(April 15, 2014) — Investors are increasingly concerned about the cost of their portfolios, but are they analysing them in the wrong way?
Investment consultants Wurts & Associates has argued that investors are too focussed on analysing the costs against the total return of the portfolio, instead of focussing on the costs being spent on alpha generation.
“Investors typically spend a huge amount of time thinking about and reaching for alpha. Most investors still have significant amounts of active management in their portfolio, and they spend a lot of time and resource selecting and monitoring those active managers. All of this effort is despite the fact that many (or indeed most) investment managers will produce zero alpha (or worse) over the medium term,” a Wurts & Associates whitepaper said.
“That difficulty has led to investors reaching outside the long‐only space and hiring hedge funds, with significantly higher fee schedules, to try to produce differentiated alpha. Even there, the amount of alpha achieved in a successful portfolio in the long term is likely numbered in the tens to low hundreds of basis points after fees.”
Since alpha is small, expensive, and rare, it is this that should be used as an effective comparison when investors are analysing the cost of their portfolio, the Seattle-based consultants continued.
In addition, ensuring investors avoid excessive costs is a lot easier than trying to create and harvest alpha, Wurts & Associates said. If investors directly control manager trading costs, shouldn’t they focus on the costs their can control?
When comparing the impact of an excess cost on several asset classes, the consultants found that the impact of costs was far larger on alpha generating parts of the portfolio.
Looking at domestic equity, international equity, emerging market equity, domestic fixed income, and global fixed income, Wurts & Associates added a 15 basis point cost to each, and compared the cost as a percentage of total return, and of excess return.
As a percentage of total return, the costs were minimal, around 2% or 3%, but when it was applied to alpha-type assets, the percentage was much higher.
“A domestic fixed income investor might care only a little about a frictional cost of 15 basis points if they think of it as being only 3% of their total annualized return. If they thought of that as 33% of the total excess return they might expect to achieve from the strategy they might think harder about its importance,” the paper explained.
Investors are also prone to forget the drag effect of costs over time, the paper continued.
The consultants found that investors spend so much of their time dealing with questions of risk and return where the distribution of outcomes roam into positive and negative territory.
This, Wurts & Associates said, was training investors’ brains to partially discount negative results: they believe that they’ll eventually make the money back.
While that approach avoids the danger of excessively conservative allocations, investors forget that there are no upsides from costs, they only ever reduce return, the paper said.
There are three steps to mitigate this situation, suggested by Wurts & Associates. The first is to take costs seriously at every step of the investment process, and to recognise the cumulative outcomes of all of the individual costs.
The second is to think hard about the more operational and administrative parts of the portfolio management process, including: custody; transition management; commission recapture and management; FX trading; and stock lending.
And the third objective investors should aim for is to participate in mechanisms governing the market structures their money flows through.
“If the end client isn’t represented then the only people at the table will likely be people representing their own interests, and those interests are likely not to align with yours,” the paper said.
“To ensure fair markets clients of all types need to be represented, even relatively small ones. Getting educated can help here, and shouldn’t take too much time. Submitting responses to consultations, reaching out to regulators or markets when they ask for input, and speaking to service providers when asked all have their place, and your voice is needed in those conversations.”
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