Reason #2: Fees
Good Morning Relaxing Retirement Member,
Over the last two weeks, we have examined the results of the recently published 23rd Annual DALBAR Quantitative Analysis of Investor Behavior (QAIB), and tried to determine why the real returns realized by the average investor are so poor.
As a quick refresher, here is what the recently published DALBAR Report revealed about the 30-year period from 1986 through December 31, 2016 (the average length of retirement based on joint life expectancy tables):
- The Average annual return of the broad market S&P 500 Stock Index from 1986 – 2016 was 10.16% (including dividends reinvested)
- However, over the same 30 year period, the average annual return of the “average” equity mutual fund investor (not investment, but an investor, i.e. a person) was 3.98%
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 star mutual fund manager 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 active 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.
As a recent Wall Street Journal study revealed, it’s a good thing they issue that warning! Of the 248 mutual funds who earned Morningstar’s famous “Five Star” status, only 4 out of the 248 retained their five-star status over the next ten years.
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 suffice it to say that 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 passively managed index fund. And, in most instances, the disparity is even greater than that as you will see shortly.
According to Morningstar’s recently published U.S. Fund Fee Study, the asset-weighted average expense ratio across all funds was 0.57% in 2016, down from 0.65% three years ago. On the surface, that appears to be good news.
However, there are (2) important distinctions:
- The simple average expense ratio of the largest 2,000 funds, which accounted for 85% of the assets in mutual funds and exchange traded funds (ETFs), was 0.72%, unchanged from 2015 and 2014. In other words, although the average expense ratio has fallen to 0.57%, eighty five percent of the invested money out there is paying 0.72%.
- The asset-weighted average expense ratios of passively managed index funds was 0.17% vs. 0.75% for actively managed funds, i.e. the expense ratio of actively managed funds is almost 4.5 times greater than that of the average passively managed index fund.
As I revealed in the February issue of Relaxing Retirement News, I shared my experience with a couple who had recently been referred to me 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 is at record levels.
We began by trying to determine why the average investor earned 60.83% less than the market barometer of “average” returns (not above average) each and every year over the last 30 years.
As we discovered over the last two weeks, it’s critically important to check your biases at the door because they are what governs investor “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
P.S.: WHO do you know who could benefit from receiving my Retirement Coach “Strategy of the Week”? Please simply provide their name and email address to us at info@TheRetirementCoach.com. Or they can subscribe at www.TheRetirementCoach.com.
I appreciate the trust you place in me. Thank you! (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.)