Protecting Investors from High Costs

protecting investors high costsThis is Part 1 of a 2 Part series on Actively-managed Mutual Funds. 

You are given two investment options.  Fund A charges an annual management fee of $22 with an annual return of 10 percent. Fund B charges an annual management fee of $78 with an annual return of 2 percent.  Seems obvious, right? Yet every day millions of investors choose a variation of Fund B by investing in actively-managed mutual funds.

Ever since the introduction of index mutual funds, there has been an ongoing debate as to which are better for investors, actively-managed mutual funds or passively managed index mutual funds. Most comparisons of index mutual funds and actively-managed mutual funds are based on returns, with the argument being that actively-managed mutual funds can provide better returns in both bull and bear markets.

Contrary to popular belief, actively-managed funds, on average, have actually tended to under-perform a broad market benchmark in bear as well as bull markets.  Despite the opportunity for active managers to add value during bear markets, they have done so inconsistently, at best.

Here is what various studies have concluded:

• Approximately 85% of actively-managed mutual funds under-perform their relevant index over the long-term.

• Analyzing two recent five-year market cycles, 1999 to 2003 and 2004 to 2008, Standard & Poors found that a majority of actively-managed funds in all nine domestic equity style boxes were outperformed by corresponding S&P indices.

• The Schwab Center for Investment Research reported that:
(1) Index funds outperformed actively-managed funds in 55% of the down markets.
(2) In the worst downturns, defined as declines of 10% or more, index funds
outperformed actively-managed funds 75% of the time.
(3) In the longest downturns, defined as declines of 5 consecutive months or longer,
index funds outperformed actively-managed funds 100% of the time.

Even when actively-managed funds outperform index funds, such performance is inconsistent and only by a slim margin on an after-tax basis.  According to David Swensen, the highly respected Chief Investment Officer at Yale University, “[a] miniscule 4 percent of funds produce market-beating after-tax results with a scant 0.6 percent (annual) margin of gain.  The 96 percent of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8 percent per annum.”

The impact of fees and other costs is a significant factor in the under-performance of actively-managed mutual funds. Higher fees and higher trading costs reduce a fund’s return. Too many investors underestimate the impact of mutual fund fees.  Each additional one percent of fees and expenses reduce an investor’s end return by approximately 17 percent over a twenty year period.

In comparing the value of index mutual funds to actively-managed mutual funds, the issue of cost is often dismissed with a statement to the effect that actively-managed funds are more expensive than index funds due to the benefits received from the active management. However, as we have shown, there are serious questions regarding the “benefits” of active management.

Most index funds charge stated annual expenses less than 0.20 percent, while actively-managed mutual funds’ stated annual expenses are generally five to six times higher. However, in truth, an actively-managed mutual fund’s effective annual fee can be even higher if you perform a basic cost-benefit analysis on the incremental cost and incremental benefit of an actively-managed mutual fund.

In my upcoming article, “Determining the True Value of Actively-managed Mutual Funds,” I introduce a proprietary metric that allows investors to measure the cost efficiency.

To learn more about James Watkins, visit his site at www.investsense.com.

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