A Simple Strategy Your Broker Hopes You Won't Learn

A Simple Strategy Your Broker Hopes You Won't Learn
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The data is irrefutable. There's a direct correlation between low fees and higher expected returns. Two recent studies from Morningstar bring this point home in a powerful way.

The significance of low fees

In the first study, Morningstar found that asset-weighted expense ratios (the management fees charged by mutual funds) continue to decline. Investors are taking note. The study found that, over the past decade, 95 percent of all fund flows have gone into funds in the lowest-cost quintile. Because index funds are very low cost, they have benefited "disproportionately."

However, the study also found the big winner during the past decade was the mutual fund industry and not fund shareholders. Assets went up by a far greater percentage than fees went down.

How you can be the winner

In the second study, Morningstar measured the performance of actively managed funds against the "net of fee" performance of passive funds. This is a more valid evaluation than comparing actively managed funds directly to indexes, because investors can't buy the index. They need to buy a fund that tracks the index and pay the management fee charged by that fund.

The study found actively managed funds "generally underperformed their passive counterparts, especially over longer time horizons." Significantly, it determined that this underperformance was positively correlated with higher fees. Lower-cost funds "were likelier to survive and enjoyed greater odds of success."

The conclusion of this study should be posted as a sticky note on your computer and serve as a major guide to investment decisions: "Fees matter. They are one of the only reliable predictors of success."

A winning strategy

It seems so simplistic. Once you have decided on your asset allocation, your globally diversified portfolio should consist exclusively of the lowest-cost mutual funds you can find. These funds typically will be index funds. The lowest-cost provider of index funds historically has been Vanguard.

If more investors followed this route, the securities industry would be in trouble. It's in the business of selling you expensive, actively managed funds. It claims to possess the ability to tell you when to dump some of your mutual fund holdings and buy others that (so it says) are poised to outperform. Could it be that this sales pitch is just hot air?

The dismal track record of consultants

A fascinating study published in 2014 provides an answer to this question. Your broker probably has many clients similar to you (individuals with various levels of assets to invest). What if, instead of relying on your broker, you had access to consultants who normally work with pension plans, endowments and foundations? These consultants advise more than $25 trillion in assets. They are the best, brightest and probably most highly compensated investment advisors in the world.

The study looked at survey data from investment consultants with a combined share of around 90 percent of the consulting market. It focused on recommendations of actively managed U.S. stock funds for the period from 1999 through 2011.

The conclusion of the study is stunning and unambiguous: "We find no evidence that consultants' recommendations add value to plan sponsors."

How could this be? Part of the reason, as found in the Morningstar studies, is cost. The institutional funds studied charged, on average, 65 basis points a year, which is much more than the fees of comparable index funds.

The study also found that consultants often recommended bouncing in and out of funds more frequently than plans that followed an index strategy. Finally, the study concluded: "Consultants face a conflict of interest, as arguably they have a vested interest in complexity."

Now think about the actively managed fund recommendations made by your broker. They are probably more expensive than comparable index funds. Also, your broker likely periodically suggests that you sell some funds and buy others, which increases your transaction costs (and reduces your returns). Lastly, your broker -- like a consultant -- has "a vested interest in complexity" as well.

The takeaway

The securities industry relies on your lack of knowledge and gullibility. Now that you understand the findings in these studies, it's time for you to become an evidence-based investor. The first step is to fire your broker. Then, buy index funds on your own or seek the services of a registered investment advisor who understands the data and will assist you both with implementing your new plan and with the balance of your comprehensive financial planning needs.

Dan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You'll Ever Read, The Smartest Retirement Book You'll Ever Read and his latest, The Smartest Sales Book You'll Ever Read.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

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