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Setting Yourself up for Underperformance

By: Sachee Trivedi

Ted Benna is an important person. In 1980, this benefits consultant took an obscure provision of the Revenue Act of 1978 that allowed tax exemption for deferred compensation and used it to create a pension plan for his employer. That fateful provision was called the Section 401(k). The rest they say is history. But Ted was not entirely pleased with what he had created, or rather enabled create – the mutual fund and the financial advisory industry. Ted never reconciled with the high fees charged by mutual funds and financial advisors.

Another person who wasn’t a fan of high fees was Jack Bogle. Often hailed as the father of index investing, his philosophy was that its difficult for an active fund manager to outperform the market over time by prudent stock picking. Add to that the high fees charged by the manager and the investor is certainly worse off. His solution: Index funds. These funds gave an investor a low-cost way to achieve market returns. The exchange-traded version called ETFs allowed investors to trade in and out of these index funds throughout the day.

Jack Bogle famously said buy the haystack rather than look for the needle.

Many US investors took these lessons to heart and decided to go one step further. They thought it was a good idea to apply these principles to investing in foreign markets, e.g. India, where they didn’t have any competence in looking for the needle. To buy the haystack in India, they decided to buy Indian ETFs such as INDA US ETF or INDY US ETF.

Turns out they bought neither the needle nor the whole haystack. They bought a much smaller haystack that gets even smaller with time, relatively speaking.

The table below illustrates the returns of the Indian ETFs popularly bought by US investors and compares it to the returns of the corresponding benchmark.

Source: Bloomberg

$100 invested in INDA US ETF ten years ago would be worth $186 today, an annualised return of 6.4%. While the same $100 invested in the MSCI India benchmark would be worth $221 at an annualised return of 8.25%!

Similarly, $100 invested in the INDY US ETF twenty years ago would be worth $182 today while the same $100 invested in Nifty 50 benchmark would be worth $229. The annualised return would be 6.2% vs 8.65% respectively.

For contrast, if we do a similar exercise for SPY US (this is the S&P 500 ETF) and S&P 500 Index, we find the returns are almost identical – an annualised rate of 10.88% vs 10.92% over a ten-year period.

So where did it all go wrong?

For a start, Mr. Bogle didn’t factor in the sun in his sagely advice. Turns out it makes a huge difference. The sun rises in Japan, travels to India and visits US some ten hours later by which time the Indian stock market is closed for trading. So, the ETF responds to the action in the Indian stock markets one day late. One day can be a long time in a rising or declining market. This is reflected in a tracking error of 3.1% and 3.3% for INDA and INDY. When you operate in the same time zone such as the SPY US ETF and the SPX Index the trading error is only 0.02%. The timing of currency conversion further adds to the tracking error.

Remember the fees that Ted and Jack so hated? Well looks like for the pleasure of running a foreign ETF, the ETF providers charge greater fees! To be fair they incur some higher expenses as well. While SPY US ETF has an expense ratio of only 9bps, INDA and INDY ETFs have an expense ratio of 65bps and 89bps!

Finally, the liquidity. SPY ETF trades c.$550 bn of assets, while the INDA trades only c.$11bn assets. INDY has less than $1bn of assets.

The table below illustrates the point.

Source: Bloomberg

Conclusion

Don’t set yourself up for guaranteed underperformance. 

At Trident Capital, we dislike fees as much as Mr. Benna and Mr. Bogle. So, we have 0% management fee and10% performance fees for our clients. Why, you ask. Because Mr. Bogle said,

“A fiduciary standard means, basically, put the interests of the client first. No excuses. Period.”

For more information please contact Spotlight Family Office Group at Info@SpotlightFamilyOffice.com.