Avoid unnecessary fees and expenses
You can’t invest without incurring some fees and expenses. When you buy and sell individual securities through a broker, you pay a transaction fee. When you invest in a mutual fund, you pay the fund’s annual management expenses. If you have a retirement plan like a 401(k), you pay a fee to the plan manager. If you buy financial advice, you pay your advisor in one way or another, whether it’s an hourly fee, a flat fee for a financial plan, a commission on financial products you buy, or an annual management fee to manage your investments for you.
The challenge here is to determine what you are actually getting for what you are paying. When something in my house needs fixing, I’m often willing to pay someone to fix it because I can tell the difference between an expert repair and one that I try to do myself. But how many investors can tell the difference between a cost-effective investment and an overpriced mediocrity, or between sound financial guidance and a bum steer? Investors may not even be aware of some of the expenses they are incurring because they’re quietly deducted without showing up explicitly on a statement. And the impact of costs on investment results is hard to assess because so many other factors affect financial performance, not the least of which are general market conditions and luck. Your financial service provider isn’t to blame if the market falls, but may be to blame for promoting products whose excessive costs aren’t justified by superior performance. Unfortunately, the complexity of financial products provides many opportunities to take advantage of unwary consumers.
Although the question won’t have an easy answer, the right question to ask is whether you are achieving any added value for your portfolio by incurring a particular expense.
No-load, low-expense funds
The post on diversification discussed mutual funds as a convenient way of investing in a wide variety of securities. Now consider how to get the benefits of mutual funds without unnecessary fees and expenses.
First, give preference to no-load funds. Loads are sales commissions on mutual funds purchased through a broker, ranging anywhere from 3% to 8% of the money invested. Frequently you have a choice of different fee structures, such as a choice between a one-time up-front commission or higher expenses in every year you own the fund. If you intend to own the fund for a long time, the up-front commission (the “A” shares) can be the better choice. But often an even better option is to contact a mutual fund company that sells its funds directly to the public, such as Vanguard or T. Rowe Price. There you can probably find an acceptable fund with neither a sales load nor high expenses. You don’t have to sacrifice performance when you go this route. The American Association of Individual Investors says, “Funds with loads, on average, consistently underperform no-load funds when the load is taken into consideration in performance calculations. For every high-performing load fund, there exists a similar no-load or low-load fund that can be purchased more cheaply.”
Every mutual fund prospectus is required to list the fund’s fees and expenses. Ideally you will see “none” in the fees part, or only some very small fees for good reasons, such as a fee for redeeming shares within one year, in order to protect the fund and its shareholders against the costs of short-term trading. What you do have to pay in any fund is annual management expenses, but you can pay very different expenses for quite similar products. This is especially true for the kinds of funds whose returns are otherwise fairly predictable, such as money market funds and bond funds holding similar types of bonds. Expense ratios may seem to vary in a narrow range (1.5% per year for one fund vs. 0.5% for another, for example), but over time, such small differences compound into large variations in investment returns. If you invest $10,000 and let it compound for 20 years, you will have $56,044 if you get a 9% return, but only $46,610 if you get an 8% return because of an extra 1% in expenses. The longer you invest in a fund, the more of your investment return you will forfeit if the fund underperforms the market because of its fees. A study by Stewart Neufeld found that underperforming the market by just 1% will cost you about 30% of your total gain over 30 years and about 40% over 50 years (Journal of Financial Planning 12/11).
When trying to hold your fund expenses down, consider exchange-traded funds (ETFs) as well as traditional mutual funds. You will pay at least a small transaction fee to purchase an ETF through a broker, but annual expenses should be as low or lower than the least expensive mutual funds. Many new kinds of ETFs are appearing, however, and not all of them are designed to provide a market return at low cost.
Index funds vs. actively managed funds
The lowest expenses are generally found in index funds because they save money by doing less research and making fewer trades. An S&P 500 index fund will hold the same 500 stocks until Standard and Poor’s changes the stocks included in the index itself. This is also known as passive investing. Its goal is to get as close to a market return as possible, unencumbered by high fees, and it can achieve that goal pretty reliably. In contrast, actively managed funds buy and sell more frequently in order to try to beat the market, so they incur additional expenses for trading and researching companies. The additional costs to shareholders can easily knock two or three percentage points off your investment return. One of the most hotly debated questions in the industry is how often active management adds enough value in skillful security selection to offset and justify the higher costs. Is active management worth paying for, or is it more cost-effective to invest primarily in low-cost index funds?
