The efficiency of an investment strategy has a big impact on net return.
Investors face a myriad of investment options, and determining which options offer the best odds of success is no mean feat. A prudent investment approach will weigh relevant elements such as risk, diversification, consistency of outcomes, expected returns, and costs.
The intersection of the latter two elements—returns and costs—forms the net return of the investment. Net returns are paramount to long-term success because they are what investors get to eat, so to speak.
Net returns can be distilled into several key components, which should be evaluated based on their combined effect on an investment. Yet many investors often focus on just a few elements and consider their isolated effect on returns. For example, a tax-sensitive investor might concentrate on investments that promote enhanced tax efficiency without taking into account the extremely high fees and expenses that may accompany a tax-efficient structure. The strategy is appealing when viewed through the singular lens of taxation, but when factoring in all the components of net returns, it may equate to paying an additional dollar in fees and expenses to save 75 cents in taxes.
Similarly, investors might scrutinise management fees and expenses because those costs are easily quantifiable and receive a lot of media attention. An investor concerned about management expenses might be drawn to low-cost investments while overlooking how other components affect net returns.
The efficiency of a portfolio’s management will have a big impact on net return.
Trading costs are an important consideration that often goes overlooked by investors. There are two key components of trading costs:
- Explicit trading costs. The brokerage and commissions paid to trade securities can have a big impact on net returns and many investment structures aren’t required to include all of these costs in their expense ratio disclosures.
- Implicit trading costs. The impact of buy/sell spreads and other market impact effects associated with trading securities will have a large bearing on net returns. These costs are very hard to quantify, but it’s important that an investor asks an investment manager what their strategy is for managing these costs and what sort of impact they expect they will have on the investment.
Both explicit and implicit trading costs will be higher if an investment manager employs an active strategy which results in high turnover of securities. The increased activity of an active strategy may be necessary for the manager to deliver a higher gross return, but it’s important for an investor to understand this extra headwind that is created by the activity and factor it in when assessing whether they feel the manager's strategy will be successful.
The important message is that when an investor is considering the cost of an investment they need to dig a lot deeper than just the management fees. If an investment is inefficiently managed it will probably have a much bigger impact on net return than management fees.