6
TRANSACTION COSTS, FEES, AND TAXES
The ultimate value of an investment is determined by how much it contributes to your consumable wealth. That depends not only on how much the value of a security or portfolio increases, but also on what fraction of that increase you get to keep. There are three basic reasons why you keep less than 100%: transaction costs, fees, and taxes. We will take a look at each in turn, but before that it is helpful to get an idea of how important these factors might be.
Exhibit 6.1a plots the nominal path of wealth (POW) for the Center for Research in Securities Prices (CRSP) index, which we saw in Chapter 1. The three lines below the top line show what the POW would look like if transaction costs, fees, and taxes reduced the returns on the market index by 1 percentage point, 2 percentage points, and 3 percentage points. Exhibit 6.1b repeats the exercise using real returns.
EXHIBIT 6.1a The impact of cost on performance: nominal stock market POWs 1926–2017.
EXHIBIT 6.1b The impact of cost on performance: real stock market POWs 1926–2017.
The exhibits show that the long-run impact of the costs is dramatic. The reason is that unlike stock returns, which are highly volatile, costs are a consistent drag every year. While in any particular year costs may seem small relative to the market movement, particularly if the market movement is large, over the decades their impact cumulates and becomes a major determinant of performance. In the case of nominal returns, ending wealth drops from $5599 to $2374 to $998 to $416 as the costs rise from zero to 1 percentage point, 2 percentage points, and 3 percentage points, respectively. The picture is the same for real returns. Without costs the inflation adjusted end-of-period wealth is $406, but when costs are 3 percentage points it drops all the way to $30.
Given their importance, costs are clearly something an investor should not ignore. To complicate matters, the extent of the costs an investor pays is not always evident. For instance, when trading small stocks, the most important cost is not fees paid to the brokerage firm – those have been driven down by competition and technological innovations, but the impact of the bid-ask spread. That impact, however, depends on the specific stock being traded and the size of the trade, among other things.
Because they can have such a significant impact on long-run investment performance, it is worth examining some of the details related to each of the three major categories of costs: transaction costs, fees, and taxes.
TRANSACTION COSTS
By definition transaction costs are proportional to the amount of trading. The level of trading is generally measured by turnover. In the equity market, annual turnover equals the total value of shares traded divided by the average market capitalization during the year. Exhibit 6.2 plots the turnover for U.S. stocks from 1975 to 2015. The exhibit shows that turnover has grown dramatically, rising eightfold from 20% in 1975 to 160% by 2015. Two factors have helped fuel this rise. First, technology has made it much easier to trade, and opened the door to algorithmic trading where computers constantly buy and sell in time periods of seconds or less. Second, improvements in technology have also helped promote a dramatic reduction in trading costs. That reduction, in turn, has been partially responsible for the rise in turnover.
EXHIBIT 6.2 United States stock market turnover in percent: 1975–2015.
The turnover rate provides insight into trading behavior. A turnover rate of 200%, which the market surpassed on several occasions, means that every six months the average investor sells his or her entire portfolio and replaces it with something new. This clearly suggests that large swaths of the market are neither passive nor fundamental investors.
When you sell one stock to buy another the only thing that happens for sure is that you pay two transaction costs. If the market is efficient, so that all stocks are fairly priced, then you end up right where you started with a fairly priced stock, minus two transactions costs. The more actively you trade, the greater the drag on your investment performance due to transaction costs.
Trading involves two types of transaction costs: fees paid to exchanges and brokers and market bid-ask spreads. Competition among brokerage firms and exchanges has markedly reduced fees. For example, SMBP recently sold 10,000 shares of an S&P 500 Exchange Traded Fund (ETF) with a market value $2,436,000. The fees to the brokerage firm were $4.95 and the exchange fees were $56.27. The total fees of $61.22 amount to only 0.003% of the value of the trade.