Both sides in this debate agree that an index fund can only provide a market return (minus a very small amount for expenses), while an actively managed fund has at least some potential to beat the market. The question is how often actively managed funds actually live up to that potential. Researching that question isn’t a simple matter, since there are so many kinds of funds, so many management styles, so many fluctuations in performance, so many old funds closing and new ones opening, and so forth. One of the key issues is what “benchmark” to use when comparing a particular fund to the market. The S & P 500 stock index is a good benchmark for comparing US large-cap stock funds, but appropriate benchmarks are less obvious for funds with less common specializations. The best research does appear to support these broad generalizations:
- Index funds provide a return that is close to the market average, but an actively managed fund can do either better or worse than the average
- Fewer actively managed funds beat their market benchmark than fall short of it
- The longer the time period considered, the more likely it is that an actively managed fund will underperform the market
The last point is a particularly interesting one, since it calls into question not only the ability of most active managers to beat the market, but the ability of investors to identify the ones who can be relied on to beat the market in the long run. Studies of mutual fund performance do find some tendency for performance to persist from year to year, but the finding must be carefully qualified. One of the reasons for continuity is that many of the same overpriced, low-performance funds do badly year after year. Those can be avoided. But choosing among the remaining funds is hard, since continuities in market-beating performance tend to be short-lived. Most of today’s winners probably won’t be the highest performers a few years from now. That leaves the active investor with two alternatives: either chase performance by frequently moving assets to “hot” funds (running a significant risk of losing money by buying high and selling low), or stay in one fund hoping that it’s one of the very few that can beat the market in the long run despite the burden of its management and trading costs.
Beating the market is both very appealing and theoretically possible, but it’s harder than most people realize, contrary to the message of some financial media and some financial services sales forces. Since there are thousands of funds, some of them are on winning streaks at any given time, either because they’re lucky or because market conditions happen to favor their particular investing style. Apparent winners get a lot of play in the media, both in advertising and press coverage, creating the impression that their managers have extraordinary abilities. But the more spectacular the performance over a few years, the greater the chance of deteriorating performance over the next few years (a familiar statistical phenomenon known as “regression toward the mean”).
Why is beating the market so hard? One reason is the inherent difficulty of stock picking, since stock movements depend so heavily on earnings surprises (discussed in the risk section). The second is the fact that so much of the market consists of mutual funds, so that professional fund managers are competing against one another: If some are performing above the market average, others must be performing below it. The third problem is the higher costs associated with active management, which tend to drag even more of the funds below the market average. When Andrew Feinberg reported that only one out of every eight mutual funds beat the S&P 500 index over a twenty-year period, he titled his article “Lake Wobegon in Reverse” because so many of the funds were below average (Kiplinger’s 11/03).
A few managers probably are truly superior, but only a long and consistent track record can distinguish skill from luck. By the time the true superiority of a fund becomes apparent, it may be closed to new investors, or the manager may switch jobs or retire. Fidelity Magellan did very well while Peter Lynch was managing it, but not so well after he retired. If the fund does remain open with the same manager, it may get so large that it has to buy too many stocks in order to avoid bidding up the price of the fewer companies it would most like to buy; so it becomes less selective and more mediocre. Many big fund managers are really “closet indexers,” too unselective to have any hope of beating the market, but charging fees as if they could! If all you need is an index fund, then that’s all you should pay for.
Consider one additional point, requiring a bit of reflection. Suppose that actively managed funds had a wide range of performance (that much is true), but on the average performed as well as the general market (that part is not quite true because expenses are a drag on performance). Would you be willing to risk underperforming the market for an equal chance at outperforming the market? Suppose your employer let you choose between receiving your regular salary or randomly selecting from different envelopes with varying amounts of money, some more than your salary but some less. Would you gamble with your livelihood, knowing that in the long run you have no rational expectation of coming out ahead? Where is the added value, especially if your employer starts charging you a fee to select an envelope!? I repeat that the issue is hotly debated, but many financial planners are skeptical about the added value of actively managed funds for the ordinary investor. Dan Wheeler says, “The most rigorous studies–those with adequate sample sizes and periods, benchmarks that control for risk and survivorship bias–reveal a trend: the pros don’t add value on a consistent enough basis to warrant their fees” (Financial Planning 11/06).
That’s why many financial planners, as well as many of the most sophisticated investors like Warren Buffet, recommend that most ordinary investors make index funds the core of their investment holdings. Investors who would also like to have some potential for outperforming the market should seek actively managed funds with moderate expenses, relatively high returns for several years, and managers who have been with the fund a long time. But recognize that you will need some luck to avoid underperformance, so there is an element of gambling in this approach.
Insurance companies have developed a number of products that combine insurance with investment. Part of what you pay to the insurance company is invested on your behalf, and may have a potential for a high return. Another part insures that you will receive at least some benefit, such as a death benefit or a guaranteed minimum annual payment. In general, these products are both more expensive and more complicated than direct investment in mutual funds, so consumers should tread carefully in this area. The insurance features of the product should add enough value to justify the added cost, but that is often difficult to determine.
