Fees Matter - reading this article could be worth six figures to you!

Recently I met with a couple of clients who had rolled pension money from an old employer to a bank IRA.
In both cases the bank placed the client in mutual funds with 5% loads and  and annual fees that averaged 1.30%. Also, in the cases I am referring to, the mutual funds have historically under performed their benchmarks.


People will often give their hard earned retirement to a bank or Wall St firm in the belief that they are doing the prudent thing with their money.

How fees can effect your investment returns:  Lets take a 40 year old investor with $100,000 to invest and who plans to save another $5,000/year for the next 25 years. Below are 3 scenarios seen in the industry:

1. A local advisory firm charges a 1% advisory fee to "actively" manage the money. If the adviser chooses mutual funds there can be a 5% initial charge (load) plus fees of 1.30% within the mutual funds

2. A bank investment department that has no advisory fee but collects a load of 5% for recommended mutual funds. In addition, there are the 1.30% ongoing mutual fund fees

3. An adviser who believes in passive investing (buying and holding a portfolio of index funds). The adviser charges .25%/year and the index fund fees average .20%. This adviser’s fees are lower because they don't have to research mutual funds and move Joe from fund to fund when a fund underperforms or changes managers.

Next,

We know, from many study’s, that there is not a system to choose mutual funds or stocks that consistently outperforms the market. In fact, over time, the vast majority of mutual funds and stock pickers have long term returns that equal the averages (or the index return). Therefore, in the table below, we can only assume all 3 scenarios earn the same return.

The differences in the long term dollar values can be staggering. A review of the table below shows that by passively investing an investor can be almost $300,000 ahead of the other options.

  

	Fee based advisor charging 1% + mutual fund fees of 1.00%	"Free" advisor - typically banks and advisors at brokerage houses	Fee only advisor who charges .25% and invests in low cost index funds with .25% fee
Initial amount	$100,000	$100,000	$100,000
annual addition	$5,000	$5,000	$5,000
up front load	5.00%	5.00%	0.00%
annual fees	2.30%	1.30%	0.45%
yrs to maturity	25	25	25
Est portfolio return	8.00%	8.00%	8.00%
$ amount earned	$682,829.04	$834,201.30	$959,325.55

We all want the secret to investing. The secret is keeping fees low. A recent study by Morningstar found that the best predictor of mutual fund performance was fund fees.  

“[When deciding on a fund], the first thing to look at is the expense ratio; the second thing is the turnover rate; the third thing is some measure of past performance… But if you had to look at one thing only, I’d pick expense ratio.”

William Sharpe, 1990 Nobel Laureate in Economics

Here is  a quote from Morningstar:

“All things being equal, funds with high costs are much more likely to produce poor performance because of their cost disadvantage.”

Russel Kinnel, Morningstar, Inc.

If you are interested in learning more about passively investing your money, feel free to email me at mcangelucci@gmail.com

The Great Stagnation a TED Talk

Tyler Cowen's perspective on our economy. I have listened to Tyler on a number of occasions as a guest on the podcast EconTalk. Here is a link to his recent TED talk:

http://www.youtube.com/watch?v=_93CXTt2K7c

He always has interesting insights, he also may be one of the most well read economists in the world. See this very interesting recent profile in Business Week:

http://www.businessweek.com/magazine/content/11_23/b4231066695798.htm

Lounge by the pool or follow Mad Money's James Cramer?

Jim Cramer's recommended trades since 1/1/2002 earned 39.2%.
But,
Simply holding the S&P 500 index fund since 2002 would have earned you 38.3%.

You could have bought the index and not looked at a thing, went on with enjoying life, or you could have followed Cramer's advice through a service - Actions Alerts PLUS and earned 39.2%.

To earn the 39.2% would have required an average of 774 trades/year over the last 3 years. Remember, with trades comes trading costs, taxes and the cost of the newsletter ($299.95 for the 1st year). Also, the return assumes you made all the trades when you were supposed to.

I would be surprised, if after fees, the Cramer advice outperforms the S&P 500.

The choice is yours, spend your time trying to beat the market year after year, or accept the returns of a well diversified portfolio and have more time to golf, read, lounge, be with kids, etc.

The above information is from Jason Zweig's  June 4, 2011 Intelligent Investor column in the WSJ:

http://professional.wsj.com/article/SB10001424052702304563104576363892725584866.html?mg=reno-secaucus-wsj

Just Capturing the Return of the US Mkt Would Have Earned You 10.5% Since 1973

An investor who simply held an index of the US stock market since 1973 would have earned 10.5% through 2010. Holding the US market since 1927 would have earned 9.8%.

How about an investor that got in the market 20 years  ago?  An index of  the US market would have returned 9.7% since 1991.

It gets even better, had you diversified into international funds and held 30% of your stocks in international indexes your returns since 1973 and 1991 would have been 13.5% and 11.7% respectively (global allocation and returns based on DFA Balanced Strategy).

These returns were simply a matter of buying and holding capital markets. No stock picking, market timing, sector allocation. No high paid gurus, quarterly meetings with your advisor and their crystal ball. Just investing in a simple allocation of global equities, re-balancing annually, and not touching anything.

