Beware of the Langoliers!
As the New Year approaches it’s time for resolutions. Many will focus on eating healthier, losing weight and quitting bad habits. We suggest focusing on the latter, particularly the bad habit of high-cost investing. Each year, investors forfeit billions of dollars in wealth due to excessive fees and inefficient tax investing. Many clients have little idea as to how much they actually pay for investment services because of weak disclosure practices. These costs can total in the hundreds of thousands, if not millions, of dollars over a lifetime for a typical client. It’s time to put your investment portfolio on a low-cost diet.
“The Langoliers”, a story written by horror and science fiction author Stephen King, are creatures with huge mouths and gnashing teeth that devour everything in sight, leaving trails of black nothingness in their wake. The real life version of these creatures is far more frightening than anything Mr. King could imagine. What and where are these Langoliers, you ask? They hide in mutual fund prospectuses and hedge fund and investment advisor contracts, among other places. We are referring to sales loads, 12b-1 fees, “2 and 20” fees, transaction costs, expense ratios and numerous other costs. Some of these costs easily recognizable, but ignored by investors. Others remain hidden in the shadows, but levy a heavy burden on net investment returns. Investor advocates and regulators are pushing for greater disclosure to help individuals make more informed decisions. But more work is needed to level the playing field. Just like the Langoliers, high-cost investments devour your investment returns.
Contrary to the typical economic relationship between price and value, more expensive investment products do not lead to higher investment returns. In fact, quite the opposite is true. The more you pay, the less you get! Empirical evidence validates that low-cost investment funds outperform high-cost funds. Therefore, minimizing investment costs is the single most important action clients can take to maximize long-term returns, but you’ll rarely here this from your investment advisor.
What You Don’t Know Can Hurt You
Many investors are familiar with expense ratios, which mutual funds are required to disclose. This ratio summarizes a fund’s annual expenses, which include portfolio management, administrative, accounting, shareholder services, distribution (12b-1) and other operating expenses, expressed as a percentage of the fund’s assets. Investors can easily overlook these costs because they are never billed for them. Instead, these expenses are deducted directly from fund assets, which are owned by investors.
However, the expense ratio tells less than one-half of the story. What many investors don’t realize is that they incur numerous other costs not included in this ratio. Fund companies and advisors like it this way and regulators have been too accommodating. Some of these costs are disclosed, but easily overlooked, while others are not disclosed at all. These include sales loads, 12b-1 fees, revenue sharing costs, transaction costs, performance fees and taxes. It's these other costs, in aggregate, that exceed the reported expense ratio (12b-1 fees are included in the expense ratio). Herein lies the answer as to why so many funds lag, year after year, the overall market’s return by a wide margin.
Quantifying the Langoliers’ Appetite
To better illustrate the costs described above and their adverse impact on after-tax returns, we introduce a hypothetical investor with a 40-year investment horizon. Our investor has $10,000 to invest each year in a taxable account. To keep things simple, we’ll assume only three investment options: 1) the Vanguard S&P 500 index fund; 2) an “average” actively managed no-load equity fund; and 3) an “average” actively managed equity fund that charges a sales load.
As shown in Figure 2, the estimated total annual cost, including taxes, of owning the index fund is 0.6% per year. This compares to 4.9% per year for the load fund and 4.7% for the no-load fund. These figures detail both the transparent and non-transparent costs (i.e., the “all in” costs) as they apply to a mutual fund investing. We further assume the stock market generates a total return of 8% per year over the investment horizon. The active mutual fund in our example generates the same total return as the overall market (and hence the index fund) because we are focusing on an average active fund, which by definition generates a return equivalent to the overall market.
Note: For the load fund, we assume a 5% charge, which equates to 0.22% per year over a 40-year investment horizon. On an annualized basis, this cost is significantly larger for shorter investment horizons. Tax costs refer only to distributions, not final sale of fund shares.
Source: Vanguard Group, ICI, various academic and industry research studies, Freeport Investment
Based on these assumptions, at the end of 40 years the taxable account will grow to $2.8M (8% gross return earned over 40 years). We refer to this figure as the investor’s "theoretical potential" wealth because it excludes fees and taxes. After fees and taxes, the investor actually accumulates almost $2.4M in the index fund, versus $838,000 in the no-load fund and $796,000 in the load fund. To put it another way, the investor keeps 85% of his theoretical potential wealth with the index fund (15% goes to Vanguard and Uncle Sam). However, he keeps only 28% with the load fund, as financial intermediaries and taxes consume a full 72% of the investor's total potential return!
Source: Freeport Investment
Just to break even with an index fund, the active fund would have to outperform the overall market’s return by over 4.0% per year, on a pre-expense basis. To put this into perspective, according to Morningstar only 3% of domestic equity funds were able to outperform the S&P 500 index by at least 4.0% per year over the 20-year period ending in 2009.
If we assume a lower gross return (< 8%), the impact of fees and taxes is even more devastating. Like Sisyphus rolling his boulder up the mountain, only to watch it fall back down, investors in high-cost funds are doomed to be crushed under the weight of fees and taxes.
Asking the Right Questions
In summary, the debate is not so much about passive (indexing) versus active investment management as it is about low-cost versus high-cost investing. The key takeaway is that financial advisors and their clients should seek out low-cost funds, whether passive or active, to achieve diversification benefits and to maximize risk-adjusted returns.
The bottom line is that clients must know the right questions to ask of their advisors. These questions include understanding how advisors are compensated and why they choose certain funds over others. If you understand the basic benefits of low-cost investing, then you are well ahead of the majority of investors.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.