Old Habits Die Hard

“A person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 20% higher than that of a comparable investor in high-cost investments.”  

– William Sharpe

Mutual funds that rely on stock-based investing where once a great idea. However, this investment vehicle’s time has come and gone. Their structure allowed the small investor to invest in a diverse portfolio of companies that was overseen by dedicated professionals. With time, however, things changed and markets evolved. Though mutual funds continue to be used by the public, they no longer offer the most effective way to invest an individual’s savings.  The advances made in investment products and technology highlights the unnecessary costs associated with mutual funds and, generally, with stock-based investing techniques. 

We have frequently highlighted that an individual has less than a 25% chance of finding a stock-based manager capable of consistently beating his benchmark. We haven’t yet spoken as to why this may be the case. Remember, stock managers are relatively bright individuals that nonetheless cannot beat their benchmarks. In the following text, we highlight research depicting the costs of running a mutual fund. We also show why the active stock-based manager starts at an upfront disadvantage, making attractive performance an even more unlikely outcome.

John Bogel, founder of Vanguard, wrote a paper for the Financial Analyst Journal in 2014 (Volume 70 Number 1) that does a wonderful job demonstrating the many hidden costs in mutual funds. These hidden costs result in the individual investor losing 50% of his investment profits. In short, if you own a mutual fund, there is an overwhelmingly large chance you are losing future purchasing power and risking the productivity of your hard earned savings. In order to clarify this concept with actual return numbers, a 7% market return will generally result in less than a 4% return to the individual investor. Additionally, these poor results are only available if you hold on through good and bad times. However, most investors do not do this, resulting in even lower returns.

In the table below, copied from the article, the penalty in return is over 2% per year compared to that experienced in a market-based product. Even after removing the sales charges from the mix results (which is frequently not the case), an investor experiences an annual deficit in excess of 1.5%.
Unfortunately, what we already mentioned is not the end to the costs. There are two large costs borne directly by the investor and not depicted within the performance of the mutual fund. These two additional costs make the case against mutual funds even more damning: taxes and investor behavior.
Actively managed mutual funds are not tax efficient. We will not delve into the details here as talking finance and taxes in the same newsletter will cause too many people to promptly finish reading. In summary, however, an investor can realize a tax liability without getting the benefit of the gain. Research, as highlighted in the article, suggests that tax inefficiency can represent 0.45% to 1% in additional reduction in annual return (remember, stock-based mutual funds are already delivering less than half of the market return and this doesn’t help).
The last major cost is investor behavior. It should not surprise you to learn that people will react out of fear, a very normal behavior that can be harmful to an investor’s return when they act during falling markets. The article reveals research showing that investors buy during good times and sell during bad times, hurting their returns by about 1.9% annually. The traditional stockbrokers were not fiduciaries and therefore their job was not to protect the assets of the client as much as it was to facilitate the client’s ability to act. This placed both parties into a bad position as the professional, whom may have had the investment experience, was not in a position to institute the change that may have ultimately helped (we use the ‘may’ for a reason).
In summary, the research paper suggests that over a long period of time in which the market will average a 7% annual return, those that invest principally in stock-based active mutual funds will only capture 2.5% -3% of that return, an unattractive outcome.
In closing, let us clarify the position of Auour Advisory. Activity is not necessarily a bad thing. However, activity needs to be focused in the correct areas and all actions need to be taken based upon analytical rigor. We attempt to counter the costs described above through reducing the fees borne by the client and limiting or avoiding the indirect costs of taxes and poor timing.