First, consider a case in which insurance does appear to add value. You are retired with a nest egg large enough to live on for many years, but you have a reasonable probability of living long enough to run out of money someday. One solution is to take a portion of your nest egg and purchase an immediate life annuity, guaranteeing that you will have at least some income for life. Another alternative is to buy longevity insurance, which starts paying an annuity only if you live beyond a certain age. There is added value here in the form of a potential to receive something you wouldn’t otherwise have gotten, an income if you live a very long time. (If you live too short a time, you won’t recover your premium cost.) Immediate annuities and longevity insurance will be discussed further in a later post.
What you want to avoid is buying insurance you don’t really need, or that doesn’t do enough for you to justify its cost. One insurance product that companies are often accused of overselling is the variable deferred annuity. Many financial professionals earn commissions from selling them, but others neither sell them nor encourage their clients to buy them. A variable annuity is an investment through an insurance company in assets that can fluctuate in value, especially stocks. You fund the account with a lump sum or with periodic payments over time. Eventually the account will be annuitized–converted to a series of regular payments, often for life. “Deferred” means that this will happen sometime in the future rather than immediately. Investment returns are sheltered from taxation until withdrawals begin, but are taxed as ordinary income when withdrawn. (This additional tax shelter appeals to investors who are already maxing out their contributions to their retirement plans, as well as to aggressive traders who want to be able to buy and sell in the account without worrying about capital gains taxes.) Variable annuities have a death benefit that is paid if the owner dies before withdrawals begin. Many also have “living benefits” that guarantee some minimum value when the account is annuitized. In effect, you are paying the insurance company to insure you against some of the risks of investing in fluctuating markets.
The special features of variable annuities come at high cost, since you are paying for a layer of insurance protection in addition to the costs of managing the investments themselves. Total fees can be many times what you would pay for a mutual fund, substantially reducing your returns. For that you are getting the promise of an annual payment for life someday. (But then, you could get that by annuitizing whatever nest egg you accumulate yourself.) You are also being protected against catastrophic losses, but a properly diversified portfolio of mutual funds or ETFs can provide much of that protection at lower cost.
Variable annuities have other disadvantages: The data needed to evaluate them as investments, such as risk-adjusted performance measures, are not as readily available as they are for mutual funds. Variable annuities are not very liquid, since they often carry surrender charges or other penalties for terminating the contract before a certain number of years. And although investment returns are tax-sheltered until you begin withdrawals, this provides no benefit if the annuity is held within an account that is already tax sheltered, such as an IRA or 403(b). Annuities can even have adverse tax consequences, since dividends and capital gains will ultimately be taxed at ordinary income rates instead of at the lower rates that otherwise would apply.
The main argument for variable annuities is that they can provide a moderate income for life even if markets perform badly. Investors who have that guarantee may feel more comfortable allocating a larger portion of their portfolios to stock. The high return from stock could offset the costs of the annuity and produce a superior return for the entire portfolio. But few purchasers of variable annuities may understand that point or feel comfortable acting on it. Investors who don’t like to invest aggressively may not get much added value from a variable annuity. They might do just as well–and keep their portfolios simpler, clearer and more liquid–with a balanced portfolio of stocks and bonds. Then their portfolio may not be risky enough to require insurance.
An even more controversial version of the variable annuity is the equity indexed annuity. On the one hand it offers the security of a minimum fixed return on one’s investment. On the other hand it offers a potentially higher return based on some portion of the stock market’s gains. (For example, if the market is up 15%, your gain might be capped at 7%. Since stock investors make most of their money in the really good years, this is a significant limitation.) You get some protection from downside risk, but at the cost of high fees and a cap on upside potential. This is another complex arrangement that is hard for a buyer to evaluate. Most independent evaluations I’ve seen have concluded that it doesn’t offer enough advantage over a balanced portfolio of stocks and bonds to justify its higher cost, so that most investors will come out behind by buying it.
Paying for financial advice
The same principles apply to buying financial advice: Don’t pay for more than you need, and expect added value for any costs you incur. You may be able to manage your own investments just fine with a little occasional help. If so, you don’t have to pay someone an annual fee of 1% to 2% of your assets to manage them for you. That can easily add up to thousands of dollars a year and put a heavy drag on performance. You may find it more economical to pay a one-time fee for help in formulating a plan, and then deal directly with mutual funds in order to avoid sales commissions.
Some people pay an annual fee for a financial manager, who may also be a salesperson with products to promote; then they pay commissions to buy mutual funds or annuities; then they pay high fees and expenses for active fund management or insurance features they may not need. So they pay and pay and pay without getting much added value, and they end up with much less than they could have had with a simpler and less expensive approach. A later section will deal with options for getting financial advice.