ISMS 34: Larry Swedroe – Consider All Hidden Costs Before You Invest

Andrew Stotz 00:00
Hey, fellow risk takers, this is your worst podcast host Andrew Stotz, from a Stotz Academy, and today, I'm continuing my discussions with Larry swedroe, who is head of financial and economic research at Buckingham wealth partners. You can learn more about his story in Episode 645. And don't forget to follow him on Twitter or LinkedIn, because, my gosh, he's producing so much material. Larry deeply understands the world of academic research about investing, especially risk. And today we're going to talk about two chapters from his book investment mistakes even smart investors make and how to avoid them. And the first one that we're going to talk about is mistake number 20. Do you only consider the operating expense ratio when selecting a mutual fund? And mistake 21? We're going to talk in the second half of this is do you fail to consider the costs of an investment strategy? So Larry, let's talk about mistake 20, about operating costs, and all those costs. Take it away?

Larry Swedroe 00:59
Yeah, so a lot of investors are aware that there is at least some relationship between expense ratios and returns of mutual funds. In fact, John Bogle did a famous study, which said, you could rank the stocks, mutual funds by expense ratio, and you get a very high correlation with the lowest expenses of funds generating the highest returns. So a lot of people at least are aware of that, although sadly, too many people even know of that, because they believe that active management is likely to add value, despite the reams of evidence on that. And by the way, just on that note, Andrew, I was just writing up a piece today because Morningstar did a new study, for the first time they published since 2002, what they call the Stiva reports, which is the passive versus active studies, and they show persistently that active managers lose. And the longer the period, the greater the underperformance and the worst of persistence. So roughly speaking, you know, every in every asset class and equities, about 92 to 94% of active managers underperform over 20 year periods. But all of that data ignored taxes, which for taxable investors, the research shows, it can be the greatest expense, when so for the first time they publish that data, and the numbers now jumped dramatically from like an average of 92% or 3%, on to like 9798, in virtually every asset class, and you can get

Andrew Stotz 02:54
some because the markets become more efficient or

Larry Swedroe 02:57
some No, it's because they that the gross return on the performance is still 9293. And if you're an endowment or in an IRA, that means that maybe 6% of the active funds outperform before accounting for risk, but just to get against the index benchmark. However, taxable investors have to pay taxes on the distributions every year. And active funds because of the higher turnover have higher distributions in general, which leads to lower returns, and more of the gains are likely to be short term versus long term. And they have higher tax rates. So about 5% extra percentage of funds, and an extra 50 to 100 basis points and loss returns came, which meant the odds of your picking, you know, a mutual fund that was going to outperform that after taxes, you know, just by throwing darts would be down to like 2%. I mean, that's just not a game you want to play

Andrew Stotz 04:07
incredible. And when I read this chapter, it's like, it's like, it looks imagine that the average return is 10%, you know of a passive or an index. By the time I finished this chapter, I felt like Okay, so the average person gets about 2% out of that.

Larry Swedroe 04:24
Not quite that bad. But so the problem is, expense ratios are not the only expense. So even index funds have trading costs and even index funds because in my opinion, they're poorly designed, enabling at least most of them are poorly designed enabling a hedge funds and other high frequency traders to trade ahead of them knowing when they're going to rebalance and they are forced to trade. So they have you know, the cost So they turnover when they rebalance their portfolios on an annual basis. They have trading costs. And so the funds underperform. Because of that. Unfortunately, people don't know that because the indices report as if those costs were embedded in the returns already. So you don't see that on the performance, even though it's real. So, active funds have much higher expenses. And so that's something then they have something called it's not just the bid offer spread that you incur active funds, because they tend to be price takers, not price makers, meaning they want to trade today. Well, you know, if you want to trade 100 shares of a stock, you can probably get it at the offer price. But if you want to trade 5 million shares, the first 100 or 1000 shares, you're going to get at the offer, and then the market is going to start to move, and you're an active fund and you want to get out because you're sure this stock is going to underperform going forward. Well, now you're gonna have market impact costs. So you have those two factors, and then you have taxes to add on top of that, as well. So what's warm is did a study, and he found that while the average mutual fund on a gross basis, actually outperformed by about 70 basis points. So in the market isn't perfectly efficient. Right, there was stock picking skills. However, the fact that the average active fund tended to sit on say for argument's sake 10% Cash and Cash is returning 5%. Well, that's 50 basis points a year and loss returns relative to the markets 10% return, you lose 50 basis, you know, on that 10%. So that costs you write then your trading costs cost you another 70. And now and then you add taxes, and now you're down several percent, probably in the order of 2% a year below the benchmark, even though your stock picking skills gap you in advantage of a 70 basis points.