This may not have the glamor of picking the next Google and getting rich overnight. But, I would argue that most investors wish that their overall return since 1991 was 11.7%.

20 years ago a friend of mine related a piece of advice his father gave him. His dad said: save regularly in the US total market index fund and don't worry until you approach retirement. His father was a successful broker for Merrill Lynch.

Some final thoughts from some pretty big minds in the investing world:

“The S&P 500 is a wonderful thing to put your money in. If somebody said, ‘I’ve got a fund here with a really low cost, that’s tax efficient, with a 15-to-20-year record of beating almost everybody,’ why wouldn’t you own it?” — Bill Miller, manager, Legg Mason Value Trust”

“Buying an index fund over a long period of time makes the most sense.” — Warren Buffett

“I can’t recall ever once having seen the name of a market timer on Forbes’ annual list of the richest people in the world. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it.” — Peter Lynch, former manager, Fidelity Magellan

“Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.” — Peter Lynch

Increase Your Probability of Investment Success

Investing in stocks or bonds?

Why are you not investing with index funds?

Did you know that a recent study showed that the Total US Stock Market Index Fund beat over 72% of all US stock funds over a 20 year period?

Did you know that similar studies show a more profound superiority with specific sectors and bond funds?

Did you know that the laws governing trusts (Restatement 3rd of Trusts, Prudent Investor Rule 1992) consider index funds the highest level of of fiduciary care?

Did you know that the Federal Government Thrift Savings Plan offers only index fund options?

Have you read The May 13th NY Times "Your Money" column: Why 401(K)'s Should Offer Index Funds?

http://www.nytimes.com/2011/05/14/your-money/401ks-and-similar-plans/14money.html

Did you know that Charles Schwab will be introducing an all index 401K plan later this year?

Why not improve your probability of investment success by:
1.  Developing a portfolio that meets your risk tolerances
2.  Fund it with index funds -  they outperform more expensive actively managed funds over time.
3.  Re-balance annually

EconTalk on Parenting

Russ Roberts interviews Bryan Caplan on his new book Selfish Reasons To Have More Kids. I try to listen to EconTalks weekly podcasts. EconTalk is a weekly, open discussion on many topics. Generally business and economics related, almost always interesting and relevant. If you have kids I think this will be valuable time spent:

http://www.econtalk.org/

Hayek, spontaneous order and index funds

If I can use a picture of Salma to get one to click on this post and read a little about Friedrichs ideas, I have achieved a small victory in educating the masses. 

"in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process… will hardly ever be fully known or measurable."

The above quote is from the 1972 Nobel prize lecture of Austrian economist Friedrich Hayek who wrote brilliant works that explained the errors of fascism and socialism. He taught that the modern economy has too many variables for one person, or organization, to efficiently allocate its resources. Hayek argued that the price system does a better job of allocating resources than a government controlled system. Hayek's observations are part of his reflections on spontaneous order - which is the idea that order comes out of chaos when many self interested individuals are involved. This idea is played out in many areas. A recent example of spontaneous order is the open architecture software - Linux, which is written by programmers from all over the world who, in their spare time, add to the code. Linux now operates some of the fastest computers in the world and is the operating systems that runs many devices that we use in our daily life.

So how does this apply to investing?

The investing world is divided by those that believe they can predict economic and investment trends - the active managers, they believe they can predict which stocks to pick for your portfolio or mutual fund. Then there are those that believe that the stock market is too complex to make those decisions accurately on a consistent basis (the indexers). The indexers argue that the collective wisdom of all the investors in the world will average out to the best answer. The indexers, one could say, are Hayekian in their thinking. They would argue that if Wal Mart makes up 2% of the stock market, then an individual investor should own 2% of Wal Mart.

What is the collective wisdom of all investors in the investing world? Answer: index funds.

What is the record of index funds? Answer: Over time, they outperform active managers. Yes, year to year some active managers outperform the average. But it is not the same ones on a regular basis.

Spontaneous order seems to play out in stock funds. It explains why index funds outperform active managers. The collective wisdom of the many results in better investment performance than that of one or a few.

What does this mean for the average investor. It means that the best course of action has been to hold a well diversified, risk appropriate portfolio of the global stock and bond market, fund it with index funds, and rebalance annually.

For an analogous column, see Russ Roberts's 2004 Business Week column : "The Bagel and the Index Fund,"

http://www.businessweek.com/bwdaily/dnflash/jan2004/nf20040120_6180.htm

I recommend Russ Roberts's podcast: Econtalk, his blog: Cafe Hayek, and his books: "The Choice", "The invisible Heart", and "The Price of Everything."

Roberts is a professor of Economics at George Mason University

In another related article, see Jason Zweig's January 8, 2011 Wall Street Journal Column, in which he also cites Hayek in his explanation on why forecasters rarely get forecasts correct:

http://online.wsj.com/article/SB10001424052748703675904576064320900295678.html?mod=ITP_businessandfinan