short-term interest rates and the ability of monetary policy to spur growth to levels more consistent with the potential productive capacity of the global economy.

Finally we assess the implications for key asset classes in the face of changing inflation expectations.

Some of our report conclusions:

The specter of deflation is already present in countries such as Greece and Switzerland and is not far off in a large number of other economies particularly those in Continental Europe
Over the last ten years no country in our sample has experienced a negative annualized inflation rate but Switzerland (0.25%) and Japan (0.31%) have come close
When using the Output-Gap to measure the divergence between current and potential levels of production, global growth has been disappointing for seven straight years
Despite massive monetary stimulus, the negative global Output-Gap of the last seven years highlights that impediments to global growth are likely to be structural in nature
Using negative policy rates are unlikely to sufficiently boost global growth and most likely will bring about an increase in investor uncertainty
Equity oriented asset classes would dis-proportionally benefit from an increase in inflationary expectations while high quality bonds would suffer
According to our macro risk factor model, the primary beneficiary of rising inflationary expectations would be at the moment Emerging Market Equities

Click here to download the report: “Being Back That Old Inflation Please”

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

Tag Archives: inflation

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