Andrew Stotz 07:29
So I think it's really valuable to go through these costs a little bit more detail. So the first one operating costs and other one trading costs another one market impact and another one taxes and another one cost of cash. Now operating costs is the is the is the one that's most transparent, I suppose

Larry Swedroe 07:47
that's what they were required to report to the SEC. Okay. And that's what you see when you go to Morningstar. And so that's what you focus on. But the higher the turnover, the higher the trading costs, and the more transparent your index, even for index funds, you're gonna have greater So a good example is the s&p 500 Probably loses several basis points, or maybe a bit more annually, because everyone knows what's going to happen when they trade that you can guess which stocks are going to move in or out pretty easily. The Russell 2000 was so transparent, that it's the Russell 2000 underperform a similar benchmark like the Chris 610, by you know, I forgot the exact number, but it might have been 150 basis points a year. And that's why Vanguard dumped that fund as a change the benchmark long ago from the Russell 2000. Because Gus Souders said was complaining, you know, that, hey, we're losing all this money, and they switched to, I think, a crisp index, and then they switched to an MSCI index, because they were paying lower fees. By that's another expense even of index funds. They pay fees to license the index, when if you can just wrap use an academic definition, you don't pay any of those index licensing expenses.

Andrew Stotz 09:21
So when we talk about operating costs, is there another name for them that the SEC calls it or that others call it like, I don't know, management fee or something like that? Or is well that's

Larry Swedroe 09:31
it, that's the management fee or the expense rate. So that's what you're getting billed for.

Andrew Stotz 09:39
And, and then the next thing is trading costs. Now, my question is, I want to understand when a fund announces a nav, the impact of trading costs

Larry Swedroe 09:55
is, is in there naturally. Yeah, it's in there. Okay. Right. And then here's the problem. So let's say a small cap stock is trading it for argument's sake, and bid and 1020 ass and you want to buy 100 shares, you can buy it at 1020, you want to buy a million shares, the first 1000 shares, maybe you can get a 1020. The next 1000 shares, you know, may cost you 1030. And the market sees that as a buyer, and that price keeps going up, by the time you're done, your average cost might be 1050. And when you're done buying the price is back to 1020 offered and 10 bit and when you go to sell, if the price has moved, you get 10 for the first 1000 shares, and then 990 and 980. And then the price goes back to 10. And so there are big costs. That's why today, for example, dimensional fund advisors, which is not an indexer, but is a word my mind is uses systematic, replicable transparent strategies, only almost all the trades are 100 shares using algorithmic trading programs to avoid those market impact costs. And they just trade patiently. But if you're an active fund, you can't do that, because you want to get out. So you are a price taker and pay to get liquidity, the Dimensionals of the world and AQR has and other patient traders become price offers or makers and they get paid to offer liquidity. So you put a thing on the offer side, you're gonna get paid the offer by some act of manager, you know, sometimes and on average, you know, you'll do okay, because the market price is the best estimate of the right price. So you have that bid offer spread. Yep, you pay away on a round trip basis. But then you have those market impact costs. And they're, of course, small, relatively for large cap stocks, like The Magnificent Seven these days, but they're gonna be very high for the smaller cap stocks where the active managers say they can add more value. But that's tough. Because you have that extra hurdle of those market impact costs,

Andrew Stotz 12:21
too. So let's just, I'm kind of feeling like trading expenses and market impact are kind of a category together, in the sense that there's an explicit trading expense where you may have to pay a commission or fee related to every trade. And then there's an there's a, that's an explicit cost. And then there's implicit that it's the bid ask spread that depending on how active you are, or how quickly you have to move, that that's going to be a cost related to trading. And then the market impact is also related to your trading. But it's just that you are causing the price to rise or fall depending on if you're buying or selling. And that just means that you're not going to get the average price you thought you were going to get you maybe get a little bit higher, or you're going to sell at a little bit lower. So all of those is what I would call, you know, related to let's say, trading.

Larry Swedroe 13:19
Yeah, absolutely. You have those costs. And that depends upon whether you're a provider of liquidity, or a taker of liquidity. Yep.

Andrew Stotz 13:30
So let's say trading fees, or bid ask spread explicit expenses in market in

Larry Swedroe 13:36
roughly 80 basis points. If my memory serves worm, it's fine.

