Increase your investment returns

Everybody wants to increase their investment returns. We plan on spelling out a few easy steps, to do just that.

This week we will focus on the basics, adding to the list of do’s and don’ts in subsequent ‘Insights’.

Each set of ‘guidelines’, or rules, will be accretive and will get increasingly detailed and focussed on the nuances of the market. We would advocate readers always go through the entire list to get the most out of it.

1. Cut costs:
This is such a basic first step to improving returns, but many investors fail to do so. We see this particularly in the retail and private banks, where clients are paying way over the odds for basic transactions – such as 1 to 3% in up front fees for investing in a fund and trailer fees of anything from between 20bps to 60bps. Such fees are often not understood by clients, as they assume they are simply the cost of doing business.

All in, the average client is probably paying around 2 to 3%, a cost they could avoid.

The Times of London once wrote about Goldman Sachs that it:

‘…makes money by charging hefty fees to the companies and clients it advises and whose assets it manages – typically 2-4 percent.’

Times of London November 8th 2009

There are numerous ways to cut costs:

Discount brokers – there are many brokers that will charge <10bps per equity trade.

Trade less – few traders make money consistently. We usually hear about the successful ones, but there are plenty of traders that ‘blow up’. Read rule two below.

Negotiate fees: Use a 3rd party such as a Multi-Family Office (MFO), or External Asset Manager (EAM), to negotiate your fees on your behalf. EAM’s can significantly cut transaction costs and, while they have their own layer of fees, these may be fully offset.

Check the fees being charged: 

• Check your transaction fees and any initial fees. In many cases you can complete the application on your own. We do this all the time for clients.
• Insist on full disclosure and transparency on all fees and charges. In the case of a fund: the manager fee, the trailing fees, the initial fee and the transaction fee. Yes, there are 4 potential fees for the bank.
• Be cautious trading less liquid credits – banks can charge very large spreads.

Avoid Universal insurance related products – these come with significant hidden upfront fees, that go to the selling agent in the first few years. They are also very illiquid, with penalties if you redeem early.

Watch out for illiquid products – yes the marketers may promise higher returns but does a 5 yr lock up justify a 1% extra return? I’m not so sure. If the market sells off you could have taken that liquidity and invested for a far higher rate of return. Only get locked up if the premium is worth it.

2. Be an Investor, not a speculator.
Remember when you buy a stock or a bond you are buying a piece of the company. You should know the company back to front in terms of its management, opportunities and threats and whether the stock is cheap enough to give the proverbial ’margin of safety’ that Buffett looks for.

Also, is management working on YOUR behalf?: Having been involved in a few private equity deals, I know first hand the importance of management. Do they work for the investor, that is taking on all the risk, or themselves?

An example that springs to mind, is of a company that declared a restructuring of the debt. Shareholders suffered complete loss, with the issued shares going to zero. New shares were to be issued, a significant proportion of which were to be given, at no cost, to the company’s management for all their ‘hard franchise-destroying’ work.

So look for management that are large holders of stock and have a terrific background of doing the right thing for stakeholders.

Does the stock price offer a margin of safety?: This does not necessarily mean cheap, on a P/E or EV/EBITDA basis. It means that the sum of the Net present value (NPV) of the company’s cash flows, which need to be as accurately determined as possible (not an easy task), is significantly higher than the current Enterprise Value of the business.

This sounds easy, but it does require some detailed analysis and reliance on forward looking assumptions. There are many books on the subject. A great book on being a value oriented investor is ‘The little book that beats the market’ by Joel Greenblatt. Check it out online.

3. Ensure you have the liquidity to weather a storm and take advantage when asset prices have sold down.

A mistake investors make all the time, is going into a market sell-off, fully invested. We have seen this at pretty much every market turn.

Not only that, but many investors start investing in illiquid trades/funds because of a marginally higher promised return. Not smart.

Here’s the thing – many private equity and illiquid funds will look to load up on committed capital even when they believe a market turn is coming. The reason is simple – they get committed capital to generate returns that become ‘abundant’ after a market sell off, on which they get performance fees. So we shouldn’t expect the fund managers to tell prospective investors to hold off on committing their capital, even at market peaks. Quite the reverse.

Private equity or vehicles with lock ups of 5 yrs or more should not, in my view, be more than 20% of invested capital. Sure, those that are wealthier and large sovereign funds can allocate a larger amount to the space. Even these investors , however, should be aware that, while average returns from illiquid investments may be higher than average, significant opportunities are missed when assets are being sold by a ‘depressed’ market at a significant discount, such as at the end of a bear market.

So investors need to consider, rule 2 when evaluating rule 3. If assets are super cheap, a higher proportion of capital could be set aside to exploit the opportunity and capture some of the premium for illiquidity.

The same applies to leverage. Don’t take leverage to earn a few percent more yield when assets are expensive – that’s a fool’s game. Rather wait until asset prices become cheap and then load up using margin financing as deemed prudent.

If you are concerned for duration mismatch on the margin loan, one can invest for example in a basket, or fund, of senior secured floating rate loans. In 2008 a number of these funds were down significantly, but had very low loss rates and delivered excellent returns coming out of the crisis. Given the duration on these loans is a few months, they are well matched to the duration of the margin loan, which is usually based on 3 month rates.

Watch out for our next set of investing guidelines, which will get more into using technicals and controlling risk.

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