Motivation The return an investor obtains Javier Estrada is - PDF document

Risk & Return (II): Stars & Costs Javier Estrada ADFIN – Winter/2014 1. Motivation • Three relevant variables 2. Stars • Morningstar style box • Morningstar stars 3. Costs • Types • Magnitude • Impact Motivation  The return an investor obtains … Javier Estrada  is lower than the return of the funds in which he IESE Business invests due to … School • the costs of financial products Barcelona Spain  Visible and ‘hidden’ • the taxes paid on the return received  These vary too much across countries to discuss here  must be considered together with the risk borne when holding those funds • Hence, risk‐adjusted returns  Therefore, a proper evaluation must adjust the return of funds by 1) all the costs paid, and 2) the risk borne, by the investor  Hence, risk ‐ and ‐ cost ‐adjusted‐return ADFIN Winter/2014 1

Morningstar  Style box Javier Estrada  Separates funds along the risk‐return categories we IESE Business discussed before School • Value v . growth Barcelona Spain • Small caps v . large caps Go  Evaluates fund managers within each of these cells • Aims to make an ‘apples‐to‐apples’ comparison  Although this somewhat questionable when the evaluation is on the basis of risk ‐ adjusted returns  Attempts to avoid simplistic return comparisons? ADFIN Winter/2014 Morningstar  Stars Javier Estrada  A measure of risk ‐ and ‐ cost ‐adjusted return IESE Go Business  Main characteristics School • Proprietary Barcelona Spain • Objective  Based on past (3/5/10‐year) performance • Account for costs and risk  Risk “with more emphasis on downward variations” • Relative measure  Ranking across funds within each cell in the style box • Easy to explain to non‐expert investors Go  Morningstar has another performance measure  Analyst rating • Subjective Go ADFIN Winter/2014 2

Costs  The most underrated of all financial variables Javier Estrada  Consider IESE Business  An initial investment of $10,000 School Barcelona  A 20‐year holding period Spain  An annual return of 12%  Annual fees of 2% (Fund 1) and 0.5% (Fund 2)  Then, at the end of the holding period … • F1: $67,275 • F2: $88,206 • The difference is more than twice the initial capital  Never make the mistake of underestimating the impact of costs on performance Go ADFIN Winter/2014 Costs  There are several relevant costs to consider Javier Estrada  Visible IESE Business • Loads (Front‐end, back‐end) School • Management fee Barcelona Spain • Incentive fee • Other fees ⇒ TER (Total Expense Ratio)  There is also a net expense ratio (Net of fee waivers) Go  ‘Hidden’ • Trading costs • Bid‐ask spreads • Taxes Go ADFIN Winter/2014 3

Costs  So, what is the actual magnitude of these costs? Javier Estrada  Cost of passive products IESE Business  Cost of active products School  Berkshire with and without fees Barcelona Spain  What mutual fund companies do not say Go  Some important implications  Bogle / Vanguard  Swensen  Kinnel Go  And the clincher: Lower costs lead to …  higher return  lower risk  higher risk‐adjusted return Go ADFIN Winter/2014 Costs  Morningstar Javier Estrada  Ability of costs and stars to predict returns IESE Go Business  And remember … School Barcelona  as far as financial products is concerned … Spain • the less you pay, the more you get! ADFIN Winter/2014 4

Appendix Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Style Box Javier Estrada IESE Business School Barcelona Spain Higher risk, higher return Higher risk, higher return ADFIN Winter/2014 Go Back 5

Star Rating Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back Stars Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 6

Analyst Rating Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back Costs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 7

Costs (Small ‐ Value) Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back Costs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 8

Costs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Costs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 9

Costs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Costs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 10

Costs – USA Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Source: ETF Landscape, BlackRock, 2010. Costs – Europe Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Source: ETF Landscape, BlackRock, 2010. 11

Costs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Costs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 12

Costs – John Bogle Javier Estrada IESE “The wonderful magic Business School of compounding returns Barcelona Spain is overwhelmed by the powerful tyranny of compounding costs.” ADFIN Winter/2014 Costs – David Swensen Javier Estrada IESE Business School “When you look at the Barcelona Spain results on an after-fee, after-tax basis over reasonably long periods of time, there’s almost no chance that you end up beating an index fund.” ADFIN Winter/2014 13

Costs – R. Kinnel (Morningstar) Javier Estrada IESE Business School “Investors should make Barcelona expense ratios a primary test in Spain fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you'll be on the path to success.” ADFIN Winter/2014 Back Costs, Risk, and Return Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 14

Stars & Costs Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014 Back 15