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The Reality of Frictional Costs and the Clash of Cultures

October 14, 2013 | About:
I was referred to Jack Bogle’s novel, “The Clash of the Cultures, Investment Vs. Speculation,”through a Berkshire chairman letter a few weeks ago and decided to pick a copy up from the public library. In the book, Bogle talks about the importance of mitigating frictional costs (management fees, brokerage fees and taxes) during the investment process. He also goes into great detail about the toxic culture that has been created through the conflicts of interest between hedge fund managers, corporate executives, analysts, salesmen and mutual fund, pension and endowment managers. Much of the book is based on an indexing approach, focused on the long-term value creation of businesses as well as the ethics and fiduciary duty an agent has to the client(s) to act in his/her best interest.

This is sadly not the case in today’s speculative frenzy of exotic derivatives, high frequency trading, short-term focused managers incentivized by assets under management (AUM), day traders, market timing strategies, actively managed funds and any other speculative “bets” you may think of. As elegantly stated in 1776 by Adam Smith, “Managers of other people’s money rarely watch over it with the same anxious vigilance with which… they watch over their own.”

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The present day industry is built on the cornerstone of marketing, not stewardship, collecting assets, not adequately deploying other people’s capital. How can one tell which fund or manager will outperform in the future? If we could accurately tell, wouldn’t we all be identifying the next Berkshire or Fairfax? Morningstar implemented a new rating system in 2011 using “The 5 Ps” as criteria when selecting a manager.

People: Thinking about the advantages the manager or team brings to the table in terms of differentiation, experience, demonstrated skill, expertise and how much the manager(s) has invested in the fund.

Process: Is the manager doing something unique or doing what anyone could replicate? (Mirror funds I believe they are called.)

Parent: Manager turnover at the firm, the culture, the quality of research, directors, SEC litigation or sanctions, and ethics.

Performance: Thepast performance of the current manager: the longer the record the better. What is the strategy and holdings of the fund and how did they perform during different periods, how consistent are the returns and what is the risk profile?

Price: The fund's expense relative to the asset size, peer group expense comparison and overall trading costs.

I do not hold mutual funds, ETFs or index funds as I find the entire investment process very enjoyable and exhilarating. When I am looking at businesses that involve investing in marketable securities I do examine the concentration, strategy and turnover of the portfolio with the most scrutiny. The difference between 1% to 2% annually, compounded over a lifetime, can be truly eye opening and astounding. Using the term of 30 years and a present value of $100,000 we will see the beneficial effects of no-load funds, low portfolio turnover and low management fees.

At 8% (with higher expenses): $100,000(1.08)^30 = $1,006,265

At 10% (index approach): $100,000(1.10)^30 = $1,744,940

A staggering difference of $738,675 or 73.4% more by mitigating controllable costs. Now imagine 8% reduced by 35% to 5.2% if you decide to trigger taxes annually instead of once every 30 years. You would have $1,134,211 in the latter scenario and only $457,585 in the first scenario of annual tax triggers. These differences used for illustration purposes essentially sum up the difference between annually changing your mutual fund investments versus a long-term indexing approach. Simply stated, taxes and fees shouldn’t be given the cold shoulder.

Here Are Jack Bogle’s 9 Simple Rules for Investment Success:

1) Remember Reversion to the Mean

This rule is based on the philosophy of “what can’t go up forever, wont” and “what goes up, must come down.” Analyzing long-term winners in the mutual fund business like the Legg Mason Value Trust Fund or the Fidelity Magellan Fund show that under closer scrutiny both actually underperformed the market over a 30-year stretch (1982 to 2012) and the hype of these well-known funds come from short-term sporadic performance that has since fizzled out.

If you hold mutual funds, read the prospectus. RTM can be simply visualized by a pendulum that is moving from optimistic valuations to pessimistic valuations and back again. What is earned in market returns in excess of what the underlying businesses actually earns will simply be borrowed from the future, based on optimistic speculation from the present. Eating your dessert before your dinner is fine and dandy, until those cooked carrots need to me muscled down.

2) Time Is Your Friend, Impulse Is Your Enemy

[/b]As briefly outlined above there is large differences between annual capital gains tax triggers and once-in-a- generation tax triggers. Do the math yourself and research the correlation between net fund returns and the turnover of fund holdings; my bet would be the relationship is an inverse one, meaning the lower the portfolio turnover the higher net returns. I also remember reading an article or comment on GuruFocus relating to how often Buffett or other concentrated value investors turn their portfolios. Again, I have no empirical evidence but my guess would be that most successful ones have a turnover rate under 25% and some may have turnover as low as 5% to 15%.

[b]3) Buy Right and Hold Tight


Relating to portfolio allocation, John Bogle and I seem to have similar views. When it comes to risk profiles and fixed income concentration, age should be a large factor. The easiest heuristic to remember would be 100 – (Your Age) = Equity Exposure. Personally, I like to take the sum and multiply it by 1.1 as I have a strong stomach for volatility, increasing my exposure to equities. Relating to the equity exposure portion it is up to each individual investor's preference to dictate what the holdings should consist of based on personal risk profiles.

4) Have Realistic ExpectationsIn the book an elaborate metaphor is used comparing an "Investment Bagel" to a “Speculative Donut." The Bagel is nutritious and represents the dividend yield plus the earnings growth. The donut is sugary and it tastes great but is terrible for you repetitively in the long run. Having realistic expectations will help thwart the inclination to speculate for larger returns and keep you satisfied with returns in excess of a few hundred basis points of the S&P 500 (or another preferred benchmark). Remember the power of compound interest: A few percent can and will make all the difference. “In the short-term the market is a voting machine, in the long-run it is a weighing machine.”

