How do you invest money for the ultra-long term? This came as a question from a reader on how to invest a dynasty trust. It’s also a question that endowments, charities, and foundations face.
A few questions come to mind when the time horizon is a century or more. What obstacles exist around management? What type of investment philosophy do you embrace? How do you ensure that what’s set in motion doesn’t diverge from its initial path?
First, this a good but difficult problem to have. The hardest part is getting things setup properly from a legal and tax perspective (a bit outside my purview). The U.S. tax system is complex and requires estate planning expertise to legally maximize long-term tax savings in relation to the client’s goals.
On the investment side, three things come to mind when thinking in terms of a century or more.
1) Management Continuity. A century or more creates a few obstacles around management. The trust or fund will not only outlive the person, or family, that set it up, but also whoever is hired initially to create a plan and manage the money.
Continuity around client objectives, investment philosophy, fees, etc. must be ensured long term. The trouble is large amounts of money (think 8 or 9 figures) attract consultants, committees, a bias towards action, unnecessary complexity, herd mentality, etc. It’s a long list. The downside is more activity and higher costs.
The team should be small to avoid bloat. It could be independent or part of a larger firm that specialize in this area. There are pros and cons to both. They should prioritize a fiduciary responsibility above all else.
Turnover in its ranks is guaranteed due to retirement, resignation, and death. They’ll face regulatory and tax changes. Market disruptions are assured.
And if the next century is anything like the last century, they’ll face numerous financial innovations that could make the initial investment choices or investment strategy obsolete. The ability to be disciplined but open-minded enough to separate fads from new approaches that fall within the investment philosophy come to mind as paramount to success.
2) Investment Approach. In general, there are three investment approaches to consider.
The two extreme options are fully actively managed or a low-cost indexed approach. In both cases, its likely to be equity heavy to take advantage of the long-term growth potential of businesses.
The actively managed approach brings the intention of outperforming some benchmark. Which means it introduces the possibility (probability) of underperforming. If the team is not picking stocks, for example, then they’re outsourcing it.
So active brings a fund of funds approach. The need to replace underperforming and retiring managers will be constant. Success will be based on the ability to find fund managers with uncorrelated strategies to create a portfolio mix that fits the long-term objective of the fund.
The advantage, assuming it’s structured with a long-term focus, is it can minimize the consequences of career risk (too much or not enough risk-taking) by fund managers. But that assumes the “picking fund managers” part is successful.
The downside: it’s fees on top of fees. Loads of research suggest how difficult it is to “beat the market” before fees. It’s even tougher to do after fees.
The indexed approach accepts what the market offers. There’s no chance of outperforming. It relies on minimal fees to get as close to the market average as possible.
The portfolio is built around a global equity allocation. A rules-based process should exist to handle rebalancing and/or risk mitigation at market extremes, while limiting tax liabilities. A simple rules-based process is not perfect but helps minimize behavioral mistakes and should lead to better results than without it.
A third, hybrid approach, mixes the two. For example, an 80/20 indexed/active blend offers the potential for slightly better returns than a pure indexed approach. If the active side falls short, its consequences, in theory, are minimal.
Even then, the size of the fund will dictate the success of the active portion. Simply, the pool of investment options shrinks as the size of the fund grows. That alone makes it harder to outperform.
Which of the three options is “best” will determine the skillset of the team and the costs attached.
3) It’s the fees. As mentioned earlier, fees have a huge impact on investment success. Charlie Munger weighed in on this in 1999 in relation to philanthropic funds (the market was going bonkers then). His greatest concern? Costs!
Not just any costs. The high costs that come with consultants, fund managers, and exotic strategies in a world where a double-digit bull market return is no longer the norm.
Now is time for a little arithmetic: It is one thing each year to pay the croupiers 3 percent of starting wealth when the average foundation is enjoying a real return, say, of 17 percent before the croupiers’ take. But it is not written in the stars that foundations will always gain 17 percent gross, a common result in recent years. And if the average annual gross real return from indexed investment in equities goes back, say, to 5 percent over some long future period, and the croupiers’ take turns out to remain the waste it has always been, even for the average intelligent players, then the average intelligent foundation will be in a prolonged, uncomfortable, shrinking mode…
All the equity investors, in total, will surely bear a performance disadvantage per annum equal to the total croupiers’ costs they have jointly elected to bear. This is an inescapable fact of life. And it is also inescapable that exactly half of the investors will get a result below the median result after the croupiers’ take, which median result may well be somewhere between unexciting and lousy.1
The “croupier’s take,” is ever present in investing. Every $1 invested at an 8% annual return over 100 years grows to $2,199.76, but after a fee of:
- 1%, you only have $867.52.
- 0.5%, you have $1,383.08.
- 0.25%, you have $1,744.73.
- 0.10%, you have $2,005.14.
The above illustrates the compound effect high fees have on money over time. A 1% fee, charged over a century, enriches the fund manager more than the net total return enriches you.
While the management team and investment strategy are important, if you pay too much in fees, it negates the other two.
The fact is fees play the biggest role in long-term investing success. Getting the fees right means you can be less perfect on team construction and investment strategy and still do alright. Higher fees require near perfection in those areas for success.
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