3 Essential Things Every Investor Should Know

In a world where misinformation is often circulated it is imperative for investors to understand a few basic facts. In today’s note we will be coving 3 essential things that investors of all levels should know.

1. Actively managed funds generally have failed to beat their benchmarks over longer time periods

As shown by the chart below, active managers have struggled to outperform their passive benchmarks over long periods of time. This is a fact that many on Wall Street would prefer individual investors were not aware of as actively managed products generate higher fees than passive products.

The success rate has been particularly low for large cap equities. Just 9.8% of U.S. Large Blend actively managed funds have outperformed their benchmarks over the past 10 years.

The picture improves somewhat for bond, real estate, and foreign stock funds which have somewhat better historical success rates. However, the success rate for each of these categories overstates the success rate of active funds as a large percentage of underperforming funds close each year. The closure of a large number of funds creates a survivorship bias in the data. Funds with weak performance histories are often closed or merged with other better performing funds. The result is that active success rates are even lower than they seem.

Investors need to know this because they should be skeptical of high fee products. You might ask: what qualifies as a high fee product?

The average expense ratio for an actively managed equity mutual fund in 2022 was ~0.66% while the average expense ratio for an equity ETF was ~0.16%. The average expense ratio for an actively managed bond mutual fund in 2022 was ~0.44% while the average expense ratio for a bond ETF was 0.11%.

While it is not impossible for actively managed funds to outperform their benchmark, the reality is the vast majority of funds fail to do so over long-periods of time. The reason is not that active fund managers are bad at their jobs.

The reason is that markets have become highly efficient and active fees are a significant headwind for any active manager to overcome.

2. The long-run historical return for a 60/40 portfolio is ~8.7%

While estimates of the long-run historical return of a 60/40 portfolio (60% in equities and 40% in bonds) will vary based on the time frame used any reasonable estimate of the historical long-term performance of a 60/40 portfolio should be between 7.5% and 9.5%.

The 8.7% number referenced above comes from analysis conducted by Vanguard looking at the time period of 1926-2019.

The average return of a 100% fixed income portion of the portfolio was ~5.3% while the average return of a 100% equity portion of the portfolio was ~10.3%.

Being familiar with these numbers is critical for a number of reasons. Firstly, any solid financial plan designed to meet an objective such as providing for retirement or college expenses requires assumptions relating to expected returns.

While future returns may be different than the past, using historical average returns represents a reasonable starting place and it is important that these assumptions are grounded in reality.

A second reason why understanding the average long-term return of a 60/40 portfolio (and the equity and fixed income components) is important to understand is when something being sold or pitched to you is riskier than it seems. For example, investors may get pitched private investment deals that promise returns in the mid-double digits. While this level of return is possible, investors should be skeptical of risks relating to investment opportunities that have returns above 10%. These investment, often private companies, may pay off but the risk to achieve returns greater than public equitiy markets is generally very high.

Finally, another reason why understanding the historical returns of a 60/40 portfolio is important is to understand at a high level what impact changes in equity vs fixed income allocations may have on long-term expected returns.

3. The tax treatment for securities differs significantly

Given the high level of efficiency in capital markets today, tax considerations and efficiency are particularly important for individual investors to achieve optimal outcomes.

Smart tax planning can often be as important or more important than security selection or even asset allocation. While all the tax considerations to be aware of would be too much to include here, it is worth highlight a few high level facts to be aware of. Note: We are not tax accountants and investors should always consult their own tax professional before making decisions. 

Public equities tend to be fairly tax efficient as majority of investment gains come in the form of capital gains and dividends. Dividends can be qualified or ordinary depending on the type of company and the holding period. Qualified dividends get taxed at the long-term capital gains rate while ordinary dividends get taxed at ordinary income tax rates. Capital gains can be short-term or long-term in nature depending on the holding period. Short-term gains are taxed at the same rate as ordinary income while long-term gains are taxed anywhere from 0% to 20% depending on an individual’s taxable income. Additionally a 3.8% net investment income tax applies to capital gains, interest, and dividends once modified adjusted gross income exceeds certain thresholds.

Fixed income investments tend to be less tax efficient as income from securities other than municipal bonds gets taxed at ordinary income tax rates. Do to their tax advantage, high quality municipal bonds tend to offer yields lower than comparable U.S. Treasuries or high rated corporate bonds.

