Jun 29
Charles Ellis: Revisit Loser’s Game of Stock Picking
Let’s revisit Charles D. Ellis’ 1995 paper, “The Loser’s Game,” where he describes his Break-Even Return (BER) equation. Here is a review of this equation.
BER = [(Turnover percentage x Transaction Cost) + Management Fee + Target Return]/Market Return
It is quite easy to set up this equation in an Excel spreadsheet and play around with different variables. I discussed these variables with an Internet friend and using what we think are reasonable “modern-day” assumptions we came up with this BER value.
It is not unusual for actively managed mutual funds to have a 100% turnover and management fees to run 75 basis points. If we assume Target Return equals Market Return at 9% and the transaction costs are 1.5% going in and coming out of the market, the equation will look like this.
BER = [(1.0 x (.015 + .015) + 0.0075 + .09)]/0.09 = 1.4166 or 1.42. This money manager must then turn in a return 1.42 x 9% or 12.7% to equal the market. Costs do matter.
Assume you are managing an ETF portfolio and you are able to reduce the portfolio turnover down to 10% per year or a reduction of 1/10 the active money manager. This is not unusual based on my experience working with passive portfolios. Further, assume we can reduce commissions and bid/ask slippage to 1% in and 1% out. If we find liquid ETFs that are not actively managed, we should be able to reduce the management fee to 30 to 40 bases points. Since we are likely to have some emerging markets, let us raise this to 50 basis points. Now the BER equation will look like this.
BER = [(0.1 x (0.01 + 0.01) + 0.0050 + 0.09)]/0.09 = 1.08. This ETF manager must generate a return of 1.08 x 9% or 9.7% to match the market. That is a 0.7% return to match the market return of 9.0%. Quite a change.
Here are the important points to remember.
- Reduce trades in order to bring down the turnover percentage.
- Purchase in large enough quantities to lower commissions. Use a deep discount broker. Use limit orders to reduce bid/ask slippage.
- Find liquid ETFs with low expense ratios so as to minimize management fees. Look for low expense ratios.
Lowell Herr
Photograph: Gaudi art in Barcelona, Spain
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June 29th, 2009 at 6:20 am
I apologize for this blog taking 15-20 seconds to load. The site where I have this blog housed seems to have servers that are currently under powered. I’ve notified them. Let’s how something is done to improve the downloading speed.
Sysop
July 2nd, 2009 at 10:54 am
An Internet friend wrote the following message as clarification when it comes to Charles Ellis’ equation. The following explanation makes the Ellis equation clearer than my presentation of the argument. – Lowell Herr
“Regarding what’s quoted (at the end below) on your blog, I’m wondering if there is some confusion between percentage and percentage points.
Let’s take a simpler formula (that assumes zero turnover and a goal to equal the averages).
(X x .09) – (0.20) = (100 x .09)
X = (9 + 0.20) / .09 = 102.22 (percent).
So, to deliver net returns equal to the market while overcoming management fees of 0.20 percent you have to deliver 2.22% (not 2 percentage points) more return. So, if the market delivers 9% you have to deliver 9.2%. Fair enough (9.2 – 9 = 0.2% and 9.2/9 = 102.22%).
Back to the original formula, the assumption that you will give up 6% of principal value for a sell/buy combination seems outrageous to me. But if that’s really true then having to outperform by 12.8 – 9 = 3.8 percentage points (i.e., 142%) may make sense.
Again, with a simpler formula, to equal the market with zero management fees …
(X x .09) – [30 x (.03 + .03)] = (100 x .09)
X = (9 + 1.8) / .09 = 120 (percent).
… means you have to deliver 1.8 percentage points more return (10.8% rather than 9%) which is indeed 20% higher.
The bottom line for your Passive Portfolio was that it needs to deliver 9.4% rather than 9% (9.4/9 -100% = 4.4% higher). Do you really think that is a difficult hurdle (to out perform the market by less than a 1/2 percentage point)?”