Investor-controlled inputs into the investment process are able to enhance market returns and drive improved portfolio outcomes. Investors have the ability to control the destiny of their portfolios. The Investor's Alpha series focuses on these inputs to highlight and illustrate how an investor has the ability to increase market returns through their own actions. Peak Capital's wealth equation is quite simple:
Wealth = Factors You Control + Investment Returns
In a low return environment where we expect stocks and bonds to deliver returns well below historical averages, investor-controlled inputs will play a large role in improving portfolio outcomes over the next five to ten years. In this part of our series, Investor's Alpha, we will illustrate the importance of controlling investment expenses in the investment process. Investment management may be the only place where you get more the less you pay.
George Herbet coined the phrase, "a penny spar'd is twice got" and unfortunately, over the years, this phrase has been diluted and corrupted into a commonly accepted platitude: "a penny saved is a penny earned." However, this Outlandish Proverbs is false. A penny spared is worth more than a penny saved or even two if time and compound returns are added to the mix. Table 1 outlines the future value of one penny saved once with a 3% rate of return.
On the surface, it might not seem worth the time or the effort to find a penny to save if it only becomes a little more than double after thirty years. However, if a penny is saved every year and also allowed to compound, the savings start to become significant. Table 2 outlines the value of saving a penny, $100, and $1,000 annually at a growth rate of 3%.
This table will be important to keep in mind as we outline the four main fees that investors incur in the management of their portfolio. A majority of these fees can be avoided almost entirely or reduced through investor action.
- Account Service Fees
- Brokerage Commissions
- Expense Ratios
- Advisor Fees
Account Service Fees
Account service fees are typically charged annually and they cover the cost of printing and mailing account statements, tax forms, and customer service. In addition, some firms also charge an IRA custodial fee to just maintain an IRA account in your name. On a positive note, this is the fee that is easiest to eliminate entirely. Several brokerage firms will waive the account service fee if the investor elects to get their statements via e-mail instead of through the postal service. Also, there are firms that do not charge IRA custodial fees at all. These fees can add up to a significant amount both in terms of dollars actually paid and foregone future value.
Working through an example of a typical investor that has a taxable account, Roth IRA, and Traditional IRA, this investor could be subject to nearly $120 annually in fees. This assumes the custodian charges $50 for IRA custodial fee and $20 for account service fee. Over a ten-year period, this investor would have paid $1,200 in fees and forgone ~$1,400 in gains assuming a 3% rate of growth. This is a difference in value of ~$2,600. If the custodian of the account does not offer a means to waive the account service fee or IRA custodial fee, an investor might want to examine alternative brokerages to hold their assets.
This is the fee that is charged to buy and sell stocks, bonds, ETFs, mutual funds and other financial instruments that trade on an exchange. I am omitting any discussion regarding loaded mutual funds since paying 5.75% upfront for a product that can be purchased from another provider for free is doltish. The tongue-in-cheek solution is to not trade. Well how is an investor supposed to invest? Several brokerage firms offer commission-free trades on a line-up of ETFs, and buying mutual funds directly from the provider can eliminate commissions.
For example if an investor maintains an account at Fidelity, Fidelity does not charge to purchase their own mutual funds and offers a line-up of their ETFs and iShares ETFs to trade commission-free. Schwab and Vanguard offer similar options of no commissions to purchase their products directly from them as well.
For those investors that are looking to purchase individual securities, selecting a low-cost brokerage firm to execute trades will help enhance returns via cost minimization. Most firms offer online trades in the range of $5 to $10. The term online is critical, since most firms will add another $20 to $30 for trades placed on the phone. If an investor trades just once a month and pays $10 per trade, after ten years, this would be a cost of $1,200.
If this non-excessive trading investor traded half as much or paid $5 a trade, this would have reduced commissions by $600 over ten years. This $60 in annual savings with a 3% return would be ~$700. Investors have the ability to eliminate or reduce their commissions by their own actions: brokerage selection and amount of trading.
