Wealth Confiscation by Your Three Investment "Partners"

As I've written about in previous blog posts, investment fees and taxes are wealth confiscators that have serious negative compounding effects on capital appreciation.One way to think about this is that every investor has three partners: their advisor, the investment manager, and the government.

Three Partners Wealth Confiscation

The advisor and investment manager take a percentage of the account returns (or principal in down years) in the form of asset management fees and/or commissions. The government operates a non-consensual profit sharing arrangement where it takes a percentage of the realized gains and gives an offset for losses to be applied against future gains. All three of these partners are bad partners and their involvement in investments should be actively minimized. Remember, the investor is taking all the risk and their three partners are sharing in the returns (or principal). The three partners are also first to the return troth, taking their share before the investor gets theirs.By focusing on planning alpha, instead of investment alpha, the wealth confiscation of these partners can be minimized.

Wealth Confiscation and the 70 Percent Rule

In 2014, Stuart Lucas wrote a white paper entitled “The 50 Percent Rule: Keep More Profit in Your Wallet”.  In this paper, Lucas proposed a simple heuristic: if you can't reasonably expect to keep 50 percent of the net after-fee, after-tax returns, you shouldn't make the investment.[1] I believe this criteria is entirely too generous. A 70 percent rule is more reasonable, after all, the investor is taking all the risk, why should she agree to a 50 percent split of the profits from her risk-taking?Let’s look at some examples of how the 70 percent rule works when applied to different types of popular investment vehicles.

Chart One: Internal Rate of Return for Various Equity Investment Vehicles[2]

Chart One shows the annualized internal rates of return for four different investment vehicles: hedge funds, private equity funds, mutual funds, and index funds. The analysis assumes the investments are each held for four years and then sold.You can see that hedge funds and private equity funds are poor performers, while mutual funds are better and index funds are the best.Importantly, even at the loose 50 percent criteria, hedge funds never make the cut, that is, at no return level do they deliver 50 percent or more of gross returns to investors. Private equity funds are a little better due to the typical long-term nature of their gains, but they only cross the threshold at the 15 percent annualized return level.  (That is a tall order at this stage of the market.)Mutual funds, which are notoriously tax-inefficient, are miles ahead of alternative investments such as hedge funds and private equity funds. They deliver 50 percent of gross returns to investors around the four percent annual return level.Index funds, due to their low fees and extremely low tax distributions, are the clear winner. They are above the 50 percent threshold at almost any return level and quickly approach 70 percent.Another way to look at this is through an analysis of the gross returns needed to get to a fixed net return.

Chart Two: Gross and Net Return Comparison – Taxable Accounts[3]

Chart Two shows the high gross returns that must be generated by hedge funds, private equity funds, and mutual funds in order to generate a net five percent to the investor if held in a taxable account. An obvious critique of this is that these investments could be held in a tax-advantaged account such as an IRA, privately placed life insurance, or other structure. This is true, and would remove the immediate tax issue (although would simultaneously create one on the back-end).

Chart Three: Gross and Net Return Comparison – Tax-Advantaged Accounts[4]

Holding these investments in a tax-advantaged account lowers the gross return level needed to generate the five percent annualized return. However, the loss of long-term capital gains treatment and various estate tax complications could greatly reduce the tax benefit over the long-term. Furthermore, most ultra-high net worth investors have the vast majority of their liquid investments outside of IRA and other tax-advantaged accounts.

Wealth Confiscation Over the Long-Term

A number of financial writers including John Kay and Terry Smith, have illustrated the wealth confiscation of hedge fund fees by applying a hypothetical 2 and 20 hedge fund fee schedule to the returns of Berkshire Hathaway.The results are that over 90 percent of the cumulative returns go to the manager! The investors cumulative return drops from $4.3 million to $300,000.

Wealth Confiscation by Arbitrary and Capricious Mutual Funds

Although mutual funds compare favorably to hedge funds and private equity funds under the 70 percent rule, they are to be avoided. The potential tax consequences of owning mutual funds can be quite negative and are outside of the investors control. For instance, Jason Zweig recently highlighted how Harbor Funds replaced the sub-advisor for its Harbor International Fund. The new sub-advisor decided to sell most of the funds existing holdings, many of which had very large embedded capital gains. The result is that Harbor now estimates a capital gain distribution of $23 to $27 per share for the Harbor International Fund when the NAV is $64.94.[5] While this is not uncommon, the destruction of investor’s principal through realized capital gains is bracing. The fact that Harbor facilitated that destruction is all the more remarkable.As I’ve written about, custom indexes offer investors a way to minimize fees, control their taxes, and defeat their three partners.