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Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
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  • Waterloo, Ontario N2L 1T2
April-02-13

You, Your Bank and the Low Return World

If investment returns are destined to fall, does that mean banks will settle for lower profits? Not if they can take a larger share of your return.

In a previous article, we summarized current research that indicates that market returns are likely to be lower over the next decade. For a 60% equity, 40% bond portfolio expected real returns (i.e. returns before adding inflation) would fall from 3.71% to 2.25%. This implies the sustainable income generated by a portfolio will fall by 40%. How should investors respond?

Recent Shifts in the Investment Industry

First, it is constructive to look at this from the perspective of the investment industry. A recent report on the North American investment industry by business consultant, McKinsey, draws a number of conclusions about current trends in the investment industry1:

  • People are managing their own savings: The investment industry has been “virtually incapable” of attracting new money, despite an increase in savings rates. In the U.S. investment returns on existing assets has accounted for most of the asset growth.
  • Rising costs: For most investment firms costs are growing faster than revenues and the profitability of investment firms is not explained by their size.
  • Movement towards low cost ETFs: There has been a fundamental shift in the industry, described lucidly by McKinsey: “[Exchange Traded Funds] ETFs have democratized access to an array of asset classes and strategies… They are also revolutionizing the way retail advisors work with clients, replacing the stock-picking advisor of the past with the “ETF asset allocator” of today. ETFs have been the most consistent growth category in the industry over the past decade, and that growth should continue, due in part to a new preference for ETFs among fee-based, independent advisors, who constitute one of the fastest-growing channels within retail. McKinsey estimates that by 2015 more than $1.6 trillion of new money will flow into ETF products”.
  • Shift of focus from growth to income and downside protection: Over the next five years retirees and near retirees will control more than 70% of investable assets. Their focus will be less on accumulation and more on income and downside protection.

For the investment industry, especially one that has failed to attract new money, the prospect of falling market returns strongly suggests falling profits. Stealing market share from each other is one way of boosting profits, but for every winner there has to be a loser. Ironically, firms that have claimed that they can outperform the markets (often referred to as generating alpha) may get to test this with their shareholder’s money, not just their clients’.

You, Your Bank and the Low Return World

If persuading clients to save more with investment firms is difficult and the firms are reluctant to cut costs, what other options do they have to sustain profits? What are left are strategies that generate additional fees to transfer wealth from the client to the advisory firm. Within the bank brokerages, advisors are rewarded for such “high production”. Some recurring themes for maintaining production (i.e. profits) for the bank are:

  • Low returns (like taxes) are only for “little people” and that this “is a stock pickers market”. The idea that smart people (or their advisors) can always find opportunity in any market is an idea that will never die because it appeals to very human instincts of optimism and overconfidence. However, in the adult world, wishing something is true doesn’t make it so.  If you imbibe this Kool-Aid (even after 2008) then you are already susceptible to the next two ideas.
  • Take more risk in the hope of higher returns. This might be through a higher allocation to stocks (equity funds tend to generate higher fees, turnover and transaction costs than bond funds), or to more opaque products such as hedge funds or to investments such as real estate and closed end funds which involve borrowing to boost returns. Unfortunately, there are many types of risks and only a few lead to expected higher returns. Moreover, few investors have the stomach for taking additional risk and will not sustain their new strategy in times of market stress.
  • The seduction of the new. The financial industry is endlessly inventive at pushing new products at investors. Some simply chase “hot” sectors (e.g. gold, high yield bonds) others offer a tax benefit but at the cost of higher fees2.  Flow through funds offer tax write-offs in risky, illiquid, bets in the resources sector. A perennial favourite is a group of products called “structured products” or principal protected notes. These tend to offer equity exposure with some upside and a guarantee of return of principal. Less attractive are the high fees, obscure risks, lack of liquidity and that many banks are promoting their own products.  Many advisors are commissioned salespeople looking to sell product and from their perspective, novelty and complexity justify the high fees. The common thread connecting these “innovations” is that the fees are certain, but the promised returns are not. 

Pushing Back

It is no surprise that the rational investor’s response to the low return world should be the opposite of the financial industries’:

  • Strip out costs instead of increasing risks. Shun siren calls to take more risk and focus on improving returns by stripping out costs. Not everyone wants to perform his or her own appendectomy with a box-cutter and a mirror on a stick. Similarly, taking control of your own investments may not be an appealing cost saver, but at least take the time to understand the total cost of your financial intermediaries and their motivations. As previously discussed, high fund management fees are an important source of wealth for the financial industry that comes directly from the investor. Unfortunately, not all fund costs are freely disclosed. For example, fund trading fees are not included in the management fee and, according to one recent study3, can suck another 1.44% from market returns.
  • Focus on the investment process, not products. New products, by their very nature, often arrive with no track record and have been synthesized to perform well only in a very limited investment environment. Successful investing is best understood not as a series of one year sprints, but as a marathon. Asset class selection, product allocation, indexation choices, rebalancing, turnover minimization, currency hedging, tax efficiency, fee minimization and meaningful diversification all sound dull but they have the very attractive quality of being controllable and if applied persistently, enhance long-term returns. This is where client centric advisors or the diligent self-directed investor can add value.

As McKinsey noted in their report, “Industry players are constantly striving to squeeze an extra basis point of alpha, like Formula One drivers pushing their vehicles to the limit. Increasingly, though, their clients would prefer to ride in sturdy SUVs instead of race cars. Retail and institutional clients alike are starting to shift away from high-octane performance in favor of more assured outcomes –like not outliving their money…. In short, these investors just want to get from Point A to Point B and are looking for a vehicle that will get them there safely and efficiently”. We would agree with that.

Links

  1.  www.mckinsey.com, “The Asset Management Industry: Outcomes are the New Alpha”, 2012
  2. The 2013 budget has squashed the prospects of tax advantaged fixed income funds
  3. Shedding light on “Invisible” Costs: Trading Costs and Mutual Fund Performance, Roger Edele, Richard Evans, and Gregory Kadlec, Financial Analysts Journal, Vol 69, (2013).
By: Graham Westmacott | 0 comments