Expense ratio is the fee charged to an investor to invest in a mutual fund or an ETF. The expense ratio covers the cost to run and manage the fund or ETF, but the cost of trading of the fund is not reflected in this figure. Another component of expense is the 12b-1 fee, which is a fee to cover marketing and distribution. It is important to note that not all funds charge a 12b-1 fee. Returning to our adage: The less you pay, the more you keep.
Selecting low-cost mutual funds and ETFs will allow an investor to keep more of their money as well as likely lead to better longer-term performance. Morningstar's Active/Passive Barometer has found that [fees] "are one of the only reliable predictors of success". The other key finding from the study is that funds that charged a higher fee were more likely to fail, close or merge into another fund.
How much is your home worth? Would you pay 10 times more for your neighbor's house?
The rational answer is no, since the homes are about the same. Why would anyone pay ten times more for the same thing? Unfortunately, investors do not always apply this same principal to their investment portfolios. Comparing Vanguard's S&P 500 index (MUTF:VFINX) to Rydex's S&P 500 index (MUTF:RYSPX) demonstrates the importance of reducing investment costs. The Vanguard fund's expense ratio is 0.16% and the Rydex fund's expense ratio is 1.55%. The Rydex fund charges 10 times more to track the same index.
For a portfolio with $100,000 invested, one fund charges $160 and the other $1,550. This is a difference of ~$1,400 a year and ~$14,000 over ten years with the assumption of no growth in the index. Below is a comparison of investing $100,000 in each fund from June 2006 to February 2017. Figure 1 illustrates that the higher fees eroded ~$31,300 from the portfolio from May 2006 to March 2017.
The asset-weighted average expense ratio of funds, mutual and ETFs, in 2015 was 0.61%. Meaning that on a $500,000 portfolio, an average investor would be paying ~$3,000 a year. A well-diversified portfolio utilizing low-cost mutual funds and ETFs can be constructed for a cost of around 0.21%. This 40bps reduction in expense ratios is ~$2,000 and over ten years is ~$23,600, assuming 3% growth.
Account service fees, brokerage commissions, and expense ratios are fees that detract from the value of the portfolio. The one common theme amongst the three is that they can be reduced or eliminated through the careful selection of a mutual fund company or brokerage firm. Taking the time to diligently research and select a brokerage firm that does not charge service fees (or provides a means to avoid them), charges no commissions or low commissions, and offers low expense mutual funds provides a means of increasing returns through cost reduction. The ability to lower investment costs is in the control of the investor.
Before diving into the cost/benefit analysis of financial advice, it is important to acknowledge that a wide variety of persons fall under the umbrella of financial advisors. For this paper, when the term advisor is used, it is in reference to a person acting in a fiduciary capacity at all times. An advisor that acts in the capacity of a fiduciary must always put the client's interest first.
The cost of investment advice is both tangible and intangible. This duality between the explicit cost of paying an advisor and the implicit cost of not paying an advisor makes it difficult to quantify an answer that also involves qualitative inputs. The cost of investment advice, similar to other costs, detracts from an investor's performance. Investors should select an advisor after careful considerations of all costs: advisor fee, transaction costs, account service fees, and expense ratios of funds that are utilized. Keep in mind that the less you pay, the more you keep.
The typical advisor charges 1% on assets under management. In addition, the client pays the expense ratio on the underlying funds that are utilized in the portfolio. The client may also be charged account service fees or IRA custodial fees. Table 3 below outlines a methodology to compute the all-in cost for advice.
Table 3 is meant to act as a basic framework to quantify the all-in cost of utilizing an advisor's services. Depending upon the set-up of the advisory firm, either the advisor will pay for the trading commissions or these costs might be paid by the client directly. The all-in cost of advice forms the foundation for the cost/benefit analysis.
Examining a simplistic example to illustrate the tangible costs of advice on a portfolio, we take a $100,000 investment into Vanguard's Balanced Index Fund (MUTF:VBIAX) that is subject to zero, 0.5%, and 1.0% fees assessed quarterly. Not surprisingly, the portfolio that paid 1% had a lower ending value than the portfolio that paid 0.5% and 0.0% for advice. Over ~17 years, an investor paying 1% for advice paid ~$22,000 for this service.