Competition and technology have also reduced the size of bid-ask spreads for actively traded securities. For instance, at the time the SMBP trade was executed, the spread for the ETF was 243.61 bid to 243.63 ask, which comes to 0.008% of the ask price. If the brokerage firm were able to execute the trade somewhere between the bid and the ask, the effective spread would be even less. Not all spreads are as low as those for an actively traded ETF; the spread depends on things like the price of the security and the volume of trading. Nonetheless, for actively traded stocks the spreads are remarkably small. The average bid-ask spread as a percentage of ask price for S&P 500 stocks was 0.042% in December 2017. This low spread is both a blessing and a curse. A blessing because trading costs are so low. A curse in that it produces an incentive for what might be excessive trading. Just because active trading has become cheaper does not mean that it has become wise.
Not all stocks trade at such small spreads. For small firms, particularly small firms in financial distress, spreads are much larger. For example, Acusphere, a small and financially troubled company with a market capitalization less than $100 million, trades at a bid-ask spread of over 25%.
As we leave the sphere of actively traded stocks, spreads start to widen. With the exception of Treasury securities, which trade at spreads comparable to stocks, the spreads on bonds are higher and more difficult to discern. This is due in large part to the problem of heterogeneity. All shares issued by a company are identical. If you have seen one Tesla share you have seen them all. That is not true of Tesla bond issues. Each issue is unique. They differ by coupon and maturity and most importantly by seniority. The seniority determines where in the queue the holders of a specific bond will be if the company is forced into reorganization and thereby affects the credit risk. As a result of differing seniority, bonds issued by the same firm can have markedly different credit risk. In addition to, and perhaps because of, the heterogeneity, bonds trade in a less transparent and less active market. Many bonds go for weeks without trading, making it difficult to discern what the market price is. To protect themselves against the price uncertainty, dealers in these bonds quote a wide bid-ask spread.
Fortunately, there is little reason for investors to actively trade bonds. High-grade bonds, as we noted in Chapter 3, are basically alike in that they respond to one central factor – the level of interest rates. This means there is no reason for an investor to exchange one high-grade bond for another because both will behave similarly. In the case of low-grade bonds, the Milken analysis holds. If an investor believes a low-grade bond is underpriced, he or she can simply buy it and hold it, thereby reaping the high coupons. There is no need to wait for the market to appreciate the mispricing so that the bond can be sold at a higher price. Finally, to the extent that an investor wants to trade a security based on his or her predictions regarding future corporate performance, the securities to trade are stocks, not bonds. Not only are the bid-ask spreads smaller for stocks, but stocks are more sensitive to changes in a company's financial performance. The bottom line is that bonds are securities to buy and hold, not to trade. This reduces the impact of their higher bid-ask spreads, because the costs can be amortized over the length of the holding period.
The other way to reduce the costs of holding bonds is to buy them through a low-cost fund. As we saw in Chapter 2, investors are increasingly holding securities through funds. The role of funds as financial intermediaries is so important that it is worth exploring in greater detail. We will use the example of investing in low-grade bonds, but the concepts apply to all similar assets.
To review, the problems with investing in low-grade bonds are that they are heterogeneous and illiquid. The high trading costs make it difficult to diversify. All of these problems can be solved by a fund. The basic idea is simple. The fund buys a large portfolio of low-grade bonds and then issues shares (or limited partnership interests) that entitle the shareholder to a certain stated fraction of the income earned by the fund after expenses and management fees. Investors get into and out of the fund by trading the shares either with the fund itself or on an exchange in the case of an ETF. Because the purchases and sales of shares by investors tend to offset each other, the fund does not have to transact very often in the underlying securities, thereby greatly reducing transaction costs. In the case of ETFs, there is no need to transact in the underlying securities at all because investors trade the fund shares with each other through the exchange.
The task performed by the fund is an example of financial intermediation. The fund transforms hundreds of illiquid low-grade bonds into highly liquid fund shares. There is nothing new about the process. It is basically what banks have done for centuries. They hold illiquid assets like loans and issue highly liquid deposits.
