Clients of O’Brien Greene have the advantage of owning their investments through separately managed accounts, which may be the best way to invest over the long term. Let me explain.
In his 2011 letter to shareholders of Berkshire Hathaway, Warren Buffett defined “investing” as follows:
the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future.
Buffett’s definition came to mind as I read John Authers’ recent column in the Financial Times (registration required), which reports on a recent study about the relative importance of diversification versus fees in investing for the long-term — from 1973 to 2013, that is. The study, which was conducted by the well-regarded money manager Mebane Faber, shows that a variety of different asset allocation strategies have strikingly similar results. Faber looked at a number of celebrated investors’ diversification approaches, including:
- A classic 60/40 U.S. stock and bond portfolio;
- A 60/40 portfolio including international stocks and bonds;
- Mohammed El-Erian’s portfolio of 51% in various classes of stocks, 17% in bonds, and the rest in index-linked bonds, commodities and real estate;
- Harry Browne’s portfolio of 25% allocations split between stocks, bonds, treasury bills and gold;
- Ray Dalio’s portfolio of 30% stocks, 15% 10-year U.S. Treasuries, 40% 30-year U.S. Treasuries, and 16% commodities (mostly gold);
- Rob Arnott’s portfolio of 20% stocks, 20% corporate bonds, 30% government bonds, 10% inflation-linked bonds, and 10% each in commodities and real estate;
- Marc Faber’s portfolio of 25 % in stocks, bonds, gold and real estate.
Except for Browne’s very conservative portfolio, which delivered notably lower returns over the period (but with the benefit of much lower volatility), all the other strategies produced annual returns that were within one percentage point of each other. The conclusion, Authers suggests, is that it’s more important to pay reasonable fees for implementing any one among a range of reasonable investment strategies than it is to pick the optimal strategy.
So far, so good. Authers is right that the compounding effects of high fees can be debilitating to an investment portfolio. It is therefore astonishing to me that so many wealth managers can get away with charging their clients 1% of their assets annually to put them in mutual funds, which in turn charge a further 1% or so. A 2%+ annual drag on investment performance gets hidden when the stock market goes up more than 30%, as it did in 2013, but it is glaring when market returns are negative or flat, as they were during the “lost decade” for large-cap stocks after the internet bubble.
Nevertheless, Authers’ take on Faber’s study is incomplete. Although his inference about fees is valid, he might just as well drawn other important conclusions, and one of which I wish to highlight is about the importance of the vehicle that an investor uses to access his investments. Authers’ discussion neglects this key aspect of investing, which is emphasized implicitly in Buffett’s definition that I quoted at the outset: investing is the reasoned expectation of getting more purchasing power after taxes have been paid on nominal gains.
Faber’s study does not take into account the differing tax efficiency of the various investment vehicles required to take advantage of different asset allocation strategies. Although most of the strategies he considers produced similar results in theory, in practice the strategies would require using different investment vehicles, and some of these vehicles are more or less efficient than others, to such a degree that the choice of an inefficient investment vehicle can have just as detrimental an impact on performance as high fees.
By “investment vehicles,” I mean mutual funds, hedge funds, exchange-traded funds, separately managed accounts, unified managed accounts, and so on. These vehicles are the financial instruments that investors can use to access the stocks, bonds, etc. that are the stores and engines of purchasing power where real investing value resides.
For example, Apple, Inc. (AAPL) has been an enviable store and engine of value, due to the superior phones, tablets and computers that it makes, the market-share it commands, the profit margins it maintains, and brand image it has cultivated. As an investor, you can trade the purchasing power of your money now for stock that gives you an ownership stake in Apple, with the reasoned expectation that in the future that stake in Apple will command more purchasing power than your cash would if you were just to hold on to it.
But how should you access that ownership stake in Apple? Mutual funds, hedge funds, ETFs, etc. all offer access to the stock, but each comes with different degrees and points of “friction” that subtract value from the ownership stake, due to tax liability, trading costs, and illiquidity. Generally speaking, when you own something through a vehicle that commingles the assets of many investors — mutual funds, hedge funds, ETFs — then you’re subject to more friction that detracts from investing value. With mutual funds and hedge funds, for example, you have to pay taxes for other people’s gains even when you might be losing money, although many ETFs are able to avoid this problem.
In most cases, separately managed accounts have by far the least friction of any investment vehicle, because they interpose the least amount of financial product between the investor who owns the account and the valuable assets that underlie it. According to an academic study reported by Barron’s, for example, for the same strategy the average separately managed account outperformed the institutional class shares of the average mutual fund by 0.62 of a percentage point annually from July 2000 through December 2010 (Lewis Braham, “Don’t Believe All Mutual Fund Returns,” Barron’s, July 4, 2014). Furthermore, for taxable assets separately managed accounts allow for customized tax loss harvesting to off-set capital gains, which can have a cumulative effect that’s even greater. Although this approach is a time-honored one, The Wall Street Journal has rediscovered the virtues of tax loss harvesting from individual stock portfolios as “the next frontier” in sophisticated investment strategies.
Wall Street loves funds instead of separate accounts because funds are scalable. Funds allow asset managers to increase their fee base astronomically, without any additional expenditures on their part. Investors who have sufficient assets to diversify themselves are much better served by investing through their own separate accounts, however. Of the various strategies considered in Faber’s study that produce clustered returns, the 60/40 portfolio of stocks and bonds is noteworthy for being easily accessible for any separate account investor, and roughly speaking, it’s what we provide at O’Brien Greene. The other asset allocation strategies would require less efficient investment vehicles to access the requisite asset classes, and the inefficiency of these vehicles, just like the consequences of high fees, should count against them.