16 Aug The three “inevitables” & the bionic advisor

Mermaid Mellissa - alpha generating portfolio managerMeet Mermaid Melissa: An Alpha Generating Active Manager

Our new bionic advisor, Bento, is now established, and has an appearance that promises permanency, success, and can help efficiently manage your portfolio of investments around three inevitable certainties in investing:

1- US domestic withholding taxes

2- Underperformance of active managers

3- Fees on investments

We now evaluate the valued-added of a human-led robo-advisor beyond the oft discussed topics of building efficient portfolios with superior algorithms that dispassionately deploy your investment needs and create reports in real time in a jiffy.

US domestic withholding taxes

A human-led robo brings in nuances such as ensuring investors don’t pay for taxes that they don’t owe, select the right ETFs based on individual needs while also working with clients to ensure that they stay focused on the path of slowly building a core portfolio.

tax pencil sketch

While many of us live in places such as Singapore, Hong Kong, and so on, where taxes on investments and income are lower than global averages, unknowingly we continue to pay taxes that apply in markets where we invest in, unless we manage this actively.

It’s in our human nature not to factor in expenses and outlay where we what we don’t physically cough up cash or write a on a cheque. Mostly unaware, we lose a chunky 30% in US domestic withholding taxes on instruments that are domiciled or listed in the US, including stocks and bonds. The highest impact is, of course, on dividend paying stocks and bonds. The impact on bonds is now further accentuated as spreads have narrowed to nothingness and all that we have are coupons to clip.

It is near impossible for individuals to efficiently claim back any of the domestic withholding tax that has not accrued by non-US tax payers like most of us. Appointing a credible third party for filing tax returns to claim back will potentially costs north of US$10,000 – I am talking of the credible accountancy firms who have the skills in this space.

As with every problem, there is a possible solution.

We suggest managing around this unnecessary tax bite by carefully selecting investment vehicles with countries of domicile that have a double taxation treaty with the US, such as Ireland or the UK. The chart below compares two ETFs that pay domestic withholding tax of 30% (SPDR Barclays High Yield Bond ETF and iShares Global HY Bond ETF) with their London domiciled counterpart (iShares USD HY Bond UCITS ETF). The implied tax savings are irrespective of the fact that UCITS ETF have a slightly higher expense ratio – 50 bps versus the other two at 40bps.


Over any time horizon, the UCITS ETF consistently outperforms its US domiciled counterparts. While there are very minor differences in the defined investable universe of the three ETFs, the ratio of spread compression and the coupon rates are comparable and therefore what the difference in performance we see is largely the impact of saving on US withholding tax. Therefore, by making an informed choice on the domicile, we help save 30% on coupons or dividends.

All ETFs are not created equal and, while choosing what to buy or what to avoid, we suggest factoring in the following:

  • Liquidity – most ETFs are traded OTC. This could be as high as 70% and what you see on data released in public domains may not paint the full picture.
  • Fees – some ETFs entail higher expense ratios but just filtering for fees doesn’t solve the invisible tax leak. Certain jurisdictions tend to be more expensive than US listed ones. While the intent is to minimize costs and shave off all the unnecessary bits of tax, jurisdiction of domicile plays a role as we have seen above.
  • Exposure type – in an environment where banks and financial institutions are not what they used to be 12 years ago, it is best to stay clear of unknown counterparty risks. We prefer ETFs with straight physical exposure and avoid those with contract for differences, participatory notes or other options that bring in risk that we don’t have a gauge on.
  • Domicile – the bite of tax on coupons and dividend take a large chunk or your portfolios’ performance. UCITS, even if slightly more expensive in certain cases, help access asset classes such as dividend paying equities and bonds more efficiently.


Underperformance of active managers

Markets are efficient, alpha is a mermaid’s song, fees make a dent & introduce conflict. Active stock selection strategies or funds are not a source alpha, but gunning for alpha is a source of costs.

Funds are sold and not bought; else the breed of active managers claiming to add value via alpha would not exist. The following chart is a tell: all and most of us are yet to meet the mermaid who justifies up to 2.50% annual fees on your invested sum including other expenses that come with maintaining the fund.

The light blue bars are the percentages of the funds in specific sectors that underperform their benchmark and the dark blue bars are funds that closed down. As we see below, an outstanding majority of active funds do not add any value over any investment horizon, regardless of the sector or the asset class we consider.


Fees on investments

While efficient markets do not allow for fund managers to outperform most markets, the key reason for consistent underperformance is the fees. And also Mermaid Melissa’s stock picking skills which clearly don’t cover for the fees.

To further cement the case with some specific examples, following are some of popular active funds compared to relevant ETFs investing in the same space. American Funds – Fundamental Investor is the highest rated Morningstar Fund in the US Gold-rated funds. PIMCO Total Return has been chosen as it occupies a prominent place in investor’s minds and hearts, and it is also well regarded by a number of selectors.


Therefore we conclude: Alpha is a zero sum game & Mermaid Melissa doesn’t exist!

These fees do not only make your investments underperform, they also generate conflict of interest. Distributors make money from front-end fees on funds plus trail commission and fund managers take up to 2.50% of your assets, no matter what.

As per Bloomberg, passive products, such as index funds and ETFs, have about 30 percent of the $16 trillion in total investor assets, compared with active products, which still have the remaining 70 percent.

Someday again in the far far future, we may build the case for active managers, when ETFs flows will have overtaken active funds by a wide margin and when inefficiencies that offer stock picking opportunities re-emerge. Active managers may once again deserve our money!

We therefore suggest building ETF-only portfolios with advisors who are compensated via advisory fees. This makes your advisor work for you and for no one else. You and I know there is no free lunch in investing and – even if your robo or your advisor says it is free – it just is NOT free!

The human element combined with the latest robo algorithms will have an edge to steer portfolios through various certainties and uncertainties, and through market cycles.


Sources: Bloomberg, Morningstar, http://cedarspringspost.com/,

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