SBJ: Efficient Investing: Spending Less Can Get You More

Industry Insight

BY: KENNY GOTT

Mutual funds and exchange traded funds (ETF’s) are baskets of dozens, hundreds, or thousands of stocks and/or bonds. Many investment advisers use these pooled funds in client portfolios.

What many investors don’t know is that the busier a fund manager is, the worse they tend to perform…so you may be better served by a simple low-cost “index fund” that simply tracks the market.

“Active” managers at fund companies buy and sell stocks and bonds, trying to match or beat the performance of the markets. Their success is judged against their benchmark index—a large representative sample of their segment of the market such as large U.S. companies (the S&P 500 index, Dow Industrials, and others), small companies (the Russell 2000 index for example), bonds (Barclays index and many others), and so on.

Every year, the Standard And Poor’s organization reviews U.S. mutual fund performance in a study called S&P Indices Versus Active, to report just how good professional stock pickers are at outsmarting the markets.

Year after year, the results show that markets are efficient: stock prices adjust quickly to account for new information, which in this age of instant communication is available to all investors more or less simultaneously.

Each year some fund managers do beat the market, but it’s not the same managers from year to year. You can’t predict which ones it will be this year… and over the long run, fund managers tend to perform about average, minus their expenses and trading costs.

You can find the “expense ratio”—your annual cost just to own a fund—in your fund prospectus.

But fund companies aren’t required to report the managers’ stock trading costs. They only report the “turnover ratio”: 100% turnover would mean that over the course of the last year, every stock and/or bond was sold, and a replacement purchased.

And those trades do cost (commissions, bid-ask spread, and market impact costs in some cases).

A 1998 research paper (“The Official Icebergs of Transaction Costs," Commentary #54, Plexus Group) came up with a broad rule of thumb for figuring typical trading expenses: for every 100% of turnover, assume about 1.16% cost.

So if a mutual fund has 60% turnover, multiply 60 x 1.16% = 0.696% estimated turnover expense. So a $1,000,000 portfolio x 0.696%  = $6,960 estimated trading costs per year.

Now you might think the trading activity of fund managers would mean better performance despite the costs—after all, they’re the experts, and if they buy or sell a stock, they could tell you why they think it’s a good idea.

However another large 2013 study, “Shedding Light On Invisible Costs: Trading Costs And Mutual Fund Performance” (Edelen, Evans, Kadlec), found higher-turnover funds perform an average of 1.92% worse than lower-turnover funds.

The less trading a fund manager does, the better the performance. Let that sink in.

Why? It’s back to the fact that markets are efficient (the same public information is available to everyone all the time)…so any given fund manager can’t consistently outsmart the thousands of other investors who are all making decisions that set the prices of individual stocks and bonds. In other words, a manager can’t consistently predict the movements of the overall markets, or whether any given stock will go up or down, before other traders make the same predictions. So their expensive trading activity is not productive, and like a boat anchor, potentially drags down performance as the trading costs evaporate from the funds.

Because of this eye-opening research, many advisers and individual investors have turned to “passive index fund” portfolios.

Instead of having a manager trying to match or beat their benchmark, an index fund simply mirrors the benchmark index…owning all the same securities that make up the index, or a large representative sample. The goal is to track the overall market, not to beat it. The investment costs and turnover tend to be very low, meaning potentially more money stays in the account, working for the client.

There are additional advantages to this approach. Lower turnover investments generate less capital gains taxes, an important consideration in taxable (non-IRA) accounts. Also, active managers may keep excessive cash handy in a fund so they can hop on “hot” stocks. Cash doesn’t perform well in an investment—this is known as “cash drag.” Comparatively, index funds need very little cash on hand.

Of course there’s one more piece to the investment cost puzzle: the fees you pay your investment adviser. They’re the gatekeeper, and may provide additional financial planning advice beyond investment management, but their fees should be reasonable.

Ask your adviser about your market investment costs and turnover—and look at your investments to see the relationship between lower costs and better performance potential.

CERTIFIED FINANCIAL PLANNER^TM Professional Kenny Gott is President at Piatchek & Associates and author of the book "Bottom Line Financial Planning". He can be reached at kgott@pfinancial.com.