Where are the customers' yachts?

Inflation, taxes, management fees, and importantly, other fund expenses are the Four Horsemen that annihilate long-term investment returns. There is not much one may do as an individual investor about the first two issues except for careful planning and some portfolio choices, but certainly you should be able to manage the expenses of running your portfolio, shouldn’t you? This cost control should always be a top priority, but never before has it been as important as it is today. Financial repression keeps gnawing away at our savings and the fast repricing of the best risk assets following the fiscal and monetary responses to the pandemic, leads many strategists to believe that future returns on some asset classes may be lower than historical.

We recently met with the head of a non-for profit organization who was concerned about the investment returns of the endowment. The first thing we noticed is that following Markets in Financial Instruments Directive (MIFID) rules, their bankers were charging separately for asset selection 0.6% per year which added to the total expense ratio of the underlying funds resulted in a drag to their performance north of 2% per year. Thus, for the previous three years their advisors had kept 66% of the gross return of their conservative portfolio. Before you keep on reading, perhaps you should check how much you are paying for financial advice and management. Make sure that when looking at the Total Expense Ratio (TER) of your funds you are using the correct share class. Some share classes have lower fees as they do not pay a rebate to the financial advisor. MIFID requires that when the customer pays an advisory fee, her portfolio should consist of the lowest cost institutional share classes for all the underlying funds. We are afraid that this is rarely the case in spite of the clear rules. It is very likely that you will find out that you may have been contributing for years to somebody else’s early retirement and little to yours.

Why do private banking customers in the euro zone continue to pay high management fees for long-only strategies when academic research has shown for decades that at least 95% of these managers will not beat their benchmark after fees and expenses for any given time period? Imagine how difficult it is to know ex-ante which managers will be part of that small group of star performers for the next decade in a consistent fashion. Your own personal experience is probably fraught with misses on this front. Conversely, almost every single one of the 25 largest mutual funds in the US is an ultra-low cost Indexed Fund or an Exchange Traded Fund. This is likely the case because the magic of compound interest works both ways and US consumers are better informed. This education is largely thanks to the gargantuan proselytising effort of one outstanding citizen, John Bogle, the founder of Vanguard and the creator of the first indexed fund. The Vanguard 500 is today the largest mutual fund in the US with over $324 billion of assets under management. This fund’s total expense ratio is 0.04%. What Mr Bogle showed American investors is that the difference between paying 0.04% and 2% in fees and expenses over 30 years for a 7% gross return is quite dramatic. A €100,000 investment will grow to €652,734 at 6.96% but it will grow to just €332,194 at 4%. This is nearly 50% less money, your money.

Twenty years ago, we made the most crucial decision of our professional careers to date. We forsook a great career opportunity and a wonderful life in New York, and returned to a European Union that had recently adopted a common currency, albeit partially. What seemed like a great idea at the time has turned out to be a tragic mistake. We were of course much younger and more naive then, and as it turned out, illiterate in euro-speak. The language of the EU’s bureaucracy is hard and expensive to learn. It sounds shockingly similar to English, except that words often mean completely different things. Thus, when euro-crats insist on the extreme importance and urgency of building a single EU market for goods and services, they actually do not mean that at all. What they do mean is “we would really like to reach that goal as long as it does not interfere with the cosy arrangements of entrenched incumbent companies that need time to adapt to changes”.

This is especially true in financial services, an area where some national privileges remained mostly unchallenged then. Member countries do retain sovereignty on fiscal matters and may as well set other obstructive wanton national regulations on the retail distribution of financial products. For reasons that are hard to understand, many national regulators favoured the interests of national champions in financial services over those of consumers. This state of affairs remains largely the case today. As a result, the asset management industry lacks economies of scale in many member states. Hence, investors continue to get fleeced in order to support inefficient distribution cost structures with their hard-earned money. Perhaps not surprisingly, twenty years on, this is still the case in spite of various additions to MIFID which only tangible result so far is to reduce customer choice. The EU’s market for financial products and services remains opaque, inefficient, and largely constrained to national borders. Consumer education remains an ongoing project as well. Our big idea twenty years ago was to offer mass-affluent investors the same financial products that large US institutions were using to manage their endowments. The time has come to revisit this idea, especially because investors today can no longer afford to pay management fees and other fund expenses that are well above the rate of inflation while yields in euros are below 0% out to 50-year tenors. There seems to be no possible justification for investing in euro area investment grade fixed income funds today because it is unreasonable to expect further capital gains from the current levels of rates or credit spreads. While capital gains have masked the high expense ratios of many funds for years, we probably have come to the end of that road. This new challenge would require enormous mental fortitude from financial advisors as the best advice might be to hold higher cash balances waiting for better entry points for stocks and bonds.

