Transaction Costs
Bogeyman or straw man?

by Ann Coleman (TMF AnnC)

Reston, VA (May 18, 1999) -- For the past several days we've been addressing some of the common criticisms of the Foolish Four strategy as articulated in a recent journal article. Last week we covered the question of "data mining," or the finding of spurious correlations between high return and other factors. This week we will finish up with discussions on risk-adjusted returns, transaction costs, taxes and the problem of "popularity."

I would have liked for you to have a copy of the article we have been discussing to follow along with, but I have been unable to find an online copy of "Mining Fool's Gold" in the March/April issue of the Financial Analysts Journal. Bill Reiser of Birmingham, Alabama, who faxed me the copy of the article, made this series possible. Thanks, Bill.

But even though the actual journal article isn't online, alert reader Edmund Schweppe found a "lighter" version that the authors did publish at the Brigham Young University website. Both McQueen and Thorley are associate professors of finance at the Marriott School of Management there. You can download and read the paper from this site:

The general gist of the article is that the Foolish Four strategy is the product of "data mining," and therefore the conclusion that it will continue to work in the future as it has in the past is not valid. The authors then argue that even if the returns do continue to beat the market by similarly large margins, these returns disappear when adjusted for risk, transaction costs, and taxes. Please see yesterday's article for my take on risk-adjusted returns. Today we will deal with transaction costs.

McQueen and Thorley point out that the Dow as a whole is a relatively stable list of stocks and that anyone investing in all 30 would experience lower transaction costs each year than Foolish Four investors. The recent introduction of Dow Diamonds makes the cost to invest in the Dow almost negligible, but I want to look at the numbers quoted in the article first, because the logic used troubles me.

The article points out that on average you would only have to replace one Dow stock every other year if you were invested in the entire group, but with the Foolish Four you are replacing 2.39 stocks per year "resulting in a large transfer of wealth from the Fools to the Wall Street Wise.... Assuming a 1 per cent one-way transaction cost, 1.20 percent of the Foolish Four's wealth was lost to transaction costs in a typical year, whereas only 0.03 percent of the Dow 30's value was lost in dissipative trading." This is significant only if you assume several things: Using either a medium- or full-priced broker or some kind of money management plan that charges a fixed percentage management fee, and NO COST to buy the original 30 Dow stocks.

Just for fun, I looked at what it would cost you to have invested $10,000 in the Foolish Four vs. all 30 Dow stocks over 20 years. I used a transaction cost of $20 per trade, which is pretty high by today's standards, and used the average rate of return for our original Foolish Four over the past 20 years compared with the Dow 30 over the same time span (22.8% vs. 17.1%). (The RP version we are now using would have looked much better, but I wanted to use the same strategies McQueen and Thorley used.)

Assuming an average of 5 trades per year after the first year (McQueen and Thorley found that 2.39 stocks were replaced each year, each requiring two trades, a sell and a buy), the Foolish Four would cost you $1,980 over the next 20 years vs. $790 for the Dow 30 (most of which comes in the first year as you acquire your original 30 stocks).

At the end of 20 years, excluding transaction costs, your Foolish Four account would be worth $608,089.26 (plus or minus a few cents -- isn't it wonderful to be so precise!). The transaction costs would amount to 0.33% of that. The Dow 30 portfolio, on the other hand, would have grown to precisely $235,037.90. (You aren't taking these numbers too seriously, I hope.) Transaction costs of $790 would be 0.34% of the Dow portfolio. I played with the numbers a bit, but the Dow 30 never overcame its higher initial cost when looking at the costs as a percentage of the portfolio.

This would have been a more realistic comparison for McQueen and Thorley to use. Picking 1% per year out of thin air is a bit thin.

But actually, the bottom-line effect would be more serious, because the commissions (small as they are) come out of your capital yearly rather than at the end. Looking at it this way, at $20 per trade and 5 trades per year after the first year, your Foolish Four account would only grow to $576,992.56 over 20 years. Hey, those transaction costs can really have an effect! Your Dow 30 portfolio, meanwhile, grows to $219,619.62. In this case, the transaction costs have a total economic impact (actual cost plus reduced return) of -$31,096.70 or 5.1% (total, not annually) for the Foolish Four vs. $15,418.29 or 6.6% for the Dow 30.

But that was then; this is now. Today you can buy all 30 Dow stocks conveniently packaged in a Dow Diamond, which will have no annual transaction fees, and you won't even have to spend 15 minutes a year renewing your portfolio.

Would it be worth it? Only if you assume that the Foolish Four won't continue to beat the Dow. Is anyone really arguing that you are better off paying no transaction costs and ending up with $235,000 portfolio than paying $2000 out of pocket for a $575,000 portfolio?

Tomorrow: Taxes (yes, again!)

Fool on and prosper!

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Today's Stock Lists | 1999 Dow Returns

05/18/99 Close
Stock  Change   Last
CAT  -2  7/16  58.69
JPM  -   5/16  136.63
MMM  -1  3/16  88.06
IP   -   3/8   52.63
                Day   Month    Year   History
       FOOL-4   -1.67%  -2.83%  25.30%  27.16%
        DJIA     -0.15%   0.44%  18.42%  17.95%
        S&P 500  -0.46%  -0.14%   8.79%   9.05%
        NASDAQ   -0.14%   0.61%  16.68%  18.28%

    Rec'd   #  Security     In At       Now    Change

 12/24/98   24 Caterpillar   43.08     58.69    36.23%
 12/24/98    9 JP Morgan    105.51    136.63    29.49%
 12/24/98   22 Int'l Paper   43.55     52.63    20.84%
 12/24/98   14 3M            73.57     88.06    19.70%

    Rec'd   #  Security     In At     Value    Change

 12/24/98   24 Caterpillar 1034.00   1408.50   $374.50
 12/24/98    9 JP Morgan    949.62   1229.63   $280.01
 12/24/98   14 3M          1030.00   1232.88   $202.88
 12/24/98   22 Int'l Paper  958.12   1157.75   $199.63

              Dividends Received      $29.45
                             Cash     $28.26
                            TOTAL   $5086.46