Massive Underperformance Reason #2: Fees
Good Morning Relaxing Retirement Member,
Over the last two weeks, I have revealed the results of the 25th Annual DALBAR Quantitative Analysis of Investor Behavior (QAIB).
As a refresher, in addition to reporting that the average investor in equity mutual funds grossly underperformed the market index again in 2018, and each year over the last 30 years, here are a few other disturbing results they reported about investors in 2018:
- The Average Equity Fund Investor (stocks) withdrew funds every month in which the S&P 500 Index had a material gain,
- The only month the Average Equity Fund Investor made a significant contribution was a month where the S&P 500 Index lost approximately 2.5%,
- The Average Equity Fund Investor’s performance trailed the S&P 500 Index in August when market prices soared and in October when prices fell sharply, i.e. when market prices rose and when they fell,
- The Average Fixed Income Fund Investor (bonds) lost 2.84% while the Bloomberg/Barclays Aggregate Bond Index gained 0.01%.
The question we always have to ask after reading these disturbing results is why? Why do the investment results of the average investor so drastically trail the most basic index of broad stock and bond market returns year after year?
As we concluded, the only two logical possibilities for this horrific performance are:
- the fees they paid, which ate into their returns, and
- “how” they invested, i.e. when they bought, when they sold, what they chased, what they were scared out of, etc., i.e. their investing behavior.
In the last two editions, I shared all of the deadly biases investors bring to the table which governed their investment behavior and led to their ugly results.
Today, let’s examine the second big reason why the average investor’s results so drastically lag market returns, and that is the fees they pay.
While investor behavior can explain away a large portion of the gap between returns actually achieved and market returns, fees also play a significant role.
There are two reasons for this:
- The majority of investors have fallen prey to the notion that they or some mutual fund manager has the magic formula and can consistently “beat the market,” and thus they are willing to pay more for that “opportunity”, and/or
- Most investors have no idea at all what they are paying.
“Beat the Market”
Let’s begin with #1. As the DALBAR statistics demonstrate, it is abundantly clear that the overwhelming majority of investors not only don’t “beat the market”, but instead grossly underperform market index returns.
What is not reported enough is how many actively managed mutual fund managers’ results also lag market index returns. The numbers are staggering.
Since the beginning of the mutual fund industry decades ago, the value proposition of “active” fund managers is that the fees they charge are worth it because their extensive research and unique strategies lead to investment returns greater than can be realized by passively managed funds which mirror a specific index like the S&P 500 or Russell 2000.
Morningstar became a household name when they created their famous star rating system so we could “easily” identify which fund managers performed best.
Unfortunately, as their tag line states, past performance is no guarantee of future results.
Dating back 20 years ending December 31, 2018, of the 2,414 actively managed equity mutual funds, only 42% are still are still in existence, and only 23% beat their respective index. And, of those who performed in the top 25% of their category, only 21% remained in the top quartile over the next five years, i.e. there is no persistence to the performance over time.
What this tells us is that, even if they have a fairly long track record, attempting to identify which actively managed mutual fund managers to invest with in the future based on their past performance does not increase your odds of a good investment result, and it certainly doesn’t increase your odds of “beating the market.”
There are many reasons for this which we will dive into in upcoming editions, but the chances of finding a manager who can consistently “beat the market” over the long run is like finding a needle in a haystack. Statistics reveal that it would be random luck.
The reason why this distinction is important is because the fees charged by the average actively managed fund are four and a half times greater than those of the average index fund. And, in most instances, the disparity is even greater than that.
Morningstar’s 2019 U.S. Fund Fee Study revealed the following:
- Investors are paying approximately half as much to own funds as they were in 2000; they’re paying roughly 40% less than they were a decade ago; and about 26% less than they did five years ago.
- In 2018, actively managed funds’ fees fell to 0.67% and passive index funds’ fees fell to 0.15%. By these numbers, active-fund investors paid 4.5 times more than passive-index fund investors on each dollar in 2018.
Last year, I shared my experience with a couple who had recently been referred to us who, entirely unknown to them, was paying an average of 2.92% in investment costs on their holdings
A very large contributing factor to this was the annuities they owned which were sold to them by a representative a large financial institution who received large commissions for doing so.
The average cost of the annuities they owned was 3.25%. And, if they wanted to get out, they would have to pay the insurance company 8% of what they invested.
This is an important point in this discussion because the level of investment into annuities continues to rise to record levels each year.
We began by trying to determine why the average investor has earned so drastically lower returns than the market barometer of “average” returns (not above average) each and every year.
As we discovered over the last two weeks, it’s critically important to check your biases at the door because they are what governs your investing “behavior” which is the leading contributor to underperforming market returns.
At the same time, a significant contributor to these awful returns is fees, otherwise known as “fee drag.”
Most investors have no idea what they are paying, nor why they are paying it, and it costs them dearly. This is the equivalent to attempting to run a marathon with a 50- pound sack of rocks tied around your waste because someone sold you on the idea that your odds of running a successful race will increase if you do so!
Know what you are paying and why you are paying it!
Committed To Your Relaxing Retirement,
The Retirement Coach
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(The content of this letter does not constitute a tax opinion. Always consult with a competent tax professional service provider for advice on tax matters specific to your situation.)