The end of kickbacks

“Perverse kickback is history” and articles of similar gist have hit the Dutch popular press in abundance over the past weeks. A result of the statement by Jan Kees de Jager, the Dutch Finance Minister, that he was going to prohibit kickback schemes in the near future. As you can understand, we were amongst those who applauded the announcement and almost suspected Mr De Jager was quoting from the “Investment Illusion” when he sensibly stated that kickbacks are not a very good way of incentivizing banks to give objective advice to their clients.

In the wake of his announcement journalists have increased their scrutiny of investment costs and general opinion seems, temporarily at least, to be swayed by 30 years of academic research: namely that controlling costs is vital to long-term investment success.

The hope is that abolishing kickbacks will not only lead to greater objectivity, but also to lower investment costs and therefore better returns for investors. From experience in other countries we have unfortunately learned that bonus hungry managers and private banking shareholders will find other ways to compensate for the lost revenue from kickbacks. Given their cost base, they have no other choice. However, abolishing kickbacks is a very positive step to at the very least making costs more transparent.

We have extensively described the importance of investment costs in chapter 2.2. of ‘The Investment Illusion’. Given that it is a ‘hot topic’ today, we thought it could be helpful to recap some of those points for you in this letter.

1. “Expense ratios are the best predictors of performance.” – Russel Kinnel, Morningstar’s director of fund research.

Morningstar, the leading provider of research on investment funds, conducted a study based on data over the 10 year period until 2005, to determine the importance of cost for funds in eight different asset classes. The funds were grouped into four equal batches based on their Total Expense Ratio (TER) and the performance of these quartiles was subsequently analyzed. The results showed that the cost ranking was mirrored exactly by the performance ranking. In other words, the funds with the lowest TER had the best net performance, the funds with the 2nd lowest TER were the 2nd best performers etc. all the way down the bottom quartile performers, which ‘boasted’ the highest TER. Every single asset class showed the same result. The probability of this result randomly occurring in eight different categories is less than 1 in a billion.

This is only one example out of a multitude of studies, including one from the Dutch association of stock owners (VEB), and they all draw the same conclusion: investment costs are the only reliable predictor of future performance of investment funds. Even so, the notion that costs are irrelevant and (historic) performance is what counts, is a very persistent illusion held by investors from all walks of life.

2. “We estimate trading costs for a large sample of equity funds and find that they are comparable in magnitude to the expense ratio.” – UK Financial Service Authority and an academic study by Edelen, Evans and Kadlec.

Fund investors generally look only at the TER. Although it does include both the management fees and operational cost of the fund, it leaves out others such as the trading costs. Trading costs are generally not disclosed, but are estimated to be similar to the TER of the average fund. Another way to estimate transaction costs is to multiply the turnover of the fund by 0.8%. As an example, an average active fund has a turnover of 100% (it replaces 100% of the stocks in its portfolio by 100% new ones) and therefore transaction costs can be estimated to be 0.8% per year.

Wise investors should therefore look at the Total Cost of Investing (“TCI”), which does include trading costs, when determining the attractiveness of an investment. For an individual investor the TCI of the cheapest index alternative in Europe is currently around 1%, but (according to the VEB) could increase to around 8% annually for an actively managed fund.

3. “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.” – Nobel Laureate, William Sharpe.

The logic behind this statement is simple and it explains the results of point 1: the 50,000 or so mutual funds in the world hold the majority of all public stocks. In other words, they hold the market. Passively managed (index) funds, are a subset of the fund universe that by definition hold the market portfolio. It follows that all the other funds, the active ones, must together also hold the market portfolio. It also follows that both types of funds, must on average achieve the market return before costs.

Costs incurred and charged by actively managed funds are around 2.5% higher than those of passive funds. Because active and passive returns are equal before cost, simple logic dictates that the average actively managed fund must underperform the average passively managed fund by around 2.5% annually.

Notice that costs are the key driver here, not passive or active management. We are not against actively managed funds on principle, we just don’t like costs. However, ‘active’ funds that have their costs under control and keep portfolio turnover low can be a good addition to passively managed funds. Especially if they are disciplined in their investment execution and have a strong focus on risk management.

We also have nothing against funds in general. On the contrary! Funds are a great tool to provide an institutionally managed, diversified, low cost investment solution to individual investors.

Unfortunately funds are getting a bad reputation, as they are often used by the industry as a profit-generating tool to overcharge investors for the illusion of outperformance. Here is hoping that Finance Minister de Jager’s initiative will give funds back some credibility and that he is not deterred by the objections of the industry.

Warm regards, and lots of investment peace of mind,

Marius and Jolmer