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Financial Planning Insights from Bob Dockendorff JD, LL.M



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The Investment Supply Chain

Keep It Simple With Low Costs and Tax Efficiency

In the last ten years we’ve seen an explosion in e-commerce, and a major phenomenon within e-commerce has been the direct to consumer (DTC) model. Savvy entrepreneurs realized that they could lower price by removing supply chain middlemen—without compromising profit.  

Suppose a manufacturer spends $2 to source raw materials and make a product. They sell the product to a distributer/wholesaler for $4. The distributor drives it around the country and sells it to retailers for $6. The retailers sell it you, the consumer, for $8.

At every level there’s are "hands in the pot." But in total, the consumer purchased something for $8 that only cost $2 to make. The consumer paid for two layers of middlemen. Were those middlemen really necessary?

What if the manufacturer could find a way to go direct to consumer? Innovation now allows for marketing and sales to take place online. Shipping is handled by a third party. This totally removes the need for wholesale distributors and brick and mortar retailers.

Now, the producer can spend maybe $3 on the whole operation and sell it for $6. The consumer spends less, but the producer makes more. Capitalism evolves to eliminate the middlemen distributors and retailers. There is only producer and consumer. This is bad for some individuals (distributors and retailers) but good for the system overall.

Companies like Warby Parker, Casper, UnTuckit, and AllBirds have successfully created quality DTC products that cost less than traditional retail products of a similar quality.

Basic commodity products benefit greatly from DTC or fewer supply chain costs because with commodity products, price is the key factor. 

Today, stock market exposure is a commodity product. It's cheap, available, and it's really hard to add value through service (stock picking). 

ETFs and other low cost passive vehicles have provided an almost DTC model for investors. They’ve taken out the genius stock picker and bloated sales team. 

Think about the old school “supply chain” of an actively traded mutual fund.

The raw materials are individual stocks. As “manufacturer”, the mutual fund company transforms an entire basket of stocks into a nice single holding available to investors. The portfolio manager and legal teams are compensated for this in the form of a management and administrative fee.

Then there’s distribution. Teams of mutual fund wholesalers travel the country visiting financial advisors to tell them the story of this great mutual fund. They also get a piece of the pie.  

All of these “fund level expenses” come through as an expense ratio. The average is between .5% - .75%, with many over 1%.

For investors that simply want stock market exposure (a commodity), they should be primarily concerned with price. The mutual fund model charges 1.5%. The ETF model charges potentially 0% for DIY investors that use zero expense ratio funds. 

It can still make sense to pay the 1.5% annual expense for busy people that can’t manage their own investments, and also receive great advice on all other areas of their finances for this fee (see Vanguard Advisor Alpha study).

Back to our supply chain analogy. If the underlying market return is the product, which for equities is say 7% annually, does it make sense to have such a long and expensive supply chain? 

Aren’t investors better off either (1) using an advisor that will provide low cost asset allocation, or (2) doing it themselves? For equities, probably yes.

What about Fixed Income? Or Real Estate? Or Private Equity?

This is where things get more difficult because the underlying investments, unlike equities, are not commodities. Wading through a strange corner of the fixed income market, or finding great real estate development deals, or buying distressed companies all require a level of skill and knowledge that commands more compensation. With inefficient asset classes, a good manager can more consistently outperform, so the additional fee may be worth it.

Evaluation needs to occur on an investment by investment basis, but in general, the sexier the asset class, the more expensive the fee. Investments should be evaluated against their “commodity” counterpart—which is most likely a publicly traded investment.

Investors should consider the gross returns of the investment, and then the net returns to understand the underlying costs and fees. 

You might see that a private real estate investment charges 2% annually, but on a net basis still outperforms their lower fee counterparts.

In other words: 

  1. Equity funds are commodity products. Without some clear benefit (hopefully not “outperformance”), investors should go with the lower priced “DTC” model.
  2. Fixed income and alternative investments require more specialization. The potential value is large enough to use a skilled professional. 

Make sure, at the very least, you’re paying attention to the investment supply chain.

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