Andrew Stotz 13:40
So now we've got and the operating cost management fee expenses. I saw some other statistics previously, but would it be one? Yeah, it's somewhere

Larry Swedroe 13:50
and it used to be 1%, I guess this is come down because of the competition from passive funds in this race to zero with these passive strategies. So my guess is it will be more in the 70 basis point range. Now, for the average fund, it might even be less, but somewhere in that range. So now, the differences probably not that great member because index one costs have come down as well. But I think the spread has narrowed a little bit. Yeah.

Andrew Stotz 14:23
Now if we look at taxes, let's think about one type of let's think about a long term holding. They're not buying or selling, and therefore, they're not selling at a gain and having a tax implication, versus a much more active person could be selling within, you know, 30 days or six months. And then all of a sudden, they have taxes that they as a fun. Oh, from their gains that they've made and that time axe is related, you know, the higher the better you're doing number one, and the more actively you're trading, that cost of taxes goes up for the fund. Is that correct?

Larry Swedroe 15:13
Yeah, that's right. And in the s&p study I just mentioned, the median, not the average, the median active, fun trail, the s&p 500 index. over every time horizon, they looked at 135 10 and 20 years by up to get this three and a half percent a year. So all of the costs including taxes, that's three and a half percent a year, at 30 years, the costs were in excess of 2% a year. And 97% of the funds, underperform their benchmark 97%. And of course, the ones that outperform, generally, by very small amounts, were the underperformance underperformed by larger amounts. So your risk adjusted risk of underperformance wasn't 3%. It might have been, you know, 9999, or one odds against you. So because when you won, you won a little bit when you lost, you lost a lot.

Andrew Stotz 16:28
Now let's let's what is the what would be the estimate of the tax impact nowadays? Let's say we said, let's say operating costs,

Larry Swedroe 16:37
based on the s&p study 1%.

Andrew Stotz 16:40
Okay, so in cost, so now we've got 1% in operating costs, 0.8% in trading costs, and 1% in taxes,

Larry Swedroe 16:50
and then the cost of cash.

Andrew Stotz 16:54
Okay, so what what do you what is your current,

Larry Swedroe 16:57
let's say, just a round, pick a number, if you think stocks are gonna get 10, the average historically, I'm not making a forecast there, but it's picking up historical return. And you're sitting on cash earning five, so use 5% on say, 10% of your portfolio, that's 50 basis points. Warren was study the period he covered found that cost 70 basis points of my memory, so but let's call it 50. Okay, you know, so you're talking expense ratio with 71% for taxes 50 basis points for cost the cash that's 220. And let's assume you do outperform, and you're picking and market timing, and you're a genius, you outperform by 70 basis points. Well, you're still behind one and a half percent, which is why the hurdle is so high, you have these people don't understand how high a hurdle it is, once you include all the expenses. Now, I will say this, that ETFs have improved the odds, because it lowers the cost of taxes. And separately managed accounts can also improve them slightly, as well, because you can harvest losses. So you know, but for the general public mutual funds, taxable accounts, that's the data we have, and ETFs while improving things don't solve all of the tax issues for investors, either.

Andrew Stotz 18:36
So let's let's just talk about one last thing about taxes, which you talked about the beginning was the idea of disbursements or something like that, or is there another tax that an individual distributions,

Larry Swedroe 18:48
I think you mean distributions? Yeah. So here's the thing. That's the great irony there that people don't think about the bad happens during bear markets often. So you get a bear market? And what do you think the average retail investor tends to do with his holding, take money out, take money out so unfortunately, they should be buying right because now valuations are lower. And like Warren Buffett said, Don't time the market but you can't resist buy when you know, when everyone else was panic selling, but that panic selling causes cash to flow out. And the fun has the then sells shares that were at gains. So in years, like 2001 to 2008 and 2021 or 22. When the market crashes, and you get them having to sell shares, guess what happens to the distributions, they go way up and you've got a loss on realize but are paying taxes because you got distributions, they only that's really is, you know, like sticking you know, stick into your hot steak, a steak that's the word I was looking at.

Andrew Stotz 20:22
It lets us understand that at the bottom of the market, certain people are getting out. And when they get out the fund is forced to have to sell. Yeah. And then they get their cash out. Yeah. Is the are the people that are still holding it funds paying a cost in relation to that? Or is it? Yeah,

Larry Swedroe 20:45
because they get the distribution. If they're a taxable investor, they don't care if they're non taxable. But that's a real problem for a lot of funds when they get cash outflows.

