Our investment philosophy allows us to avoid or minimize the main pitfalls associated with traditional active management: cash drag, market impact costs, unnecessary taxation and trading costs.
1. Cash Drag
Mutual funds need to hold large cash reserves as money flows in and out. Since this money is not in the market, investors are missing out on potential returns. Depending on the year, the average cash holding in a mutual fund can be as much as 8%. If the equities in that fund return 6%, this means the return of that fund is reduced by 0.48% (i.e., 8% cash earning zero times the 6% return). Cash drag adds to the long-term cost of holding mutual funds.
At Polaris, we keep cash as close as possible to zero, thereby minimizing its impact on your returns.
2. Market Impact Costs
Many mutual funds buy or sell so much of a given stock that its price is affected. When large blocks of a stock are sold, the supply of that stock in the market increases, which tends to drive the price down. When large blocks of a stock are bought, the demand for that stock in the market increases, which tends to drive the price up.
The result is that mutual funds tend to buy at a premium and sell at a discount, thereby reducing the investor’s returns. Returns are reduced even further because mutual funds typically turn over 75% to 200% of their securities every year. How much are these costs? Studies done by Dr. Donald Keim at the Wharton School of Business at the University of Pennsylvania and Lewis Chan at the University of Illinois estimate that these costs average between 0.6% to 0.8%. If we take the mid-point of this range, then the average market impact cost is 70 basis points, or 0.7%.
At Polaris, we employ a broad market, buy-and-hold methodology that minimizes the effects of market impact costs. In fact, DFA has introduced strategies to actually take advantage of market impact costs and turn them into positives for investors.
3. Unnecessary Taxation
Unlike Polaris, traditional active managers may buy and sell between 75% and 200% of their holdings each year. This excessive trading can generate unnecessary taxation. Since taxes must be paid every year on these gains, there is less money available to grow. KPMG performed a study that calculated the extra tax cost to investors at 2.2% per year.
At Polaris, we minimize trading and use tax-efficient investment tools from DFA, iShares and Vanguard. These tools allow us to defer capital gains. Since taxes are deferred, there is more money available to grow.
4. Trading Costs
Most investors look at the management expense ratio (MER) of a mutual fund to see how much it will cost to own a particular fund. The MER of a typical mutual fund may be outrageous on its own. However, it does not include brokerage commissions, and therefore understates the true cost of ownership. Trading costs are instead part of the Trading Expense Ratio (TER). The MER plus the TER is the true cost of owning the fund. Typically, funds with high turnover (lots of buying and selling) have higher TERs and are therefore more expensive to own.
At Polaris, our use of investment tools from DFA, iShares and Vanguard reduces trading costs and minimizes the total fees our clients pay.