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Stingy Investor Tip Sheet


I had the pleasure of talking to the Ryerson Investment Club today. You can flip through my overhead slides via the following link.

Practical Portfolio Construction

The first part of my talk focused on fees, taxes, and other things that tend to lower investment returns. I presented very similar arguments in Unwanted Partners. But in today's talk I went a step further. Slide 9 shows the downside of high fees, high taxes, inflation, and bad timing.

I briefly quote several bad timing studies on slide 8. The numbers change from study to study, and they depend on the time period in question, but poor timing drags down returns by roughly 3 percentage points a year for many fund investors. Unfortunately, that includes index fund investors.

For instance, currently reports that the Vanguard Total Stock Market Index Fund (which sports a low annual fee of 0.15%) provided annual returns of -2.67% over the last 10 years through to the end of February 2009. But investors in the fund earned -7.91% a year over the same period. That is, investors trailed the fund's quoted performance by 5.24 percentage points a year. That's a stupendously high level of underperformance.

Essentially, investors trailed the index fund by buying high and selling low. They piled in on the way up and invested more money near the top. On the other hand, the fund's raw (or time-weighted) performance figures assume that the entire investment was made at the start of the period under observation.

The timing problem is huge but I'm not sure there are any easy solutions. After all, prices become dear when everyone wants to buy and then they collapse when everyone wants to sell. It's a feature of the markets. Of course, a few investors can avoid timing drag but not all of them.

On Performance Fees

I also encountered a nice investor who pays their broker a performance based fee. The arrangement was quite rich. They pay nothing if annual returns fall below 5% but they pay 50% of any gains above 5%.

To put this into context, let's look at applying a similar fee arrangement to the returns on the S&P/TSX Composite index. The S&P/TSX Composite provided average annual returns of 10.5% from 1970 to 2008 and grew a $1,000 initial investment into $29,780. But if you apply a fee of 50% of gains over 5%, then your after-fee return would be 5.5% annually and a $1,000 investment would only grow to $5,880.

The fee arrangement is a great deal for the advisor but it doesn't look like a good one for the investor. It also appears to conform to the cynical old saying that the stock market is a place where people with experience get the money and people with money get the experience.

03/11/2009   8:30 PM EST   Permlink   save & shareMarkets

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