"I bet that cost you a pretty penny," I said with a grin. "No Daddy, it cost you a pretty penny," my daughter replied with an even bigger grin. The object we were referring to was a very expensive double BOB stroller that had caught my eye in my daughter's garage. It appears that, unbeknownst to Grandpa, Grandma had gone a little wild with gifts from Babies "R" Us. With a new grandchild arriving virtually every year for the last ten years, my wife has purchased so much stuff from that store that you would think she could have saved them from bankruptcy all on her own.
However, I don't begrudge her joy when it comes to buying presents for the grandkids. On the contrary, I encourage it because being doting grandparents is important to me. Growing up, I thought of grandparents as old people who lived far away, and you never saw. My mom's mom was 86 when I was born and her father was older than that. They lived in Boston and we were on the west coast. I saw them once before they died and I was only two at the time. My Dad's parents were half as far away, in the mid-west, but I only remember seeing them twice. The first time was when I was eight, and the main thing I remember about that trip was the agony of having to sit in a car for 10 hours a day. To calm me down when I threw one of my recurring "I can't stand sitting still" tantrums, my parents would tell me how wonderful it would be when I finally saw grandma and grandpa. So you can imagine the consternation I felt upon pulling into my Dad's hometown of Pewaukee and having Dad stop at the graveyard and say "That's where grandma and grandpa Ely are buried." Not realizing he meant his grandparents and not mine, I blew a gasket.
For those of you who are not mechanically inclined, that idiom refers to a car engine. When the head gasket blows, your car loses power, overheats, and eventually stops running. I don't know much about leaky head gaskets, but as a financial advisor I know the warning signs of a faulty financial head gasket. And that is why I am not worried about my wife's spending on gifts for the grandkids. They are well within our targeted spending rate, so there is no danger of blowing a financial gasket.
In a September 2018 blog, Michael Kitces, a well-known financial writer and advisor, explains why spending rates are so important. In his article he writes about the rule of thumb of saving 10% to 15% of your income for retirement. "The key point, though, is that it's not really the 'savings rate' that defines a successful savings path to retirement. It's actually the spending rate - and having a spending rate that is less than 100% of household income - because functionally most people don't 'choose' what to save per se... they choose what to spend, and then save the limited dollars that may or may not be left over..." And it is the big ticket items that make the biggest difference. So, "...making good decisions about the cars and the house matter way more than the lattes and the avocado toast!"
From the start of our marriage, we were prudent not only about our housing and transportation costs, but also about the lattes and avocado toast. We always lived in houses that were a little below our means and bought cars based more on economics than ego. We also controlled our monthly expenses by artificially limiting the amount available to spend. On top of that, we practiced what Kitces preaches that "...you can improve your spending rate (and therefore have more money available to save) by either spending less or simply by spending the same but earning more (or even earning more and spending more as long you don't spend ALL of the raise!)"
To paraphrase the Beatles: as an eight year old, I blew my mind out in a car. However, as adults, my wife and I have lived far enough within our means to avoid blowing a financial gasket. And now that our house and cars are paid for, grandma has the freedom to go a little bit wild.
To football fans he is a Super Bowl MVP quarterback, but to my daughter he will always be the ‘little brat’ that she babysat. While Anna has never played football, she has been on the receiving end of a number of our signal caller’s tosses. But it wasn’t footballs he was throwing and it wasn’t pass routes she was running. He was throwing water balloons, and she was running for cover. It was New Year’s Eve and the little brat along with his brothers had locked Anna out of the house. As she banged on the front door, alternately begging for mercy and spewing threats, the little gang of juvenile delinquents was stealthily sneaking out the back door. After retrieving their stash of water balloons they continued on their well-planned but ill-advised adventure.
I called their plan ill-advised because they never considered the consequences of their actions. They caught Anna completely by surprise, but they should not have been surprised by the hell they caught when their parents returned home. Being a good parent requires knowing when to extend mercy and when to impose consequences. Our future field general and his band of brothers found out real quick that this was not going to be a time for mercy.
Like parents, the IRS imposes consequences for stupid decisions. But, unlike good parents, they rarely show any mercy. So it surprises me how often tax consequences are ignored when investors purchase mutual funds. While the income tax implications of a particular fund’s strategy is not a consideration when selecting investments for an IRAs or a 401(k), it should be one of the most important considerations when selecting investments for taxable accounts.
