Broker Check

The Investment Cost That Dare Not Speak Its Name

March 12, 2020

I've often written that one of the problems undisciplined, uncoached investors have is they always seem to be focused on picking up pennies while they miss seeing the dollars that would be otherwise available to them -- in other words being pennywise and pound foolish. While costs are important, the focus tends to be on internal portfolio costs and the desire to avoid any professional/coaching fees even if they are fully justified and inure to the long-term benefit and returns of the investor.

While it is well known that most investors underperform (the market rate of return) more because of their behavior than any other reason, this behavior goes beyond just reversing the well known dictum of successful investors by their buying at market tops and selling at the bottom. There are unreported or rather unpublicized structures or management techniques applied to portfolios that generate additional returns so that when one compares a passive, structured asset class portfolio to an index fund or ETF we see a differential in the long-term returns that favor the asset class portfolio.

One of these is a cost that will be visited upon specific index fund investors this year that is directly related to their behavior (as a group) in the face of the current market decline. As noted above, uncoached investors tend to sell either into a bear market or at the bottom. What this does is to cause a net outflow of cash from the funds. Since they are required to be fully invested in order to track a specific index (i.e. S&P 500, Dow, et al), this behavior by their investors cause them to have to sell stocks in order to raise the cash to meet the investor redemptions. Given we've had a wonderful decade up till now (in terms of investment performance), selling will cause capital gains to be realized and now the dirty little secret will become known.

Taxes (although they tend to not be considered by investors) are every bit of an investment cost as management and professional fees. When these capital gains are realized the tax consequences are visited upon investors in the form of 1099 income that has to be reported when tax returns are filed next April (2021).

So what does this have to do with discipline and even more importantly coaching? Specific asset class fund families that rely upon the coaches for their distribution to institutions and the public, historically have not been faced with this net cash outflow problem. The reason of course is coaching imposes discipline by its very nature. For our investors who have been with us and Matson Money for years, just reflecting back upon the last bear market of 2007 - 2009, we had net cash inflows during that entire period which represented the discipline of our investors and the impact that coaching had upon them. The result has been the positive returns they experienced over the last many years and just as importantly the negative experience they DID NOT EXPERIENCE in terms of substantial capital gains taxes having to be paid during a declining bear market.

The below comment and chart illustrate how these fund flows move and the negative impact taxwise they can have during market declines.

This is from a current edition of Seeking Alpha.

"...The index and ETF sellers? Well, they just sell."

"It is often suggested that individuals who buy "passive indexes," such as the SPDR S&P 500 Index (NYSEARCA:SPY), are they themselves "passive investors." In other words, these individuals are willing to buy an "index" and hold it for an extended period regardless of market volatility.

Reality has been far different. (emphasis is mine)

This was clear last week as the S&P 500 ETF saw some of the biggest outflows in its history, with the exception of the February 2018 market plunge as Trump announced his "Trade War with China...."

Coaching and professional fees don't cost, they add value over the long-term!

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Frederick C. Taylor
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