El SEGUNDO, CA (Oct. 19, 1999) -- In my last two articles I have been focusing on the costs of investing in various mechanical strategies. In part 1, I talked about how to convert a strategy's backtested return which didn't consider costs into a real-world return. In part 2, we looked specifically at strategies that trade monthly. We saw that someone starting with $2000.00 could end up losing to a money market fund while following a monthly strategy that returned 42% annually before costs.
Today let's compare after-cost returns for strategies with varying initial investments and holding periods. Remember, although longer holding periods may show lower returns in our cost-free backtests, investors need to realize that those "lower" return strategies may put more money in their pockets.
The following chart shows the after-cost but before-taxes return for the RS-26 week monthly strategy and the PEG strategy in its monthly, semiannual, and annual versions. (The PEG's return is also fairly close to the Keystone and Spark screens if you are interested in their after-tax returns.) By the way, don't think you can ignore this reality just because you may soon be opening up one of those free-trade accounts at American Express. You still need to consider spread. If you have a free-trade account then just assume you are in the $1,000,000.00 category when calculating your return.
Amount Invested RS-26 M PEG-26 M PEG-26 S PEG-26 A Cost Free Return 42.0% 44.1% 47.9% 45.8% $2000 3.9% -12.6% 32.7% 35.6% $5000 24.8% 14.9% 40.5% 41.2% $7500 29.5% 21.0% 42.2% 42.4% $10,000 31.8% 24.1% 43.1% 43.0% $20,000 35.3% 28.7% 44.4% 44.0% $30,000 36.4% 30.2% 44.8% 44.3% $50,000 37.3% 31.4% 45.2% 44.5% $100,000 38.0% 32.4% 45.5% 44.7% $1,000,000 38.6% 33.2% 45.7% 44.9%
M = Monthly
S = Semi-Annual
A = Annual
4-Stock Portfolio's - all starting in January
Annual and Semi screens turned over all the stocks every time
RS-26 M made 28 trades/yr. PEG Monthly had 38 trades per year
RS screen assumed a spread of 0.41%.
All PEG screens assumed a spread of 0.89% (based on actual spreads for October 1st stock selections)
As you can see, because of the frequent trading and high spreads even with a $1 million portfolio, the PEG monthly strategy loses almost 11 percentage points from its backtested average return. For the RS-26, the results aren't quite as bad because the screen has lower turnover. With a $1 million dollar portfolio, the investor's return will drop 3.35% due to costs. The returns drop steadily, though, as lower and lower portfolio values are used.
But the big question here is: What's the point of monthly trading? It never beats the semi-annual and annual screens? I don't think that this chart is the stake in the heart of monthly trading. It's possible to pay less than $10 per trade, and these are only two strategies, both of which have fairly high turnover. An investor who pays less per trade and is using a monthly screen that has lower turnover may find the costs less of a problem, but only if returns are at least as high as the average over the past 12 years.
Then again, the chart above assumes that the money is in a tax-deferred account. At the very least, it should put a stake in the heart of monthly strategies if taxes are considered and, of course, it sounds the death knell for smaller portfolios using a monthly strategy. It also should certainly be a wake up call for all investors to look very, very closely at costs as a percentage of their own portfolios especially if they trade frequently.
Remember when making any investment decision, don't let greed today make you feel foolish tomorrow.
Until next time, Fool On!