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The easy way to returns

It's traditional to make predictions and prognostications at the start of a new year. I'll touch on a few economic portents. But rather than making stock-market auguries, I'll focus instead on a time-tested way to boost long-term returns.

I admit to suffering from a touch of trepidation when envisioning what might be in store for investors in 2023. After all, inverted yield curves in the U.S. and Canada bode ill for the economies of both countries. The curves turned decisively negative in late 2022 with three-month Treasuries offering higher yields than 10-year Treasuries. Historically, U.S. recessions regularly follow negative spreads with a delay of up to a year or so.

It will be interesting to see whether spreads prove to be reliable predictors in 2023 given that the world is in an unusual state following the extraordinary pandemic responses of the past few years. To confound matters, stock markets usually bounce off their lows before the economic pain really sets in. So, there's a chance that stocks have already hit their lows for this cycle. But if the economy crashes, we might be in for a long deep plunge of the sort that started in 1973, 2000, or 2007.

Worryingly, inflation rose from the dead to cause pandemonium in 2022. While the Bank of Canada has been hiking interest rates to try to bash inflation down, the recent move by the federal government to stop issuing real return bonds suggests that high inflation is here to stay.

It brings back memories of the 1970s when the stock market was savaged. High inflation is a big problem for investors and even the relatively tame inflation of recent decades put a big dent in returns.

For instance, Canadian inflation climbed by a total of 64 per cent from the start of 2000 through to November, 2022, which corresponds to an average annual rate of about 2.2 per cent.

The Canadian stock market (as represented by the S&P/TSX Composite Index) climbed by an average of 6.7 per cent annually over the same period. Remove inflation and the index's real return falls to about 4.4 per cent annually.

In dollar terms, a $1,000 investment in the index grew over the period to about $4,400 before accounting for inflation and to about $2,700 after factoring in inflation. In other words, inflation cut the investment's nominal gain of $3,400 in half to $1,700 in inflation adjusted terms.

The impact of inflation and fees on Canadian stocks

You can see inflation's corrosive impact in the accompanying graph where the top two lines show the growth of the index before inflation and after inflation. (The graph uses monthly data from Bloomberg but the very last data point is based on closing prices on Dec. 28, 2022, and an estimate for inflation in December.)

The third line on the graph provides a big reason for the popularity of low-fee index funds. It shows the after-fee results of an expensive index fund that tracks the S&P/TSX Composite Index before fees and charges 2 per cent of assets a year, in monthly payments, to do so.

(By way of comparison, some actively managed mutual funds have annual fees in excess of 2 per cent and perform worse than the index before the fees are accounted for.)

As you can see, investors got to take all of the risk of stock ownership from the start of 2000 through to, very nearly, the end of 2022 but they walked away with a total gain of 60 cents per dollar invested after fund fees and inflation were accounted for. The index climbed by about $3.16 per dollar invested before adjusting for fees and inflation. Investors pocketed a little under 20 per cent of the market's total dollar growth over the period thanks to fees and inflation.

Slashing fees is an easy, and practical, way to boost long-term returns and it explains the popularity of low-fee funds and very low-fee index funds in particular. For instance, a 0.2-per-cent annual fund fee on a S&P/TSX Composite Index fund would have left investors with a gain of about $1.41 per dollar invested after fund fees and inflation since the start of 2000, which is more than double the gain of the high-fee fund.

Alas, there's not much an investor can do about the corrosive impact of inflation and the move to stop issuing real return bonds makes matters worse. After all, inflation-adjusted returns were very poor - and often negative - in the 1970s not including fees - or taxes. While it's easy to be overly pessimistic when considering the possible problems ahead, it seems likely we'll muddle through with a fair share of both the good and bad over the long term. But no matter what the market throws at us, I hope you and yours have a happy, healthy, and prosperous 2023.

First published in the Globe and Mail, January 2 2023.

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