Andrew Stotz 20:59
So they're having to realize the gain or loss,

Larry Swedroe 21:03
the fund has to realize the gain, right, right. Yep. And then therefore, the IRS forces them to report that then distributed and the investor gets a 1099. And now it's taxable income. And unless they sell their shares, they've got a gain and pay income taxes. And depending upon where they bought their shares, they might not be able to get a loss on their purchases. You know, if they bought it long ago, they would, you know, they can still sell, maybe they held it 20 years already. And the price they bought it, I'll make this up was 20. And now it's 80. And but it drops down to 40. They still have a gain, so they don't want to sell, but yet they're getting distributions and having to pay taxes.

Andrew Stotz 21:57
And there's one other factor that we didn't even talk about, and that is the timing impact with people having bad timing. So we're already talking about costs ranging somewhere between two and three and a half percent. And then you have this bad timing, as you said, when people sell during the bad market, I've seen some numbers on that, which is terrifying. But when you add it all up, like I say, you start to wonder, like, the advice I gave my nieces was by the the, you know, Vanguard fund that has every stock in the world, total stock market index, and never sell

Larry Swedroe 22:34
and never sell this. Actually, I would tell unless she's 100% equities, make sure she rebalances at the end of every year, whenever she has new cash buy whatever the underperformer was without minding the gap gap. Most of the studies show that investors underperform the Verde funds they invest in by somewhere between one and 2%. Seems hard to do you couldn't do it. If he tried, you literally tried you wouldn't be able to do it. But because people tend to sell after periods of poor performance when spective returns are higher. That's how they end up losing. Peter Lynch did an interesting study on that near the end of his career, he had a bad year. And then the next year who rebounded and he found that the app while his fund provided decent returns during that period that he looked at the average investor actually lost money because they pulled money out after the bad returns, and then weren't there for the good returns. actually lost money when he did pretty well as a fund. It's really sad. And unfortunately, social media exacerbates the problem. So the best thing to people to do is ignore Robinhood ignore Reddit. You know, don't watch CNBC. Never listen to Jim Cramer and just be a patient investor. Follow Warren Buffett's advice, as I waded out and my button think, act and invest like Buffett.

Andrew Stotz 24:18
And one nice thing is if you're looking at a company's, you know, offerings, you see that they have funds and they have ETFs. Nowadays, like Vanguard as an example. For the absolute amateur that's just thinking, I've just got to build some exposure to the overall market and contribute over many, many years. Is it better for them to buy it as a fun or as an ETF these days?

Larry Swedroe 24:41
So for? In general, the rule would be if you're in a taxable account, buy the ETF because it's more tax efficient. You're in a tax advantaged account by the mutual fund because you don't pay a bid offer spread and you Don't care about the tax efficiency and the font. So that's a general rule. Also, I would note, if you're going to buy with an ETF don't trade first thing in the morning, or last thing, at the end of the day, you can get really screwed by price movements. But for the average investor, just middle of day, put in your water and execute it, and you'll be fine.

Andrew Stotz 25:27
Well, that's a pretty amazing discussion. And I think for it's enlightening for everybody to just think about the seriousness of the cost. Let's go into Mistake number 21, which is, do you fail to consider the cost of an investment strategy?

Larry Swedroe 25:43
Well, this is obviously related to our whole discussion. So I think we could make a pretty sure. But so for example, when you see returns have a strategy, they often don't include costs, they look at, okay, the strategy is you buy these stocks, and they take the closing prices on the day and you buy it, and then you sell at the closing price later. But of course, that ignores all of the bid offer spreads, market impact costs, etc. And that ignores taxes as well. So that's a real problem. But a really good The best example I could think of off the top of my head on this relates to value align strategy. So value line, when I was growing up, my dad was a real stock junkie, and he watched Louis Rukeyser, every Friday night, and he, you know, would watch Value Line and listen to them. And they were famous for their every Friday night they mail out their recommendations. Right. And they would say, here's our returns, and they would base it on the closing price on Friday. Now, let me ask you this. Andrew, on Monday morning, can you buy at the closing price on Friday? And what do you think happened when Value Line mailed out these recommendations to people? Oh, got it over the weekend? What do you think happened to the bid price? On the first thing Monday, it went way up. So you know it was phony reporting you couldn't buy at it. And once you accounted for that all of the outperformance of Value Line disappear. But they bragged about their outperformance. It wasn't there. It wasn't real. It was a paper out performance. So that's a good example. You know, of that situation. And you have no other trading costume. There's no other bid offer spread, you ignore any commissions, everything. That's pretty typical. And all good academic papers today anyway, probably for the last 20 years at least make an attempt to incorporate estimates of trading costs in their studies to make sure they're looking at what the real live data would look out there at least make an effort to include trading costs.

