Saturday, September 27, 2014

Why I Use Low Cost Instruments to Access the Markets

I remember years ago taking a look at my 401k statement and being quite surprised. That year, the S&P 500 had returned 16%. I looked at my 401k statement and the S&P 500 fund I was using returned around 14 1/2%. "Odd" I thought. "Why would my S&P 500 Fund return less than the S&P 500?"

Similarly, my small cap mutual fund was also underperforming the small cap index. My mid cap mutual fund was underperforming the mid cap index. Across the board, my funds were underperforming their various indices.

One fund I had was outperforming the S&P 500. It called itself a large cap fund...but I looked into its holdings and sure enough, it had some mid cap stocks and even a few small cap. I did a little research and found that over time, small cap stocks return more than mid cap and mid cap return more than large cap. So, essentially, the fund manager was cheating a bit. He or she was exhibiting what is now known as "style drift," including the fund in one category but using instruments from another. Was he really doing as well as the indices he held? I'll never know...which is probably exactly what that fund company wanted.

I did some digging and found that my S&P 500 fund had around 1 1/2% internal fees...hence the 1 1/2% underperformance versus the index. Similarly, the mid cap and small cap funds were in the same situation. The funds were underperforming their index by approximately the same amount as their fees.

I then looked at a couple other groups like Vanguard and Dimensional Funds. They were much closer to achieving the yields I'd expect. In fact, I seem to remember the Vanguard S&P 500 ETF returning 15.90% versus the S&P 500 returning 16%. You guessed it, Vanguard at that time had a 0.10% internal fee.

Over the last couple years, research has become overwhelming supportive of low cost instruments. In fact, Morningstar, the group that makes their money by assigning stars to mutual funds came right out and said, "In every single time period and data point tested, low-cost funds beat high-cost funds. To see the results, click here." This is from the group that makes money using their star system to rate funds. The full article can be accessed here.

Wall Street and the big Wall Street firms want people to think that expensive managers can "foresee" market downturns and outperform the indices. Nothing could be farther from the truth. Check what this Forbes article said about active managers: "The claim that active managers can successfully time markets isn’t even close. The truth is that a majority of active fund managers performed badly in bad markets and good markets."

The number one way to increase your market performance is to decrease your expenses. If you manage money on your own, use low cost ETFs and funds. If you hire a manager to handle things, hire a low cost manager who uses low cost funds.

Lastly, 1 1/2% may not sound like much, but remember, that's $15,000 dollars of underperformance each and every year on a $1mm portfolio.

Increase your odds of successful portfolio performance with the above recommendations from Morningstar and Forbes. Keep that $15,000 for yourself rather than giving it to Wall Street.