Minimizing cost is critical to achieving long-term investment success. Unlike future performance of your investments, costs are predictable and controllable. Countless studies and mathematical analyses have shown that higher costs do not lead to higher returns. Dollars spent on management fees, trading costs, and taxes are dollars lost to the investor. Market rewards are finite and investment expenses come off the top before the investor gets their share. Smart investors should be concerned with finding investment products, with low fees.
In one recent study of mutual fund performance (Financial Research Corporation, 2002, Predicting Mutual Fund Performance II: After the Bear) the predictive value of several fund metrics were examined. The possible indicators of future returns that were examined included: a fund’s past performance, Morningstar rating, alpha, beta, as well as expense ratio. It turns out that the fund’s expense ratio was the most reliable predictor of its future performance. In other words, low-cost funds delivered better performance. This was true for all of the periods considered by the study.
John Bogle, Founder and Former CEO of the The Vanguard Group talked about another study when he spoke in 2003 to the Society of American Business Editors and Writers. The study quantified the relationship between the total costs of equity funds and their returns by looking at the returns of 803 diversified U.S. equity funds. Using the Morningstar database, each of the funds investment returns along with its costs were compared. The average expense ratio for these funds was 1.3%, and their average portfolio transaction costs were estimated at 0.7%, for a total of 2.0%. The funds were then divided into quartiles by cost (fees). The results included these important facts:
-The high-cost quartile of funds, with all-in expenses of 3.4%, provided an average annual return of 6.8%.
-The low-cost quartile, with expenses of 1.0%, provided an average annual return of 10.2%, earning an advantage of 3.4 percentage points per year.
-On a fund-by-fund basis, the inverse correlation between cost and return was remarkable: minus 0.60%.
-Funds with the highest costs also assumed the highest risks, generated the highest turnover, and produced the poorest tax-efficiency.
-Funds with the lowest cost had an even greater advantage in risk-adjusted return and an amazing advantage of 4.0% per year in after-tax return.
Fees as they impact returns are also the subject of an article by Nobel Laureate, William Sharpe: The Arithmetic of Active Management in Section 6.2( http://www.golio.net/Chapter6.html). Here’s what Sharpe concludes:
If "active" and "passive" management styles are defined in sensible ways, it must be the case that
(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and
(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar
These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.
As an individual investor, how can you reduce fees? Using a low cost mutual fund provider should allow you to assemble a portfolio with an expense ratio on the order of 0.20%. Fixed income investment (bond) requirements for your portfolio can be satisfied using a short to intermediate term US Government bond fund. An S&P500 or Wilshire 5000 index fund can be a good choice for the stock portion. Other low cost index funds can provide further diversification if desired.
The average mutual fund has an expense ratio of about 1.30%. Fees of this magnitude result in significant drag on your portfolio performance. The figures and analysis below provide an estimate of how much can be gained from using low fee funds rather than average or high fee funds.
The figure labeled “Effects of fees while saving” considers an investor that invests $2500 per year for 40 years and earns 7% per year on the total investment. The 5 curves illustrate the effect of fees on the portfolio value. Fees of 0.2% are typical of low cost index funds. Managed funds average over 1% fees. Some managed funds have fees as high as 5%. Over a 30 year investment period, the cost to an investor investing in funds with a 1% fee is over $32,000 compared to the investor using mutual funds with a 0.2% fee. Compared to an ideal “no fee” return on investments, the investor gives up over 16% of the gains on his/her own money over this period of time. The investor takes all of the risk, but pays over 16% of their gains to the mutual fund company.
At the end of 40 years, 1% fees have cost the mutual fund investor over $93,000 compared to the low cost investor. The investor has now paid almost 30% of his/her investment gains to the mutual fund company.
The figure labeled “Effect of fees in Retirement” illustrates how fees affect a retiree during the distribution phase of investment history. The figure assumes a retiree starts retirement with a $1M portfolio, spends $45K the first year and adjusts this spending upwards by 3% per year to match inflation. The unspent portfolio is assumed to earn 7% return per year. The investor who is invested in mutual funds with 0.2% fee survives over 40 years in retirement. At a 1% fee level, the retiree runs out of money in year 34. An investor using mutual funds with a 4 % fee runs out of money in year 22.
The road to investment success is improved when expenses are minimized. Your portfolio performance is driven primarily by
- your saving rate,
- your asset allocation and
- amount of time in the market.
Personal values and frugal living drive your saving rate. Asset allocation is a matter of establishing your personal risk-return comfort level. Time marches onward for all of us. This leaves little or no reason to diminish your returns through commissions and fees. Even a 1.00% management fee costs a lot in terms of reduced nest egg and retirement income. Spending the small amount of time required to learn about financial markets and managing your own retirement assets should reap significant rewards.
More about investment instruments and mutual funds: http://www.golio.net/Chapter5.html
Information on developing your own investment allocation plan: http://www.golio.net/Chapter6.html
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