John C. Bogle, Founder of Vanguard and arguably the most revered advocate of the individual retail investor, has stated innumerable times “do not allow the tyranny of compounding costs overwhelm the magic of compounding returns.” Never has this been more true than today. The costs of investing have never been lower — if you make the right decisions. There are essentially three major categories of costs: the cost of employing an advisor, which people may or may not utilize, depending on how comfortable they are with navigating the plethora of information available. The second cost is the cost of actually owning the asset, typically called an expense ratio if that asset happens to be a mutual fund or Exchange Traded Fund, or ETF. The last major cost investors must bear is the cost associated with buying and selling the securities, or transaction costs. Of course there are numerous other costs associated with investing, such as sales loads, cash drag, and even market impact costs that drive up prices when attempting to fill large orders, but for the sake of simplicity, we’ll use these three major costs as an example. When evaluating the amount investors spend on their investments, it is prudent — and obvious — to keep in mind that whatever you don’t pay for, you get to keep; so if you pay for nothing, you get everything.
Most investors realize that if they would like to benefit from a service, they’ll have to pay at least something for it. With regard to the selection of securities, there is little doubt that one will have to pay something. The same holds true for the costs of transacting. However, an investor can completely forgo the costs of an advisor, if he or she so chooses; therefore, guaranteeing a higher return than if they had opted to pay for an advisor. And since every dollar not spent must equal a certain percentage of guaranteed return, investors have the ability to literally control their returns, at least to a certain extent.
Spending less and investing more
There will be many people who seek guidance when it comes to investments, as well as general financial situations. It is imperative that investors evaluate the extent to which their advisor is able to help them. Certain issues are quite difficult to handle without an advisor. For example, for proper estate planning, it might be beneficial to work with an attorney who has significant experience dealing with such issues. Contrary to this notion is the fact that some financial issues may be entirely unnecessary when it comes to seeking professional guidance, but oftentimes this doesn’t stop advisors from making clients believe that they indeed need these additional services. Planning for a child’s college education, for example, is quite often a straightforward task and can be started with a quick search of Section 529 plans and the like, which offer tax-advantaged benefits to those who wish to put their child through college. Paying an advisor hundreds of dollars per hour to help with this does little but decrease a client’s overall return on investment.
Spending less on advice is entirely controllable, but investors are often faced with constraints when it comes to fund fees and transaction expenses. Most of these constraints are a direct result of the 401(k) program that an employer has chosen. Investors must choose among a short list of funds, which may or may not have low costs. It is often prudent, therefore, to look at other options in addition to your 401(k), should your employer offer one and make matching contributions.
Match the market, without incurring high fees
There are two schools of investment thought: active investing attempts to “actively” beat a particular benchmark index after incurring substantial costs to do so, while passive investing endeavors to match benchmark returns by incurring minimal costs. Over a 10-year period ended December 31, 2013, actively-managed funds lost to passively-managed index funds on average about 75% of the time.1 Numerous studies of active vs. passive management have had similar results over both short- and long-term periods.
What’s more, if an investor decides to allocate his or her assets with an investment manager or advisor who attempts to beat a particular benchmark index, the chances of consistently outperforming the market decrease substantially over longer time horizons. And investors pay far more for this strategy in the form of advisor fees, expense ratios, and transaction costs. For example, advisor fees average around 1% and actively-managed fund fees typically add another 1%. The 2% all-in fee of an investor’s assets under management (AUM) means that he or she is hoping that the strategy will return at least 7% just to break even with a hypothetical market return of 5%.
A better strategy is to accept the fact that most of the time fund managers and advisors are going to be unable to consistently outperform the market. When investors recognize this fact, the only other option available is to attempt to match the market’s return by investing in passively-managed index funds. These funds have but one goal: to match a particular benchmark index, like the S&P 500, without incurring excessive costs along the way. Thus, the investor comes very close to gaining the net returns the market has to offer over a given time period. This, of course, assumes that the investor is not paying for the services of an investment advisor or financial planner.
The industry standard of 1 percent
The decision to seek guidance from an advisor results in a net decrease of an investor’s return. It is the investor’s sole responsibility to determine if the loss of return is worth the services provided. The standard of the advisory industry is to charge 1% to 1.5% of an investor’s capital on an annual basis. For example, an account balance of $500k will cost anywhere from between $5,000 to $7,500 per year, resulting in a loss of the exact same amount. And this excludes the opportunity cost of making a return on that money, compounded over time. This equates to a monthly payment of about $400 to $625 per month; an undoubtedly expensive service.
The goal of a passive investment strategy is to capture most of the market’s returns, which is lost once investor’s pay excessive fees to advisors without gaining value in some way, whether it be in the form of estate planning services or tax preparation and planning. Value can also be added by implementing a strategy which utilizes index funds while keeping the fees associated with that advice to levels commensurate with the service. After all, why would a 1% advisory fee be assessed for a strategy that involves little cost in the form of research, tactical market timing, low transactional costs, and personnel to carry out such tasks? The dirty little secret of the industry is that investors would be much better off doing absolutely nothing in reaction to market movements, but if advisors told their clients this — or were even perceived as not doing anything — there is a good chance their business would be taken elsewhere. Bogle said it best when he wrote: “While the interests of the business are served by the aphorism ‘Don’t just stand there. Do something!’ The interests of investors are served by an approach that is its diametrical opposite: ‘Don’t do something. Just stand there!’”
Adding true value
True value is only perceived in the eye of the beneficiary. Investors, therefore, must see value in a strategy that recognizes that the odds of outperforming the market are not in their favor. They must then ask themselves how much they’re willing to pay an advisor for this advice. Of course, advisory services are not measured by simple one-off tips that clients receive; rather, they should consist of valuable ongoing services that support the client’s objectives throughout the relationship. Value is created by creating an investment plan, implementing it, staying on track during fluctuations in the market, adjusting allocations to better align with objectives, and introducing ancillary services that fully support a comprehensive investment plan. Supplementary investment services should align with a strategy aimed at accumulating funds for future use. One such service that fully complements an investment strategy of low-cost, indexing is tax planning. Taxes result in real costs for an investor in the form of a reduced percentage of the return on their portfolio. Any savings that can be had with an investor’s tax liability are directly reflected in an increase of their return on investment. Within the investment advisory and financial planning industry, the only true value is created when investors are able to maximize their returns from the services they receive. It is incumbent upon the investor to decide which services truly add value.
1. The actively managed funds are those listed in the respective Morningstar categories. Index funds are represented by funds with expense ratios of 20 basis points or less as of December 31, 2013. All returns used were for the investor share class. Data reflect periods ended December 31, 2013. Sources: Vanguard and Morningstar, Inc.