Hang On Tight Because I’m Dropping The F-Bomb!

In my last post we talked about the difference in investment returns between passively managed mutual funds (called index funds) and actively managed funds. We also talked about no-load funds versus load funds (funds that have a sales charge). In that post I claimed that both actively managed funds and load funds underperformed their passive and no-load competitors. Now it’s time to back up that claim. So please hang on tight, because I’m dropping the F-Bomb!

Investment Fees: The Other F-Bomb!

There are a few general reasons why active funds and load funds underperform their competitors. Here are the top reasons that are generally agreed upon:

• Actively managed funds tend to have higher (sometimes much higher) management fees than index funds. These are fees that you as an investor end up paying. I’ll show you an example of these numbers in a second.

• Actively managed funds, in trying to beat their indexed competitors tend to trade the stocks or bonds that they manage. Sometimes they trade a lot. This increases their operating expenses, which are passed on to you.

• If your mutual fund isn’t in a retirement account you’ll pay taxes as the mutual fund trades. This also represents a drag on performance, which ultimately takes away from your investment returns.

 

Investment fees chip away at your returns both in the long term, and sometimes very quickly!

 

This isn’t to imply that active fund managers aren’t good at what they do. They’re typically very smart people, with lots of analysts who work for them and they use the very best technology. But the higher fees and expenses they charge add up to hurdles they have to clear just so they can break even with index funds that follow the same investing strategy. Here are a few of the implications:

• Actively managed funds may equal the market return of index funds before fees and expenses. But after these, their return falls behind the market.

• If they’re beating the market by so much that their return after fees and expenses still beats the market, chances are they’re taking a huge amount of risk for that level of return.

• That’s fine if all their investments are going up. But investments don’t always go up. So, a large level of risk may equal a greater return on the upside, but it can lead to steeper losses on the downside.

Simply put: to compensate for their higher expenses, many active managers take even higher risks to get a their level of return. This can lead to even greater losses. Remember: risk and reward are directly related: the greater risk you take, the greater return you should be able to expect (or the greater loss that’s possible in a downturn).

Not All Index Funds Are Created Equal!

I also have to say that unfortunately, not every index fund is created equal. For instance, some index funds (from different fund companies) may follow the same index. But one company may charge many times what the other charges in fees. Consistent with the theme of the rest of this post: bigger expenses equal smaller returns!

But please don’t take my word for it. You can analyze mutual funds at the Financial Industry Regulatory Authority (FINRA) website here. While the analyzer may take a little getting used to, it’s a GREAT resource for analyzing funds and comparing them side-by-side. So, based on an analysis on that website, this table compares three different (and real!) funds each with the same goals (they’re all S&P 500 index funds) but with very different fees:

Load (sales charge) Expense ratio Cost (fees & sales charge over 20 years) Ending balance
Fund A 5.75% 0.72% $2,917 $26,243
Fund B 0% 0.21% $776 $30,752
Fund C 0% 0.04% $151

$31,816

 

Let’s look at the difference between these investments for just a second. Fund A has a sales charge (a load), while the other two don’t. And of the three of them, Fund C by far has the lowest expenses. This scenario assumes you invested $10,000 for 20 years earning 6% per year. If you’d invested in Fund A versus Fund C (which are supposed to be identical investments), you’d have $5,573 less at the end of 20 years. And these differences are even more stark if you look at investing larger amounts of money for longer periods of time.

So, the bottom line: Fees are the other F-Bomb! If you see two identical investments with everything the same except for fees, please consider using the lower cost investment!

My Market Prediction!

As I write this in late October 2018, the stock market is going crazy. Long-time winners have nose-dived, and volatility has returned to the investing world. If you join me for my next post, I’ll tell you where the stock market will be at the end of the year! Really!

In the meantime, if you like these posts please drop me a line at andy@andyproctor.com. And better yet, drop me a line and pass this post on to a friend or two who you think may benefit from these insights!

Thanks so much for joining me this week. I truly appreciate it!

Till next time!