Quite on the contrary, when faced with such constraints, investment advisors and managers will offer new “enhanced” credit investment products. Collateralized Debt or Loan Obligations enhance returns with the use of leverage. If CDOs or CLOs sound familiar to you, it is because of the central role they played in the US subprime mortgage crisis of 2007. How soon we forget! Direct lending is a very popular strategy today whereby investors gain access to highly illiquid corporate loans underwritten by their clever fund managers, thus disintermediating commercial banks. It is interesting to observe that while banks’ management teams complain of the great difficulty they encounter in finding demand for loans from creditworthy clients; these much smaller organizations do not seem to share such concerns. Unfortunately, the pandemic[contexto id=»460724″] may turn out to be an insurmountable problem for many of the companies in their portfolios and thus for their investors who will only then discover what illiquid means.

We face three distinct scenarios. Firstly, should current monetary policy succeed in reflating the economy, corporate bond prices will suffer as the yield and spread curves should experiment an upwards shift as ECB intervention diminishes. Conversely, should the current expansionary fiscal and monetary stimuli fail to deliver results; there will be very likely significant credit losses as the economy falters and unemployment remains high. Moreover, the third case, a muddle through scenario, is different from that of previous years because as we mentioned earlier the entire euro curve out to 50-year tenors today has negative yields.

A new approach to portfolio construction would appear more reasonable before the customers demand it, or worse yet, leave their advisors for greener pastures. We suggest a focus on the TER of the entire portfolio. Low cost indexed funds are an important cost reduction tool (low cost Beta). On the other hand, higher fees may be justified for higher value added products in alternative asset classes (unconstrained Alpha). The financial literature on passive vs actively managed funds’ long-term returns unequivocally favours indexing for liquid strategies, and in spite of current thinking, a number of alternative managers in liquid strategies have been able to generate excess returns for long periods.

Indexing is very different from factor investing. The latter is a popular and growing trend. At the end of the day, it is very much like active management under a different guise. The publication of Fama & French’s “Three Factor Model” in 1993 opened the floodgates of seeking alpha by favouring value vs growth or smaller capitalization stocks over larger capitalization stocks, the two factors explaining investment returns that they studied in their seminal paper. Unfortunately, alpha generation was not that simple.

Indeed, the ensuing rush to value seems to have been ill timed, or as is more likely the case, the publication of the study itself modified the conditions of the professors’ experiment. Since 1993, the compound return with dividends reinvested in the index for the Russell 2000, a proxy for small capitalization stocks, is 9.0%. While the Russell Value 1000 has returned 9.4% vs 9.2% for the Russell 1000 Growth, the S&P500 has returned 9.7%, the NASDAQ 10.7%, and the Nasdaq 100, our chosen proxy for a large capitalization growth stocks, has returned 13.0%. In addition, there is very little dispersion among the risk-adjusted returns of these strategies.

Currently, there is a rush to invest in funds that are compliant with loosely defined Environmental, Social, and Corporate Governance (ESG) factors. Who wouldn’t want to invest in such companies in principle? However, we should be wary to use these factors as the sole guiding principle of portfolio constructions as one could end up being ensnared in “greenwashing”. Additionally, many of these companies will suffer greatly in a higher interest rate environment. We believe that most rear-view mirror investment strategies will prove self-defeating, as any information content will be arbitraged away as was the case with other factors in the past.

Investing successfully requires making predictions based on the available information and assigning probabilities to likely scenarios. Undoubtedly, “it’s difficult to make predictions, especially about the future”. Indexing takes the guesswork out of the equation. Some people believe that what may be good for investors may be bad for society because indexing does not allocate capital properly, we do not share this view.

An investment strategy where one minimizes costs on the exposure to liquid markets and pays higher fees only for high value added investment strategies will very likely result in higher returns for both customers, and in some cases for their advisors of performance is good, and thus lower customer attrition rates. The focus should change from annual revenues to lifetime revenues. While private bankers may be required to have more skin in the game by accepting to trade fixed management fees for performance fees, their overall career revenues could be larger. Needless, to say that liquidity will remain a key constraint for private clients’ portfolios.

Thus, in spite of the current popularity of illiquid alternative strategies, liquid strategies should very likely play a much bigger role in meeting customers’ investment objectives because experience suggests that customers change their minds more often than they would admit to in a MIFID questionnaire. Most self-defined investors for the long term have difficulties staying the course during market down drafts. A good financial advisor should know this and plan accordingly. Overall, this approach sets the stage for having the option to gain significant market share, as the value proposition is far superior to current industry practices. This is predicated on the observation that “you can fool all the people some of the time and some of the people all the time, but you cannot fool all the people all the time”. In the interim, and until such time as investors react to protect their assets from confiscatory fees, most will not be able to meet their financial targets for retirement, nor will they be able to buy the yacht.