Andrew Stotz 28:20
And so let, when I think about these two chapters, and I bring it together, what I'm thinking about is there is this operating costs that you see. And then there's all these additional costs, depending on how active the more active the fund is, chances are the higher those costs are. Yeah, but those are all wrapped up in the nav and the performance of the next step for the taxes. Except for the taxes where you as an individual, if let's just say you own something that you never sold, you just left it for 30 years, you're not gonna have any taxable event.

Larry Swedroe 29:02
No, no, no, that's, you're gonna still have taxable events in the form of dividends. Number one, which we didn't even discuss, but also the fun even though you don't trade, the fund is trading and making distributions. So they're going to give you a 1099 or a port income that you have to report whether you sold it or not.

Andrew Stotz 29:28
And how often are those distributions 1099 is coming from a typical fun. Well, they come

Larry Swedroe 29:34
every they're required every year so you can report for income tax purposes.

Andrew Stotz 29:39
And so in other words, what's happening is that the fun is required to pass through.

Larry Swedroe 29:45
That's the right words. Yes. Okay. And they can't pass through losses however, they can only pass through gainst

Andrew Stotz 29:53
heads I win.

Larry Swedroe 29:55
And tails the IRS wins.

Andrew Stotz 29:58
Exactly. And uh, Okay, so that that's helpful now does the does let me add

Larry Swedroe 30:02
was one other thing we should discuss here, which is really important to understand, because a lot of people think, and hopefully, if they've listened to our prior, you know, discussions, they've been disabused of that belief. But they think that past performance of active funds is a predictor of future, which means and results in the fact that successful funds, see their AUM or assets grow. But all the research shows, there are diseconomies of scale in active management, because the bigger the funds get, guess what happens to their market impact costs? It's higher, go higher? Or if they try to avoid that, how could they do that answer? What do you think they could do to minimize the market impact costs, leakage of modular, they could diversify across more stocks, they don't have the big impact on say, 30 stocks, maybe they aren't as good. And if they're, well then goes your active performance because you're now a closet index fund with big expenses. So you can't win that game. That's a real problem. That's another reason why active management doesn't persist successfully. Because successful active management, the way I like to explain it sews the seeds of its own destruction.

Andrew Stotz 31:32
In other words, size does matter. Size matters.

Larry Swedroe 31:35
And it matters even more in the bond market, because the corporate bond market is much less liquid than the equity market. And it matters much more in small stocks were active managers claim they can outperform, although there's no evidence of that that's true. So if you find an active manager in small caps, that had outperformed now, cash flows in they've really got problems in trading costs. Here's the little incident story on this subject that I just discovered today, and writing up this paper about s&p and the after tax performance. So I keep a list of my favorite quotes. I've been doing that for 25 years and use them in my articles. And there was a fellow ran a fun trying to is Aronson Ted Aronson was his name. He ran aronsohn partners. That was a very successful fund in the 80s 90s. And he was highly acclaimed big endowments investor built it up. And by 2018, the fund that grown from very little to $23 billion. Now, he stated, let's see if I can get the quote here, directly. And then I'm going to tell you what surprised me was one second here. He said this, none of my clients are taxable. Because once you introduce taxes, and remember, this is an act of manager admitting this rare act of managing probably has an insurmountable hurdle. We have been asked to run taxable money in decline, the cost of active strategies are high enough without paying Uncle Sam, capital gains taxes, when combined with transaction costs and fees, make indexing profoundly advantage. So here's the interesting note. And, in 2018, as I mentioned, the fund at 23 billion in 2020, the fun close because of a massive outflow, because the Fund had performed extremely poorly over the last few years. And he shut the fund down. This was a $23 billion fund. And the guy said, I gotta give you them. Oh, as performance is not a predictor of future performance.

Andrew Stotz 34:21
Amazing. Well, that was a great, great discussion and a lot of great information. I want to thank you for that. And really helping us to think about how we're creating growing and protecting our wealth. And for listeners out there who want to keep up with all that Larry's doing. I'm telling you, you can't keep up with Larry. Just go to Twitter at Larry swedroe Or to LinkedIn, type in his name. And you'll get there and you'll see that Larry is just cranking out all kinds of great stuff. So thanks for joining us, Larry. And this is your worse podcast hos Andrew Stotz saying I'll see you On the upside.