Let’s revisit Charles D. Ellis’ 1995 paper, “The Loser’s Game,” where he describes his Break-Even Return (BER) equation. Here is a review of this equation.
BER = [(Turnover percentage x Transaction Cost) + Management Fee + Target Return]/Market Return
It is quite easy to set up this equation in an Excel spreadsheet and play around with different variables. I discussed these variables with an Internet friend and using what we think are reasonable “modern-day” assumptions we came up with this BER value.
It is not unusual for actively managed mutual funds to have a 100% turnover and management fees to run 75 basis points. If we assume Target Return equals Market Return at 9% and the transaction costs are 1.5% going in and coming out of the market, the equation will look like this. Transaction costs are highly dependent on the dollars one is investing and 1.5% is now on the high side, particularly for those of us who rely heavily on commission free ETFs.
BER = [(1.0 x (.015 + .015) + 0.0075 + .09)]/0.09 = 1.4166 or 1.42. This money manager must then turn in a return 1.42 x 9% or 12.7% to equal the market. Costs do matter. Assume you are a TDAmeritrade client and you are picking individual stocks. If you negotiated $7.00 trades and you are buying only when you have $1,000 to invest, then $7.00/$1,000 reduces commissions to 0.7% going in and out. BER is then the following.
BER = [(1.0 x (0.007 + 0.007) + 0.0075 + 0.09)]/0.09 = 1.2388 or 1.24. This manager must turn in a return of 1.24 x 9.0% or 11.1%. Still a very high percentage.
Assume you are managing an ETF portfolio and you are able to reduce the portfolio turnover down to 10% per year or a reduction of 1/10 the active money manager. This is not unusual based on my experience working with passive portfolios. Further, assume we can reduce commissions and bid/ask slippage to 0.5% in and 0.5% out. If we find liquid ETFs that are not actively managed, we can reduce the management fee to 30 to 40 bases points. Since we are likely to hold a few ETFs that are not commission free, let’s raise this to 50 basis points. Now the BER equation will look like this.
BER = [(0.1 x (0.01 0.01) + 0.0050 + 0.09)]/0.09 = 1.08. This ETF manager must generate a return of 1.08 x 9% or 9.7% to match the market. That is a 0.7% return to match the market return of 9.0%. Quite a change. If you are paying someone 70 basis points to manage your portfolio, you are paying out a 100% rate to beat the market. Read that sentence again.
Here are the important points to remember.
- Reduce trades in order to bring down the turnover percentage or use commission free ETFs.
- Purchase in large enough quantities to lower commissions as a percentage of the total investment. Use a deep discount broker. Use limit orders to reduce bid/ask slippage.
- Find liquid ETFs with low expense ratios so as to minimize management fees. Look for low expense ratios.