There is one other problem that banks and some funds also solve – evaluating the underlying securities. As part of the lending process, banks assess the credit worthiness of the borrower. Depositors, therefore, do not have to evaluate the quality of loans themselves.1 Actively managed funds, including active stock funds, hedge funds, and private equity funds, which we discuss below, perform similar information-processing services. In this respect, they are different from passive funds, which simply match certain indexes. The information-processing service, however, does not come cheaply, as we describe below.
As an example of intermediation, the Vanguard High-Yield Corporate Fund holds positions in 524 low-grade bonds, but it has an expense ratio of only 0.23% per year. For individual investors interested in low-grade bonds, such a vehicle provides a liquid, low-cost, diversified way of taking a position. Vanguard does not try to determine whether the bonds it holds are properly priced. To the extent that an investor feels that certain low-grade bonds are mispriced, individual bond holdings can be added to what is largely a diversified, passive strategy.
Moving beyond bonds, spreads tend to widen further. We postpone our discussion of alternative assets including real estate until the chapter on alternative investment, but two points are worth making now. First, assets with large bid-ask spreads are not appropriate trading vehicles. The cost of a round-trip buy and sell can be as much as an entire year's return. Second, the best way to hold these assets is typically through funds. For instance, in the case of real estate there are real estate investment trusts that purchase large diversified portfolios of properties and then sell shares or partnership interests to investors. In general, as intermediation services have become more efficient with the rise of ETFs, holding fund shares has become the optimal way to hold most illiquid assets. As financial technology continues to improve, the role of funds as intermediaries is likely to become even more widespread. The question that remains is choosing between passive and actively managed funds.
MANAGED INVESTMENT FUNDS AND FEES
From a conceptual standpoint, managed funds work the same way as passive funds. The fund holds a portfolio of securities and issues shares (or partnership interests) against them. The difference is that managed funds add investment selection to the list of services provided. For that service, they charge fees and have expenses that are significantly greater than passive funds. This is in part due to the fact that managed funds, in an effort to beat the market, have higher turnover than passive funds.
Actively managed stock funds (primarily mutual funds, pension funds, and ETFs), hedge funds, and private equity funds differ primarily in the types of investments they hold and the fees they charge. Traditional stock fund managers hold primarily common stock. Many of the active stock fund managers follow strategies similar to those that we described in the chapter on fundamental investing, but there are a variety of approaches. For obvious reasons, the details of how a fund makes its investment decisions are proprietary. Fees and expenses at active mutual funds and pension funds average about 1% (100 basis points) per year, but they can be as low as 25 basis points and as high as 150 basis points. Because of Securities & Exchange Commission (SEC) regulations, mutual funds are required to disclose their holdings on a periodic basis.
The term hedge fund originally arose to describe managers who held short as well as long positions. Today it means funds that can hold just about anything. Hedge funds are typically set up as general/limited partnerships. In this structure, the general partner assumes responsibility for the operations of the fund, while limited partners can make investments into the partnership and are liable only for their paid-in amounts. In order to be excluded from SEC registration, hedge funds are generally constrained to have no more than 99 limited partners. This means that most hedge funds are not available to small investors. That limitation has been circumvented by so-called funds of funds, which are specialized funds that hold limited partnership interests in hedge funds and issue shares to final investors. The general partner's responsibility is to market and manage the fund, and to perform any functions necessary in the normal course of business, including hiring the fund managers and managing the administration of the fund's operations. Because of the exclusion from SEC regulations, hedge funds do not face the same disclosure requirements as mutual funds and many are quite secretive. In some cases, secrecy itself becomes a marketing tool. The idea is that if you have a secret sauce, as many hedge fund managers claim, you would never disclose it. However, this secrecy makes it more difficult to measure the risk and assess the performance of hedge funds.
The other feature of hedge funds is the size of their fees. While fee structures vary, one of the most common is 2/20 which refers to 2% of assets under management and 20% of profits. At that fee level, you can see why many hedge funds are secretive. To justify such high fees, a hedge fund must convince investors that it can sufficiently outperform the market on a pre-fee basis, so that investors can still beat the market after paying the fees.
