[PDF] - Motivation The return an investor obtains Javier Estrada is PDF Document

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1. Motivation
Three relevant variables
2. Stars
Morningstar style box
Morningstar stars
3. Costs
Types
Magnitude
Impact

Risk & Return (II):

Stars & Costs

Javier Estrada ADFIN – Winter/2014

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Motivation

The return an investor obtains …
is lower than the return of the funds in which he

invests due to …

the costs of financial products

 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

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Morningstar

Style box
Separates funds along the risk‐return categories we

discussed before

Value v. growth
Small caps v. large caps

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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?

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Morningstar

Stars
A measure of risk‐and‐cost‐adjusted return

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Main characteristics
Proprietary
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

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Morningstar has another performance measure
Analyst rating
Subjective

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs

The most underrated of all financial variables
Consider
An initial investment of $10,000
A 20‐year holding period
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 Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs

There are several relevant costs to consider
Visible
Loads (Front‐end, back‐end)
Management fee
Incentive fee
Other fees

⇒ TER (Total Expense Ratio)

 There is also a net expense ratio (Net of fee waivers)

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‘Hidden’
Trading costs
Bid‐ask spreads
Taxes

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs

So, what is the actual magnitude of these costs?
Cost of passive products
Cost of active products
Berkshire with and without fees
What mutual fund companies do not say

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Some important implications
Bogle / Vanguard
Swensen
Kinnel

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And the clincher: Lower costs lead to …
higher return
lower risk
higher risk‐adjusted return

Go Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs

Morningstar
Ability of costs and stars to predict returns

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And remember …
as far as financial products is concerned …
the less you pay, the more you get!

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Appendix

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Style Box

Higher risk, higher return Higher risk, higher return

Back Go

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Star Rating

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Stars

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Analyst Rating

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Costs

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs (Small‐Value)

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Costs

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs – USA

Source: ETF Landscape, BlackRock, 2010. Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs – Europe

Source: ETF Landscape, BlackRock, 2010.

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs – John Bogle “The wonderful magic

f compounding returns

is overwhelmed by the powerful tyranny of compounding costs.”

Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs – David Swensen “When you look at the 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.”

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Costs – R. Kinnel (Morningstar)

“Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor

f performance. Start by

focusing on funds in the cheapest or two cheapest quintiles, and you'll be on the path to success.”

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

Costs, Risk, and Return

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Javier Estrada IESE Business School Barcelona Spain ADFIN Winter/2014

Stars & Costs

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