?? Investment "gotchas" (and how to see through them)
Vieje’s newsletter last week on hidden/obscured fees in private investments got me thinking about other investment “tricks” that I see from time to time. Trick is probably too strong a word; a more generous interpretation of some of this stuff is marketing spin, and some of it is probably simple naivete.
Here’s my non-exhaustive list that I would encourage you to research in more depth to ensure you know what you're really getting from your investment portfolio.
?? Price return vs total return
Some investments pay dividends or distributions. A “price return” doesn’t account for those dividends, while total return does. When you open the stocks app on your iPhone and look at the return of a stock over its history, that’s the price return, not the total return. I don’t understand why anyone would care just about the price return. Total return is the relevant measure of investment success because it's total, and that’s what matters. For example, over the past three years, Coinbase and AT&T have had pretty similar price returns at about ~40% cumulative. However, once you account for dividends, AT&T’s total return is much more attractive at nearly 74% over the same time period.
?? Internal Rate of Return (IRR) vs Compound Annual Growth Rate (CAGR)
IRR is a common return metric used in private market investments. It’s a fine calculation, but you need to understand how it differs from other return calculations, or you’re setting yourself up to potentially be tricked. The IRR calculation accounts for cash flows (both in and out of the investment) and, this is the key, assumes any distributions can be reinvested at the same rate of return. Managers can potentially inflate the reported IRR by sending out a distribution early on in the life of the investment. That will boost the reported IRR but won’t necessarily make you better off if you can’t actually invest that money at the same rate of return for the rest of the investment life. In contrast, Compound Annual Growth Rate (CAGR) represents the steady annual return required for an investment to grow from its beginning value to its ending value and assumes a smooth compounding effect, ignoring cash flow timing. Both measures have their place, but they’re often not comparable to each other. Like many things, the devil is in the details.
?? Benchmark shenanigans
Picking an appropriate benchmark is critical to interpreting investment performance. There are literally thousands of indexes. Some of them will have great track records, and some will have poor track records. It’s far easier to look good on a relative basis if you pick a benchmark that happens to have done poorly historically or is just not comparing like for like. For example, an equity fund benchmarked against the S&P 500 that invests a meaningful portion of its assets in small/micro cap stocks is not benchmarked appropriately because the S&P 500 doesn’t include small and micro cap stocks. It’s not an apples-to-apples comparison.
?? Volatility smoothing
Gaming volatility is one of the most common tricks. The way it’s employed is often to show the correlation of the strategy to the stock market. What people want is low correlation and high returns. The problem is, you can’t compare an asset that doesn’t trade continuously to one that does. It’s mechanics. If you run a correlation of the S&P 500 returns with the S&P 500 returns but marked at quarterly intervals, it’s less than one, not because the S&P 500 marked quarterly instead of daily is better…or even different at all, but because that’s how the math mechanically works.
?? Assuming tax deferral is tax avoidance
Death and taxes are the two things you can’t avoid, right? Deferring a realized gain can be quite beneficial, but it doesn’t mean you’ve avoided your tax liability forever. In most cases, it’s just kicking the can down the road to a later date. Once you account for the fact that you will likely eventually have to pay the capital gains tax, the benefit of deferral isn’t quite as attractive. Additionally, if your tax rates go up in the future because you move to another state with a higher tax rate, move up tax brackets, or even if tax rates go up in general, deferring the tax bill to that date when you pay a higher rate can be worse than paying it now. Don’t get me wrong, tax deferral is usually beneficial, but not always beneficial, and it’s helpful to understand why so you can be more strategic.
There are myriad other gotchas like assuming returns are normally distributed (i.e., underestimating tail risks), relying on short time periods, cherry-picking start and end points, not accounting for taxes, ignoring transaction costs, using spurious correlations, and more! But if you wrap your head around even a few of these issues, you’ll be far ahead of most investors.
Things we’re digging: