Wednesday, May 2, 2012
I am going to give you financial advice worth over $100,000, are you willing to listen? That’s right…over $100,000 with one tip. That is a lot of 5-star trips – or better yet – gifts to charitable causes.
Here is my $100,000 piece of advice: (1) invest in passive index/ETF based funds and (ii) invest in low fee funds.
Passive based funds are portfolios of securities that track certain indexes or asset classes. The funds are passive because, after the index has been established, there is no decision making for the fund manager. As a result, these funds closely match the index returns.
An “Active” mutual fund is actively managed by a portfolio manager. This manager makes daily decisions to buy and sell securities. Unfortunately, 90% of the active mutual fund managers do not tie or exceed their index. That’s right, 90% of Active fund managers cannot beat their indexes and miss by at least 1 percentage point.
As Larry Swedroe, an investment manager and writer puts it: Let’s say you are playing golf on one of the hardest golf courses in the world and, for every hole, you are given the choice to accept par or try to beat par…what would you choose? Most people would certainly accept par.
Now let me focus on cost. When you invest in a mutual fund, there are costs which are deducted from the net return even before you see the results. The average active mutual fund charges 1.5-2% of assets under management. This cost covers the fund managers salary, marketing material and analysts who cover the stock portfolios.
In a passive index based fund, these costs are less than half of a percent (anywhere from 15 to 45 basis points). The costs are less because after the index is selected and the stocks are purchases, there is no need to pay for the high salaries, the marketing materials or the analysts.
“One and a half percent…that’s not much. Plus, these people know a lot better than accepting market rates of return for each asset class”…you say. That is what I used to say. Lets get to the calculation:
Let’s begin the calculation for my advice worth over $100,000.
To start, let’s assume that you have $50,000 saved in you 401K and you plan to keep it there for the next 20 years. The historical rate of return from inception for the S&P500 has been 9.5%. So let’s say your expected investment return is 10% (after fees).
If you invest in a traditional actively managed Mutual Fund which invests in large stocks, you will pay an additional 2% in fees (1% extra for being in an “Actively” managed fund and another 1% for the 90% probability that your fund will not beat or tie the corresponding index).
Here are the results:
• Your portfolio will have an expected balance of $336,000 if you invest in an index
• Your portfolio will have an expected balance of $233,000 if you invest in an actively managed fund.
• This is a difference of $100K
THE WALL STREET SECRET
What is this not talked about more? Here are some of the reasons:
• This is boring – even to the investor
• Lots of publications want to sell books and magazines
• The big institutions make their earnings off of these high fees
• I’ve read recently where finance reporters report lots of news about stocks during the day but, at night, invest their net worth in passive funds/ETFs.
If you have a moderately sized portfolio (in this case $50K) and are investing for the long term and are currently not employing this strategy, my advice is simple: employ a passive investment strategy, ensure you keep fund management fees to a minimum and earn an extra $100,000!