When was the last time you paid more for something than it objectively was worth? You’re probably thinking “This morning, standing in line for a $4 cup of coffee!” And you’d be right — but also far from understanding the real damage being done to your retirement.
The “latte effect” of everyday overspending is well documented, but I’m talking instead about your long-term investing costs. Charley Ellis — a respected author and a member of the investment committee of my firm, Rebalance — makes a fascinating case in the most recent issue of the Financial Analysts Journal.
Jason Zweig, the Wall Street Journal columnist, recently wrote at length about Charley’s latest contribution to investment industry research. As he points out, it’s a real sea-change moment.
During the 1980s and 1990s, nobody quibbled over a fee of 2% when stocks put on 18% a year. Since 2000, Zweig notes, returns have averaged just 4%. A fee of 1% is now quite a burden, a quarter of your return straight to the pockets of active managers.
That sounds bad enough, but Ellis goes on to explain that the truth is far worse. It’s not that low-cost index investing is an option you should consider. Rather, it’s fast becoming the only way to invest that makes mathematical sense at all.
The major point is to consider active vs. index investing apples-to-apples, that is, with each adjusted for the risks involved. Since the index investor gets the market return at the market level of risk, active managers must outperform consistently to overcome the down years they experience, times when their strategies fall out of favor.
But let’s assume they do that. And let’s assume that the active fund somehow beats its benchmark by 0.5%, year after year. Even so, Ellis explains, such a fund charging 1.25% in fees and a 12b-1 fee of 0.25% as a percentage subtracted from assets is in fact asking the retirement investor to accept a constant 75% hit on the return.
That’s right. The fund beats the market for years (one hopes) and, even so, you get just a quarter of the gains and they keep three-quarters of it. And it’s your money at risk. Nice work if you can get it!
Now back to reality. “Because a majority of active managers now underperform the market, their incremental fees are over 100% of the long-term incremental, risk-adjusted returns,” Ellis writes in the FAJ article.
What’s going on here? As Ellis explains, markets have changed dramatically. Once, institutional investors such as banks and insurers were behind less than 10% of trades and individuals did more than 90%. Beating the market was not just possible, Ellis contends, it was “probable for hardworking, well-informed, boldly active professionals.”
Those days are gone. “Now, more than 95% of trades in listed stocks and nearly 100% of other security transactions are executed by full-time professionals who are constantly comparison-shopping inside the market for any competitive advantage,” Ellis writes.
Ellis concludes by asking, When will the industry admit that its ability to exploit tiny price discrepancies is vastly outweighed by the fees charged to its customers? When will clients recognize how bad a deal active investing is for most investors?
That the investing industry continues to promote active management raises real ethical questions, Ellis maintains, questions that retirement investors would be wise to raise with their own advisors.
The value of a financial advisor, Ellis argues, is found less in “price discovery” and more in “values discovery,” that is, talking with clients about what’s going on in their lives: their wealth, income, time horizon, age, obligations and responsibilities, investment knowledge and personal financial history, and then designing an appropriate strategy.
Yes, actual financial advice is more work. But retirement investors have never needed it more.