Private equity funds are specialized investment companies that provide financial backing and make investments in the private equity of startup or operating companies. Like hedge funds, private equity companies are typically general/limited partnerships. In fact, private equity firms can be thought of as hedge funds that specialize in investing in private companies. Fees charged by private equity firms are also similar to those of hedge funds.
To boost potential returns for limited partners, hedge funds and private equity firms make significant use of borrowed money. As the result of this leverage, the returns of successful hedge funds and private equity firms can be spectacular – in either direction. One famous hedge fund, Long-Term Capital Management (LTCM), was noted for aggressive use of leverage. For every $1 of equity capital, LTCM borrowed nearly $100 to leverage its positions. Unfortunately when the market turned against LTCM that leverage proved to be its undoing and the firm went bankrupt. Despite the experience of firms like LTCM, when fund returns are spectacularly positive, investors clamor to invest despite the high fees. Compared to a potential 100% return, even the hedge fund fees look small. Academic research has found that the flow of funds occurs despite the fact that, as we noted in Chapter 2 and will revisit in the next chapter, short-run performance has virtually no predictive power for future performance.
The case of John Paulson provides a perfect example. Paulson was an obscure hedge fund manager prior to the onset of the financial crisis. He became famous by taking a very large and highly leveraged short position in mortgage-backed securities. With the onset of the crisis, Paulson's fund made profits in excess of $10 billion dollars and Mr. Paulson personally raked in profits exceeding $4 billion. Not surprisingly, Mr. Paulson became an investment sensation. He was even the subject of a popular book, The Big Short, which was made into a movie. In response to the massive past profits, investors poured money into Paulson's fund. Unfortunately, over the five years following the financial crisis, the return on Paulson's fund was approximately −65%. The story illustrates the risk of chasing the huge returns that successful hedge funds report. If those past returns are not predictive of future performance, all the investor gets out of the chase are the transactions costs of moving money and the opportunity to pay 2/20.
TAXES
With rates up to 50% for wealthy investors, taxes clearly affect after-tax investment performance. This makes tax strategy an important part of investing. However, the U.S. tax code currently runs to 73,954 pages, so a book on the conceptual foundations of investing can hardly do justice to the subject. There are, however, two basic tax issues that all investors should keep in mind: the distinction between income and capital gains, and the distinction between realized and unrealized gains and losses.
Income Versus Capital Gains
Income is generally taxed at higher rates than capital gains. This fact is not particularly relevant to investors who hold funds. For such investors, the breakdown between income (dividends) and capital gains will be determined by the stocks in the fund and how fund management trades them. Investors who hold stocks directly gain the ability to choose the ratio of stocks that pay dividends to those that do not, thus altering the ratio of income to capital gains. That can reduce taxes because income is taxed at a higher rate than capital gains.
Some investors may fear that holding only non-dividend-paying stocks will be a drag on total return, but that thinking is incorrect. Remember that the expected return on a stock depends on its risk, not on whether it pays a dividend or not. When stocks pay a dividend, the price drops by the amount of the dividend, so there is a direct substitution of income for capital gain without any impact on total return. However, a strategy of focusing on stocks that do or do not pay dividends does have a cost in terms of reduced diversification.
Interest income is taxed at income rates unless the bonds are issued by a tax-exempt entity. Like the corporate bond market, the tax-exempt bond market is highly heterogeneous. Bonds are issued by state and local governments, educational institutions, public works projects, and hundreds of other smaller tax-exempt entities. The ratings of tax-exempt bonds cover the waterfront from AAA to being on the verge of default. As we write this, the territory of Puerto Rico, for instance, has $72 billion in bonds outstanding, none of which are rated investment grade.
As was the case for taxable bonds, most tax-exempt bonds are illiquid and trade, if at all, at high bid-ask spreads. Consequently, the best way to hold the bonds is through a fund, for the reasons described previously. The Vanguard Long-Term Tax-Exempt Bond Fund currently holds 3,669 bonds and has an expense ratio of 0.09%.