Preferred stock is a hybrid type security which can offer investors fixed dividend payments which are treated in many cases as qualified dividends. However, the tax treatment of preferred securities varies on an issue by issue basis. Generally, most, but not all, financial preferred issues qualify to be treated as qualified dividends.

Publicly traded partnerships including master limited partnerships are often very tax efficient as distributions are considered a return of capital. The result is that an individual’s cost basis is reduced overtime and tax is owed on the capital gain at the time of sale. Thus, the investment is able to grow on a tax deferred basis. On important thing to note about publicly traded partnerships is they come with a K-1 form which is can be highly burdensome from a tax preparation standpoint.

For 2023 the highest ordinary federal income tax rate is 37% while the highest applicable long-term capital gains tax rate (which also applies to qualified dividends) is 20% (23.8% if subject to the net investment income tax.) Thus, ensuring maximum tax efficiency and asset placement (where an asset is held e.g. IRA, trust, or regular account) is important for any investor.

For investors concerned with estate planning, the capital gains offered by equity investments may be even more valuable due to the step up basis rule which allows the cost basis to “step up” to the market price upon transfer when someone dies. If an investment does not pay any distributions and an investor never sells their position these gains may be transferred to heirs tax free.

Thank you for reading. If you enjoyed this article and believe it was value additive please consider sharing it with friends or colleagues who you think may be interested and encouraging them to subscribe to the Blue Chip Portfolio’s Newsletter here: https://bluechipportfolios.beehiiv.com/  

Blue Chip Portfolios is a publisher of financial information and is not an investment advisor. Blue Chip Portfolios does not provide personalized or individualized investment advice. Information provided is not tailored to the needs of any particular recipient. Blue Chip Portfolios does not guarantee the accuracy or completeness of the information provided in this page. All statements and expressions herein are the sole opinion of the author or advertiser.

THE INFORMATION ON THIS WEBSITE IS NOT AND SHOULD NOT BE CONSTRUED AS INVESTMENT ADVICE. INFORMATION PUBLISHED ON THE SITE DOES NOT PURPORT TO BE AND DOES NOT EXPRESS ANY OPINION AS TO THE PRICE AT WHICH THE SECURITIES OF ANY COMPANY MAY TRADE AT ANY TIME. THE INFORMATION AND OPINIONS PROVIDED HEREIN SHOULD NOT BE TAKEN AS SPECIFIC ADVICE ON THE MERITS OR CONSIDERATIONS OF ANY INVESTMENT DECISION. INVESTORS SHOULD DO THEIR OWN RESEARCH AND MAKE THEIR OWN DECISIONS REGARDING THE PROSPECTS OF ANY COMPANY DISCUSSED HEREIN. INVESTORS SHOULD NOT RELY ON THE INFORMATION CONTAINED HEREIN. INVESTORS SHOULD OBTAIN INDIVIDUAL INVESTMENT ADVICE BASED ON THEIR OWN SITUATION BEFORE MAKING ANY INVESTMENT DECISIONS

No expression of opinion or statement, or any other matter herein, directly or indirectly, is a solicitation or offer to buy or sell the securities or financial instruments mentioned.

The author, publisher or insiders of the publisher may currently have long or short positions in the securities of the companies mentioned, or may have such a position in the future (and therefore may profit from movements in the trading price of the securities). To the extent such persons do have such positions, there is no guarantee that such persons will continue to maintain such positions.

Any projections, outlooks or estimates herein are forward looking projections and are thus inherently unreliable. They are based upon assumptions and should not be construed to be indicative of the actual events that will occur. Other events that have not been taken into account may occur and may significantly alter the returns or performance of the securities discussed herein. The information provided herein is based on matters as they exist as of the date of preparation and not as of any future date, and Blue Chip Portfolios undertakes no obligation to correct or update the information in this document or to otherwise provide any additional material.

Blue Chip Portfolios does not accept any liability whatsoever for any direct or consequential loss howsoever arising, directly or indirectly, from any use of the information contained herein.

By using the Site or any related social media account, you are indicating your consent and agreement to this disclaimer and our terms of use. Unauthorized reproduction of this newsletter or its contents by photocopy, facsimile or any other means is illegal and punishable by law.