Most mutual funds have an active investment strategy that attempts to increase returns by trying to unload poor performing stocks and replace them with winning ones. The result is that the typical US stock fund turns over about 95% of their assets each year. These transactions not only generate costs, but they also increase taxes because of the pass-through of the capital gains. The fact that many of these gains are taxed at higher short term rates makes things even worse.
To significantly reduce costs and taxes, smart investors choose indexed mutual funds which have turnover ratios in the 10% range, or less. According to ten-year statistics from the Summer 2006 issue of The Journal of Wealth Management, switching to an index fund would increase after-tax returns by 1.2 percentage points per year. And this number doesn’t include the cost advantage index funds have over active funds (but that is an issue for another time). Extrapolate only that tax savings over 20 years and the result is a 27% increase in value for the index funds.
This is good, but you can do better. While an active investment strategy is pretty much a guaranteed loser, active management of taxes (and costs) has just the opposite effect. By combining passive index investment strategies with active tax strategies, mutual fund companies have been able to significantly enhance the tax savings. Using our 20- year numbers, the tax savings could increase values by an additional 8%, on top of the original 27% increase.
Our little water balloon tossing quarterback grew up and learned to consider the consequences of his actions. Investors also need to grow up. Terry Bradshaw, a former quarterback turned announcer, described the maturing process in a unique way, “I may be dumb, but I’m not stupid.” In other words, learning from dumb mistakes is part of maturing. So mature investors consider the tax consequences of their actions because paying too much in taxes is just stupid.
“What’s the line for?” It was my oldest daughter’s first day of work at Murdock Elementary School, the same school I attended as a young boy, and she was curious why there was a line of students in front of the nurse’s office. She was told they were waiting to receive their hyperactivity medication. Upon hearing her story, I mentioned that fifty years earlier I was in a similar line. But it was at the end of the day and it was in front of the principal’s office. And, likewise, we were waiting for our hyperactivity medicine. However, instead of being a pill administered orally, it was a paddle administered to our behinds.
Attention-deficit disorder (ADD) - later changed to attention deficit-hyperactivity disorder (ADHD) - was introduced into the lexicon in the mid-1980s. Before that, it was simply known as “boys being boys.” When I started kindergarten, my mother was worried because I was the classic hyperactive child who couldn’t sit still. My favorite movie line of all time is “Can I move?” It was uttered by the Sundance Kid in Butch Cassidy and the Sundance Kid and it had to do with the fact that he couldn’t shoot straight unless he was allowed to move. I doubt anyone else even noticed that line but, for me, it really hit home.
Mutual fund managers also have the urge to move. However, what they are moving is investments around. “Call it hyperactivity,” says Economist columnist Buttonwood, “…fund managers, sitting at their desks all day, have the urge to trade…” But, unlike the Sundance Kid, fund managers (and their clients) would be far better off if they didn’t move. That conclusion was reached by Roger Edelen, Richard Evans, and Gregory Kadlec in their academic paper, Shedding Light on “Invisible” Costs: Trading Costs and Mutual Fund Performance. They “…found a strong negative relationship between…trading costs and fund performance.”
Most mutual fund investors are not aware that the expense ratio does not capture all the costs of a fund. In fact, it only captures the “visible” costs and those are less than half the total costs. Edelen, Evans, and Kadlec explain that “…[mutual] funds incur a host of ‘invisible’ costs that are less transparent to investors – most notably, the transaction costs associated with implementing changes in portfolio positions.” Their research determined that mean trading costs were 1.44% a year, whereas the mean expense ratio was 1.19%.
While it is well established that the expense ratio is one of the few reliable predictors of mutual fund performance, the effect of trading costs on returns had been unclear before Edelen, Evans, and Kadlec published their work. They found that risk-adjusted performance clearly decreased as fund trading costs increased. “The difference in average annual return for funds in the highest and lowest quintiles of aggregate trading cost was -1.78 percentage points.”
With average mutual fund trading activity increasing almost seven fold in the last fifty years, hyper-trading portfolio deficit disorder (HTPDD) has reached epidemic proportions. While medicating or paddling your mutual fund managers is a consideration, I doubt it would be effective because “traders will be traders.” A better option would be to get out of the high cost hyperactively managed fund line and get in line with a low cost, passively managed portfolio of index mutual funds.