02 Nov 2018 Investment Efficiency
Efficiency measures what is produced against the inputs required to produce it. Efficiency is generally reduced by some form of drag, such as friction, cost, energy, or time, but there can be great reward in improving efficiency.
An investment portfolio produces greater wealth as the friction of expenses, taxes, and under-performance relative to markets are reduced. While the most efficient way to achieve the returns of a particular market is to own that market. The most practical way of doing that is through the use of an Exchange Traded Fund or ETF. We use the VTI offered by Vanguard to efficiently position our clients’ portfolios in the total US stock market. It is one of the most efficient ETFs available at only a nickel for every $100. But Vanguard is able to offset much of that expense through various techniques employed by its managers making the fund nearly free to own. What is an ETF?
Practically speaking, (without a crystal ball to achieve perfect timing) if you wanted to efficiently capture the returns of the US stock market over the next 10, 20, 30 or 40 years you would invest a lump sum estimated to achieve your goal and you would not touch it or add another penny to it until it was time to begin drawing on it. Why not touch it or add to it? The stock market is volatile and volatility becomes a drag when adding or removing money from a portfolio. Higher volatility increases the probability that you will buy or sell at the wrong times, which have the effect of reducing your overall returns relative to the returns of portfolio left alone.
But who can leave an account untouched for ten, let alone 40 years? Those saving for the future routinely add to their 401Ks, Roths, or other investment accounts to build wealth for future needs, like houses, college, and retirement. Those in retirement typically draw from their investments. In the latter case, the impact of market declines can be more acutely felt as they clearly see their nest egg depleting faster. But the saver might think, ‘well if we continue adding to our portfolio, the value will come back all the sooner.’ In fact, however, the inefficiency of volatility impacts both savers and spenders.
A young man or woman starting an investment program consisting of 100% stocks at age 25, investing a thousand a month (increasing each year with salary increases of 3%) for the next 40 years would amass a portfolio worth $6.2 million in today’s dollars calculated on a straight-line basis. But markets don’t go up in a straight line – they fluctuate. In fact, using Monte Carlo probability analysis, which takes into account the volatility of stocks, our investor would have a portfolio worth only $2.7 million at at age 65, at the 80% percentile. Volatility reduces efficiency for savers, just as it does for spenders.
On the other hand, if our young investor started with $245,000 today, he or she would not have to add another penny to it for the next 40 years to have the same $6.2 million (adjusted for stock market volatility at 80% confidence). While there are not a lot of 25 year-olds plopping $250,000 into the stock market today for a retirement 40 years from now, its important to highlight, speaking in terms of efficiency, that they could avoid all those monthly contributions into their 401ks to use for other purposes – $230,000 worth of other purposes. The sooner money is invested, the longer the power of compounding your wealth can work for you.
There has been a growing trend in the last decade or more of investors turning to what is known as index- or passive-investing. Through the use of ETFs or mutual funds, investors seek to mirror the returns of broad markets, sectors of the market, industries, or some other categorization. The alternative form of investing, is known as active management, whereby investors seek to outperform market index or benchmark returns. These investment vehicles concentrate or ‘weight’ their investments in certain industries and sectors in hopes of outperforming their benchmark or index, but over longer periods of time, like saving for retirement they fall short, depriving their investors of better market returns. Most under-perform their respective indexes over even ten year periods. That’s an inefficiency you can avoid by owning a cheap index fund or ETF that will closely match its market.
A group called Dalbar conducts a 30-year study every year of stock and bond mutual fund investors and the results are remarkable both in what they reveal about our emotional inefficiency in investing and its cost. “No matter what the state of the mutual fund industry, boom or bust: Investment results are more dependent on investor behavior than on fund performance. Mutual fund investors who hold on to their investments are more successful than those who try to time the market” according to Dalbar. The S&P 500 index averaged 10.16% for the last 30 years ended 12/31/2017, while the average investor in equity mutual funds, averaged 3.98%. The substantial and sad difference due mostly to their buying and selling behavior being driven primarily by their emotions. Emotions are a huge drag on investing efficiency, but with a sound planning and investment process, that drag can effectively be eliminated.
Tax and Expense Efficiency
When investments in taxable accounts are sold, particularly toward the aim of beating markets, wealth is eroded as gains are taxed. Morningstar, the leading reporter and analyzer of mutual funds, provides investors with an after-tax return on funds they hold in taxable accounts. Some of the more popular funds generate taxes sufficient to reduce their returns by as much as 1% or more. Mutual funds are required to report to the IRS all gains they realized throughout the year. These gains generate tax bills, known as ‘phantom income’ for their investors, even if they didn’t sell a share.
ETFs do not suffer phantom taxable income like mutual funds do making them far more tax-efficient for investors in taxable accounts. But most taxable investors have not benefited from this new tax-efficient vehicle because their managers trade ETFs just like any other stocks. Active managers use many ETFs and funds in the construction of their portfolios to enable them to ‘weight’ or concentrate positions (like those in the figure below) to better market returns. The cost is a drag on efficiency as it generates taxes when they are sold to move to the next strategy.
If your aim is to efficiently model the US Stock market, without weighting as mentioned before, you could efficiently do so with the Vanguard Total Market ETF, symbol VTI. It contains all the sectors of the US economy; like basic materials, financials, health care, etc. Wall Street loves to show these as pie slices in colorful charts that do little more than increase complexity, costs and reduce efficiency. You don’t have to own a bunch of (more expensive) sector ETFs to replicate the US market. There all in the VTI.
Bringing it all together, we have designed our portfolios to excel in all areas of efficiency. They are designed to reduce volatility to generate more wealth over time and to make our clients more comfortable during the inevitable economic storms that come along. Our Treasury holding generally bounce when stocks fall, keeping the total portfolio more stable. International stocks, denominated in non-US dollars offset the long-term decline in spending power of the dollar, preserving your purchasing power for imported goods. What’s more, our portfolios are designed to provide the maximum return for a given amount of risk, making them efficient in the esoteric realm of modern portfolio theory.
Investing efficiently is about as exciting as watching grass grow, if you are not aware of the substantial benefits it offers to your lifestyle or if you don’t mind making others rich at your expense. We can show you how even small improvements in investment efficiency can compound your wealth measured in thousands, hundreds of thousands, even millions of dollars.