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“Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’” ~ Warren Buffett (2008 Berkshire Hathaway Shareholder Letter)
A recent Charles Schwab commercial advertised the new fee for their S&P 500 index fund. The expense ratio is now 3 basis points. As in 0.03%. In a one decimal world that rounds to free.
Access to a broad index of US equities for something close to free is a good deal. As asset managers have traded blows in a price war for passive index assets, investors have come out ahead. With cap-weighted index funds approaching zero-bound, the battle has moved to factor-based, fundamental index strategies where costs are rapidly declining as new entrants come to market.
One of Oxford’s core investment principles states: Fees and taxes are often the most predictable components of investment returns – and the most controllable.
This statement rose to the level of investment principle because the research process should never lose sight of the “controllable” variables. Careful consideration of cost is a basic part of the analysis of an investment strategy. And consistent with the example above, most times lower cost is synonymous with better value. I doubt anyone views that statement as controversial.
At Oxford, we have utilized low-cost index funds as part of client portfolio for decades. But as we’ve stated in the past, we don’t view the active/passive debate as mutually exclusive. Both continue to have their place in a client portfolio. As the Charles Schwab example shows, cost is the primary determination of value for an index fund. Interestingly, the availability of these nearly free index funds helps investors look beyond a simple comparison of fees among active strategies.
When comparing costs of active strategies - whether it’s an emerging markets equities manager or a trend-following managed futures fund - a cursory look at the management fee doesn’t fully address the true cost of the active decisions. It’s a start, but it’s incomplete.
A second dimension of cost needs to be considered that quantifies cost relative to what’s different from an investable index. In other words, don’t apply the fee to what can already be owned for nearly free. As a result, it’s entirely possible for an active strategy with a lower overall cost to have less value (What am I getting for what I’m paying?) to the investor than one with a higher overall cost. Did I mention investors can buy an index fund for free?
Imagine you are trying to decide which golf course you want to play (it’s March in Minnesota… I have to dream). Course A costs $75 per round. Course B costs $100 per round. You like both courses equally. Which do you choose? With the information you have, Course A is likely to get the tee time. Lower cost, better value.
Now let’s add another variable to the decision. Your best friend is the owner of a third golf course (Course C) and she lets you play there for free. But Course C is on the same property as Course A and they actually share 14 holes. Now would you still choose Course A? Knowing a majority of the holes you would play you can access for free? Likely not. Maybe you decide to play for free on Course C. Maybe you are willing to pay to play Course B because it’s different. Either way, suddenly Course A is a poor value.
That last piece of information is what is needed to evaluate cost against value in an apples-to-apples manner for active strategies. In that framework, the burden of the fee should be applied to the portion of the portfolio that is different than the index. If a strategy consistently has 70% overlap with an investable index, the portfolio manager better be really good to justify the fee. The evolution of extremely low cost index funds has provided investors the Course C option for most asset classes.
Notice there are no judgments on skill, performance over cycles, etc. in this example. This is not an attempt to identify outperformance or “alpha” available to active strategies in various segments of the market. It simply provides a more intuitive framework for examining cost with respect to active strategies.
At Oxford, all strategies are analyzed with this concept in mind. Concentrated portfolios, niche opportunities, and unique return streams are among the common characteristics in areas of a client portfolio that lie outside more passive and systematic beta exposure of the allocation. It is the “index huggers” with a high fee burden on a minimal amount of active positioning that should see the most significant narrowing of their value proposition as a result of the index fund price war.
Investors would be wise to take their game to Course B or C. Value doesn't always mean paying less.
The above commentary represent the opinions of the author as of 3.30.17 and are subject to change at any time due to market or economic conditions or other factors.Print