It is simple to quantify the explicit costs of hiring an advisor. It is more difficult to quantify the cost of forgoing advice. Is the investor missing out on potential gains that could have been captured by receiving the advice of a qualified, competent advisor? At its most basic level, a good or service should be purchased if its value exceeds its cost. This holds true with investment advice. Investment advice should add to the performance of the portfolio exceeding its cost.
Vanguard's Advisor's Alpha concludes that an advisor can add up to ~3% in returns implementing their framework. Exploring the Vanguard framework can assist an investor in quantifying the value added by an advisor. Table 5 outlines the areas where Vanguard is able to quantify a value add figure based upon empirical research. It is important to note that not all categories will be applicable to every investor and the value added will vary depending upon the unique circumstances of the investor. However, this table can serve as a basic framework to evaluate the value of an advisor to an investor's circumstances.
For example, an investor that already has a low cost portfolio of ETFs, rebalances the portfolio, and efficiently located assets to reduce tax drag on the portfolio would only gain a portion of the value an advisor could add. This investor would not gain value from an advisor in those three areas. However, behavioral coaching and withdrawal strategy could be areas where an advisor adds value. Investors should diligently evaluate where and how much an advisor can add to their unique situation. Not all of the categories will apply to every investor.
Beyond the seven areas of alpha Vanguard identified, it is also important for an investor to consider the value of any additional services that the advisor might provide outside of investment management. Does the advisor also provide financial planning, cash management, tax advice, estate planning, etc., that is included in their fee? These areas can also be easily quantified to add to the areas of alpha by comparing the cost of hiring a professional for those services separately.
Quality of service, peace of mind, willingness to teach, and time savings are highly subjective factors that also factor into the value that an advisor provides. These qualitative traits in isolation, especially time savings and peace of mind, could provide more intangible value than the tangible cost of employing an advisor.
In a low expected return environment, reducing investment expenses is a simple and easy method to improve portfolio performance. The less you pay, the more you keep. Reducing investment expenses by $1,000 annually combined with a 3% rate of return results in ~$49,000 after thirty years. Investors through their own actions have the ability to eliminate or reduce the various investment fees: account service fees, brokerage commissions, and expense ratios of funds and ETFs.
It is also important for investors to evaluate the need for financial advice in terms of explicit and implicit costs. Like any good or service that is to be purchased, the value should exceed the cost. In light of the tremendous value of saving a penny, George Herbet's proverb should no longer be considered outlandish.
Investors through their own actions have the ability to control the outcome of their portfolios compensating for the inability to control or predict the markets. Managing the cost of investing is one of the investor-controlled inputs that drives the wealth equation:
Wealth = Factors You Control + Investment Return
- Savings Rate & Spending Rate
- Systematic Portfolio Rebalancing
- Proper Asset Allocation
- Tax Management
- Proper Asset Location
- Investment Expense
Peak Capital urges all investors to consider the deleterious effects of fees and expenses on their investment portfolios and to carefully consider methods to lower these costs. Over an investing lifetime, investors could pay tens of thousands or hundreds of thousands of dollars in investment expenses. Peak Capital implores investors to take action to keep more of their money.
We hope our Investor's Alpha series is helpful to you, the investor, or to the advisor in communicating with your clients. Any questions or feedback is always appreciated.
Adam Hoffman, CFA, CAIA
 Morningstar. (2016, April). "Morningstar's Active/Passive Barometer: A New Yardstick For An Old Debate." Retrieved from Morningstar.com
 Morningstar. (2016, April). "Average Fund Costs Continued To Decline In 2015: But Investors Are Not Necessarily Paying Less." Retrieved from Morningstar.com
 Vanguard Group. (2016, September). "Putting A Value On Your Value: Quantifying Vanguard Advisor's Alpha." Retrieved from Vanguard.com
Disclosure: I am/we are long VTI, VXUS, VCSH, VCIT, VMBS, VFIIX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Peak Capital Research & Management's clients are long the following positions in either Vanguard ETFs or Mutual Funds or utilizing a similar iShares ETF. Broad US Index, Broad International Index, short-term corporate bonds, intermediate-term corporate bonds, and GNMAs.