Focus on the impact of expenses, taxes and inflation on gross returns.
When it comes to investing, high gross returns might grab headlines, but they often fail to tell the entire story. “The reality is clients can only consume returns after expenses, taxes and inflation,” says Peter Mladina, director of portfolio research for Wealth Management at Northern Trust. “These are the returns that count in the real world.”
By overlooking triple net returns – or returns after expenses, taxes and inflation – investors risk chasing performance that doesn’t account for reality, saving too little and finding themselves with a wealth shortfall later in life. Read a hypothetical example of how one investor’s returns are impacted by expenses, taxes and inflation.
Triple Net Returns in Action
A hypothetical example of how returns can be impacted by expenses, taxes and inflation:
|Carol invests $100,000 in an equity mutual fund for 20 years.||The stocks owned by the mutual fund earn a gross return of 8.5%. The $100,000 investment would grow to about $511,000 at the end of the holding period assuming no expenses, taxes or inflation.|
|Carol’s expense profile:||Carol pays an annual expense ratio of 1%; the fund generates 50% annual turnover of underlying stock holdings. Fund expenses plus trading costs, including market impact, run approximately 1.4% per year. Carol earns 7.1% return net of expenses.|
|Carol’s tax profile:||Carol is in the highest marginal tax bracket. She incurs dividend taxes, short-term and long-term capital gains taxes from ongoing turnover, and long-term capital gains taxes from the final liquidation of the fund for consumption at the end of the 20-year period. An annualized estimate for taxes over the 20-year period runs approximately 1.5%, producing a 5.6% return net of all expenses and taxes.|
|Maintaining purchasing power:||Annual inflation over the 20-year period is 3%.|
|Carol’s triple net return:||Carol earns a 2.6% triple net return.|
|Carol’s true outcome:||The $100,000 investment will grow to about $167,000 after considering all expenses, taxes and inflation.|
The need to plan around triple net returns rather than gross returns amplifies in the context of a Goals Driven Wealth Management approach in which clients align their unique life goals with a highly customized and dynamic asset allocation. As investors pinpoint the specific goals they want to fund, more precision is needed around estimating the full cost to fund those goals over time.
“If a client wants to fund annual lifestyle spending for 50 years, you have to consider the dollars that are likely to be available in real purchasing power for each of the next 50 years,” Mladina says. “The only way to do that is by thoughtfully considering triple net returns.”
Fortunately, with upfront planning, investors can potentially minimize the impact of expenses, taxes and the risk of inflation on their returns – and have greater confidence in achieving their goals.
In the simplest context, certain options for fulfilling investment strategies are higher cost; some are lower cost. “All things being equal, clearly you would prefer a lower-cost option to a higher-cost option,” Mladina says. “Of course, not all things are equal.”
Investors can potentially mitigate expenses by considering lower-cost engineered or passive solutions, or rigorously vetting active managers to ensure they generate enough excess return to overcome the additional expense.
“It’s all about being sensitive to expenses and being willing to incur them if there is evidence of additional return from manager skill or some other value-added contribution to the total portfolio,” Mladina says. “It’s about being eyes wide open with these kinds of tradeoffs and thoughtfully incorporating them in portfolio construction.”
Minimizing the Impact of Taxes
While taxes are a drag on returns, much depends on an investor’s individual situation and specific goals. “Assets serve a purpose that should be to fund life goals, and that purpose weighs heavily on tax implications. If you’re going to consume the returns yourself, you’re going to pay tax on it at some point in the future,” Mladina says. “If the assets eventually transfer to a child or grandchild, you’ll have other tax consequences depending on the wealth transfer strategies employed and timing. If certain assets go to philanthropy, you might have a very different perspective on tax efficiency.”
When incorporating tax-efficient strategies, certain asset classes such as high-yield bonds might be less appealing to a taxable investor, who might consider a lower exposure to high yield than a tax-exempt investor would. For example, a taxable investor might opt for municipal bonds in place of corporate bonds. Asset location plays an important role as well. Deploying less-tax-efficient assets in a tax-deferred account, such as an Individual Retirement Account, can potentially mitigate the tax concern.
Certain investment strategies can help minimize the impact of taxes on returns. “A manager who trades often and generates significant short-term capital gains might be avoided – unless the manager can persistently generate enough gross return to overcome the additional tax,” Mladina says. “An investor instead might consider longer-term strategies with lower turnover.”
Mitigating the Risk of Inflation
While investors clearly can’t control the inflation rate, they can control some of the risk that inflation brings to a portfolio. The first step, Mladina says, is simply recognizing that inflation-adjusted returns are significant when it comes to maintaining purchasing power and funding future goals. From there, a number of strategies can help mitigate the risk of inflation:
- Incorporating inflation-protected bonds
- Investing in assets that offer an equity-like return premium but have shown sensitivity to inflation when it becomes a problem (natural resources, for example)
- Ensuring bond allocations don’t mature too far into the future and therefore are overly exposed to inflation risk
Reading Beyond the Headlines
Investors who chase performance, and whose eyes are set intently on gross returns, likely will end up disappointed. “Gross returns grab headlines, but what counts are the returns you keep, which are the triple net returns,” Mladina says. “It’s not just about performance; it’s about funding your goals with confidence.”