5) Forget the Needle, Buy the HaystackI do not entirely agree with this statement but for the people who do not have the time nor the inclination to research and “turn rocks,” indexing is the best alternative. Because (as most people that understand math would agree) everyone that is involved in the market is the market, proactively and reactively placing bets on new information received that represents each individual's perception of the probability of outcomes that may occur. Because we are the market, at least 50% of the participants must underperform the market. If you do not believe you have the correct psyche, skill or amount of time it takes to outperform the market (over a lifetime average), it may be best to index your returns using low-cost approaches. As Munger once said, the market in a (very) simplified state, is a parlay horse track, actively adjusting spreads based on participants' expectations of the outcomes.

6) Minimize the Croupier’s Take

This cannot be stressed enough! If you understand the effects of compound interest, even 0.50% over a lifetime can make a noticeable difference. You need to be proactive in reducing management’s take, the government's take and the broker's take of your hard-earned dollars. No-load funds with low annual turnover and a low MER are a great place to start. It is absolutely ridiculous that expenses attributed to marketing can be eliminated from an investor’s net return. The sole purpose of marketing funds and institutions is to increase AUM or the fees that the portfolio managers can collect and is in no way beneficial to an individual shareholder who is subsidizing this service. (One could argue it is actually harmful due to the law of large numbers.)

Whatever happened to fiduciary duty and stewardship or am I just a naïve young kid? Agents must act in the best interest of the client and should only be given one chance. We are dealing with people’s life-long earnings here: Show some respect. Keep an eye on those fees and do all you can to minimize taxes. “The best holding period is forever.”

7) There’s No Escaping Risk

A capital markets line sums up this statement and with greater reward comes greater risk. This is not always the case (as measured by risk adjusted returns) but it is a general rule of thumb. Embrace risk but only to the point where you are still comfortable sleeping at night. If this is not the case "sell down" or change your portfolio exposure to a more comfortable level.

8) Beware of Fighting the Last War

Fighting the last war is related to the bias the immediate past casts on our perception. A brief example of this is how skittish investors are to the thought of a large-scale decline in the market similar to 2008 through 2009 or over-valuation of the late '90s. We fear events after they have happened, essentially driving with the rear view mirror. Yikes!

9) The Hedgehog Bests the FoxThe Greek poet Archilochus once said, “The fox knows many things but the hedgehog knows one thing.” The fox, that is sly and astute, represents the institutional investors of today, that know (or believe they know) about the complex market and strategies that will outperform. While the hedgehog, which curls into a ball with an almost impenetrable spine, knows only one thing: Long-term investment success is built on the cornerstone of simplicity. The simplicity is known to be the magic of compounding returns and low frictional costs, keeping costs to a minimum, while efficiently allocating capital.

“Compound interest is the eighth wonder of the world. Those who understand it, earn it. Those who do not, pay it.”

About the author:

Tannor Pilatzke
I am a self taught investor through Warren Buffett, Charlie Munger, Ben Graham, Peter Lynch, Joel Greenblatt, David Einhorn, Seth Klarman, Howard Marks, Phillip Fisher and Thornton O'Glove. My focus is a bottoms up Value-GARP strategy with a mix of top down contrarianism.

"When you find yourself on the side of the majority, it is time to pause and reflect." - Mark Twain

Visit Tannor Pilatzke's Website


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Comments

TannorP
TannorP premium member - 8 months ago

How to Minimize Investment Returns (From Warren Buffett) 

It’s been an easy matter for Berkshire and other owners of American equities to prosper over the years. Between December 31, 1899 and December 31, 1999, to give a really long-term example, the Dow rose from 66 to 11,497. (Guess what annual growth rate is required to produce this result; the surprising answer is at the end of this section.) This huge rise came about for a simple reason: Over the century American businesses did extraordinarily well and investors rode the wave of their prosperity. Businesses continue to do well. But now shareholders, through a series of self-inflicted wounds, are in a major way cutting the returns they will realize from their investments.The explanation of how this is happening begins with a fundamental truth: With unimportant exceptions, such as bankruptcies in which some of a company’s losses are borne by creditors, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all investors feel richer when stocks soar. But an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves.Indeed, owners must earn less than their businesses earn because of “frictional” costs. And that’s my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.To understand how this toll has ballooned, imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks. After paying taxes on dividends, this family – generation after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 billion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefit. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of American business minus commissions paid. The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on.After a while, most of the family members realize that they are not doing so well at this new “beat- my-brother” game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the managers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers.The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s finances have taken a turn for the worse. The solution? More help, of course.It arrives in the form of financial planners and institutional consultants, who weigh in to advise the Gotrocks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them.The Gotrocks, now supporting three classes of expensive Helpers, find that their results get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, managers, consultants – are not sufficiently motivated and are simply going through the motions. “What,” the new Helpers ask, “can you expect from such a bunch of zombies?”The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self- confidence, the hyper-Helpers assert that huge contingent payments – in addition to stiff fixed fees – are what each family member must fork over in order to really outmaneuver his relatives.The more observant members of the family see that some of the hyper-Helpers are really just manager-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-important, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family decides to pay up.And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling army of Helpers. Particularly expensive is the recent pandemic of profit arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fixed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked).A sufficient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks. Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac’s talents didn’t extend to investing: He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men.” If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases. 

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