RetireWell™ Part 7: Capturing Returns Effectively

Once we have used the RetireWell tool and decided on the distribution of a retiree’s assets and the asset allocation for each portfolio, then we need to execute the investments well by helping them to gain the right exposures to the broad markets and capture the returns that they need. 

For this, we prefer to use instruments that are low-cost and do not try to beat the markets such as Exchanged Traded Funds (ETFs) and Indexed Funds (e.g. BlackRock iShares Unit Trusts), and evidence-based funds from Dimensional Fund Advisors. 

Low Cost, Consistent Results

One clear reason why this approach works is fees. Eugene Fama, Nobel Laureate in Economic Sciences, pointed out that before costs, active investment must be a zero-sum game, in which active investors who have positive returns must have made it at the expense of other active investors. After costs, however, in terms of net returns to investors, active investment must be a negative-sum game, where the sum of the returns that those investors get is less than the total returns available in the market due to fees. Thus, we like market-based funds because they are low-cost. 

In both the case of Index Funds and Dimensional Fund Advisors (DFA) funds, their costs are kept low as they do not trade as often as other active managers might, and they generally pay no distribution fees to advisers to sell their funds. What this means is lower management fees for clients. 

Every dollar that a client pays in fees to a fund manager is one dollar less in earnings. So, it is important to keep these fees reasonable so that investors can keep the return that is due to them for participating in the markets. 

Counting on Low-Cost Index Funds

Index funds are excellent tools in giving investors broad market exposures and helping them capture market returns. They essentially mimic the market’s performance by holding all the largest stocks in a particular market index according to their relative size. For example, an S&P500 tracker index fund which seeks to replicate the performance of the U.S. stock market would buy shares of all the 500 largest companies in the U.S. weighted according to how large each of those companies are. 

This means that the fund holdings are diversified, and representative of the market. Additionally, as the companies within the portfolio grow or shrink, the weightage is automatically adjusted. As a result, the fund managers running the funds do not have to trade too often to keep the portfolio in balance and thus costs can be kept low. 

The return that investors can expect from such a fund should be very close to the market’s returns, less the cost of running it. 

Not Really Active, Not Really Passive, But Evidence-Based Investing

From our years of experience, and from the research (some of which we shared in the previous chapters), we know that active fund managers seldom outperform the market. For those who do, it is rare to do it consistently over time. The one active manager who has managed to outperform the markets over the past decades is Dimensional Fund Advisors (DFA). DFA has managed to achieve this because they have kept their cost low (average fee of 0.3% p.a.) and they do not time the markets. Instead, they diversify their portfolios over thousands of stocks and tilt their portfolios towards value stocks, small caps and companies of higher profitability. According to academic research, a diversified portfolio of stocks of this kind outperforms the general indices in the long run. 

The uniqueness of DFA is that they really straddle between actively managed funds and index funds. Like index funds, they are broadly diversified. One of their funds, the Global Core Equity Fund holds 6,500 companies. Like index funds, they do not time the market because they believe that market pricing is efficient. As they do not trade in and out frequently, they avoid incurring high costs. But like actively managed funds, DFA picks securities that give a higher expected return. The difference is that they only pick those that show evidence of a higher expected return that are persistent across time periods, pervasive across markets, sensible and cost-effective to capture. This has good basis in academic research by scholars like Nobel Laureate Eugene Fama, Kenneth French and others. Many of them act as academic consultants, board directors or investment committee members to DFA. 

Enough Returns 

While these market-return-based methods of investing do not give spectacular returns, they give sufficient returns for our RetireWell portfolios. We are mindful that as retirement planners, our job is not to make retirees rich (they are already!) but to keep them rich and safe. What they want is really security and peace of mind in their retirement. 

In his book “Enough”, John Bogle, founder of Vanguard, and arguably the man who brought index funds to the masses, shares his view on what enough means in money, business and life. In the world of finance, he argues that it is marked by too much cost, and not enough value; too much speculation, and not enough investment; too much complexity, and not enough simplicity. In the business world, it is focused too much on counting and salesmanship, and not enough on trust and stewardship; and our society at large is too obsessed with charisma and wealth, and not enough with character and wisdom. 

This mindset of having “enough” is aligned with the approach we use to help clients retire. It is about not taking unnecessary risks and not incurring high costs, so that we get enough returns to give them a reliable income stream in their retirement. 

The writer, Christopher Tan, is Chief Executive Officer of Providend, Southeast Asia’s first fee-only wealth advisory firm and author of the book “Money Wisdom: Simple Truths for Financial Wellness“.

Here are the links to the RetireWell™ eBook chapters:

We do not charge a fee at the first consultation meeting. If you would like an honest second opinion on your current investment portfolio, financial and/or retirement plan, make an appointment with us today.

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