The decision whether to hold taxable versus tax-exempt bonds depends upon a comparison of the investor's tax rate with the tax rate impounded in bond prices. For example, the yield on the Vanguard Long-Term Tax-Exempt Bond Fund is currently 2.11% compared to a yield of 4.06% on the Vanguard Long-Term Corporate Bond Fund. Based on these two yields, the break-even tax rate is 48%. Unless the investor's marginal tax rate is greater than 48%, a rate which few investors pay, the corporate bonds are currently a better choice.
There is a particularly nefarious interaction between taxes and inflation that arises because taxes are computed based on nominal dollars, not real dollars. A simple example using interest rates illustrates the problem. Consider two different inflationary environments. In the first, the real interest rate is 1% and inflation is 2% so that the nominal interest rate is 3.02%2 – rates comparable to those today on high-grade bonds. In the second, the real interest rate is 1% and inflation is 5%, so that the nominal interest rate is 6.05%. The investor is assumed to pay taxes at a rate of 30% on nominal interest income. Assume that the investor is investing $100. At a 3.02% rate of interest the end-of-period nominal amount is $103.02 and the real amount is $101.00. However, the investor pays tax on the entire $3.02 of nominal income. At a 30% tax rate that comes to $0.906. The effective tax rate is 90.6% so that the investor's after-tax real return is less than 0.10%. A tiny real return, but at least it is positive. In the second scenario, the $100 investment grows to $106.50 in nominal terms but is still $101.00 in real terms. However, the investor's tax bill is now 30% of $6.05 or $1.815. After paying the taxes, the investor is left with $99.185 in real terms – less than the initial investment. The effective tax rate is an astonishing 181.5%!
Although the calculation is easiest to do for interest income, it holds across the board. Total nominal return is always a combination of the real return and inflation. Taxes are levied on the nominal returns. When inflation accelerates, and some day it probably will again, real after-tax returns can easily become significantly negative because the investor is paying tax on both the real return and the part of the nominal return that is compensation for inflation. One way to partially offset the impact of the rising inflation tax is to hold assets like non-dividend-paying common stock that offer return in the form of capital gains rather than income and then postpone recognition of the gain.
Realized Versus Unrealized Gains and Losses
Capital gains taxes are levied when a gain or loss is realized, not when it occurs. This makes it possible to benefit from what is called the tax timing option by realizing losses and deferring gains. An added benefit of the tax timing option comes from the fact that long-term gains are taxed at lower rates than short-term gains. Therefore, losses can be realized when they are short-term, while deferring gains until they reach the long-term status.
The tax timing option is more valuable for investors who hold individual securities rather than diversified funds. The holder of a diversified fund pays taxes on the net capital gains taken across all securities in the fund. An investor who holds individual securities can choose which ones to sell and when to sell them. It is even possible to sell a stock, realize the loss, and then repurchase it. However, if the repurchase occurs within 30 days of the sale, the loss is disallowed, so be sure to wait.
Although postponing capital gains can partially offset the impact of the inflation tax, it can lead to some nasty long-term surprises. Suppose that you buy a stock in an environment in which inflation is 5% and hold it for 20 years, earning a nominal return of 5%. Despite the fact that the real return is zero, every $100 invested in the stock would rise to $265.33 in nominal terms. If you then sell the stock and the tax rate is 30%, you would owe $49.60 in taxes on an investment whose real value was unchanged.
We have only scratched the surface on taxes. Taxes, like fees and transaction costs, are something over which an investor has some control, unlike the random variation in asset prices. Often there is excessive focus on asset prices because swings in prices are attention grabbing. Over the long run, however, taxes, transaction costs, and fees can be just as important.
CONCEPTUAL FOUNDATION 6
Conceptual foundation 6 states that although the random fluctuations in asset prices are beyond the control of investors, costs are not. Careful management of transaction costs, fees, and taxes is a sure way to improve investment performance. Elimination of costs on the order of 1% per year can have a significant impact on long-term wealth accumulation. Cost considerations also imply that the best way for investors to hold less liquid assets is through low-cost passive funds.