Unlocking Investment Success: The Power of Simplicity, Fees, and Tax Efficiency

At Highland we prioritize simplicity in decision-making. Identifying and mitigating unnecessary complexity is crucial, particularly in the realm of investments.

When it comes to investment strategies, there are essentially two approaches:

• Passive and Cost-efficient: This strategy aims to match the performance and characteristics of the benchmark as closely as possible.

• Active and Higher Cost: Here the objective is to outperform a specific benchmark by identifying mispriced assets.

Intuitively, the second option may sound appealing. Shouldn’t a group of professionals be able to add value beyond a simple benchmark? Of course, but we have to consider the impact of fees and their compounding effect on net returns over time. At the end of the day, net returns are what matters when comparing performance.

A recently published SPIVA Study compares fund performance across different categories against appropriate benchmarks using net of fees returns. The study is released semi-annually and goes back more than 20 years. The most fascinating part about the results is the consistency at which the majority of funds end up trailing the benchmark over the long run on a net return basis.

This doesn’t mean that every active fund is bad or that outperformance is impossible; rather that for most of the market the odds are far too low. Another way to interpret the data is that by sticking to the benchmark as close as possible one can end up ahead of the majority of funds within a given category.

Last year, the same group also published a report covering the tax inefficiency of active funds and the drag on net performance it creates. For example, over a 20-year period annualized return for an average US fund focusing on large companies was 2% below the S&P 500 Index on an after-tax basis1. The compounding effect of a 2% annual gap in returns over a 20-year period is simply too high to ignore.

The overwhelming evidence showing unfavorable probabilities for long-term outperformance means that chasing “outperformance” juice is probably not worth the “fee” squeeze and added complexity. Instead, it is more beneficial to look at the underlying funds to understand fees, expenses, and tax efficiency that could have a material impact in the long term.

Here are three key factors that Highland considers in our investing strategy:

Simplicity vs Complexity

While it may sound counterintuitive, when it comes to investments, simplicity is often an advantage. We work to identify areas where complexity leads to wasted resources without adding value. With over 90% of equity funds trailing the benchmark over a 20-year period (based on the study above), the odds favor simplicity.

Fees Matter

High fees associated with actively managed funds can significantly erode net returns over time. According to a 2022 Morningstar study2, the average fees for US and international equity active funds were 1.04% and 1.14%, respectively. In contrast, Highland’s equity portfolio carries an underlying fund fee of just 0.04%3.

Tax Efficiency Matters

Actively managed funds are often inefficient from a tax perspective. Over a 20-year period, the annualized return of an average US fund focusing on large companies was 2% below the returns of the S&P 500 Index on an after-tax basis. In contrast, a good tax-loss harvesting program can enhance annualized after-tax returns by up to 3% per year, depending on the market and investor’s tax profile⁴. Highland’s ‘asset location’ strategy, where assets are allocated to accounts based on their tax efficiency, can enhance after-tax benefits even further.

As always, please do not hesitate to reach out if you have any questions. If you would prefer a more in-depth discussion, please reach out to your advisor and we will schedule a call including one of our investment team members.

Sources:
¹ SPIVA® After-Tax Scorecard: The Effect of Taxes on Indices and Active Funds 12.31.2022
² Morningstar’s 2022 U.S. Fund Fee Study
³Highland equity fund expense ratio based on weighted average underlying fund prospectus data as of 12.31.2023
⁴Joel Dickson, Kevin Khang, and Thomas Paradise, 2021. “Tax-Loss Harvesting: An Individual Investor’s Perspective”