It takes no special intelligence for a broker or financial adviser to place a client into an equity fund. All you need to have is a securities license and that's about it. The planner you choose—or that someone refers you to—will often check your pulse for risk and then make the selection for you; or worse yet, have you make your own selection of funds for your retirement account. As you read on later in this chapter, you'll find out how well these funds work—or more appropriately don't work—for long-term planning like retirement.
According to Goldman Sachs, an astounding 88% of active stock funds underperformed the S&P 500 in 2011.
Last year, 65% of large-cap funds underperformed the S&P 500. Mutual-funds managers were not the only ones struggling. The Economist reported that, except for 2008, the S&P 500 Index has outperformed the average hedge fund index for a decade.
SEC Chairman Arthur levitt, Jr. warned of growing unfairness in the relationship between individual investors and mutual funds in January 2001. Mr. Levitt made the following comment:
“There are a number of instances that, quite frankly, do not honor an investor's rights. Instances where…hidden costs hurt an investor's bottom line, where spin and hype mask the true performance of a mutual fund, and where accounting tricks and sleight of hand dresses up a fund's financial results.”
What most people don't know is that there are five separate bills that mutual funds charge. The best way to determine if an investment is effective for you or not is to dollarize the benefit or the burden. When you invest in the typical mutual fund (assuming outside of a qualified retirement plan), you face costs that erode your benefit.
The five costs of mutual fund investing are:
- Tax costs – excessive capital gains from active trading.
- Transaction costs – the cost of the trades themselves.
- Opportunity costs – dollars taken out of portfolios for a fund's safekeeping.
- Sales charges – both seen and hidden.
- Expense ratio, or “management fees” – no end to increases in site. This is a calculation based on the operating costs of the fund divided by the average amount of assets under management.
How do fund expenses affect you? Well, with the expense ratio, which averages 1.6% per year, sales charges of 0.5%, turnover generated portfolio transactions costs of 0.7% and opportunity costs of 0.3%—when funds hold cash rather than remain fully invested in stocks— the average mutual fund investor loses 3.1% of their investment returns every year just on fees. While this might not seem like much on the surface, costs and fees alone could consume 31% of a 10% market return. Think about that. You could be losing almost a third of your return before it's even taxed. You're losing a third of your return just for the cost of maintaining your investment. Add in the 1.5% capital gains tax bill that the average fund investor pays each year and that figure shoots up to 46% of your return being lost to fees and expenses, nearly half of a potential 10% return. When you hear that, don't you feel like you're taking one or two steps back instead of going forward? This what most working Americans and middle class are relying on for retirement.
In the long run, stock returns depend almost entirely on the reality of the investment returns earned by corporations. The perceptions of investors reflect speculative returns. It is economics that controls long-term equity returns; emotions, so dominant in the short-term, don't play a major role in the actual return on investment.
After subtracting the cost of managing the fund—management fees, brokerage commissions, sales loads, advertising costs and operating costs—return to the investors as a group falls short of the market return. In a market that returns 10% as a gross return, what is the actual return to the investor after expenses?
There are two certainties:
- Beating the market before costs is a zero-sum game.
- Beating the market after costs is a loser's game.
In equity funds the expense ratio, which is the management fee and operating expenses combined, averages about 1.5% per year of fund assets. Add another half percent in sales charges, assuming a 5% initial sales charge is spread over a ten-year holding period. If the shares are held for five years the cost would be twice that figure.
There is also another cost for portfolio turnover that's estimated at a full 1% per year. The average fund turns its portfolio over at a rate of 100% per year, meaning that a $5 billion fund buys $5 billon of stocks each year and sells another $5 billion. At that rate, brokerage commissions, bid-ask spreads (the difference between the bid price and the sale price of a stock) and market impact costs add a major layer of additional cost. In the end, the cost could be as high as 3% to 3.5% per year for expenses.
It's important to think of all this math as a blueprint by which you can gauge how successful your investment in a fund has really been. If you're returns, after management fees and taxes, don't surpass the rate of inflation, then you might as well have stuck your money in a savings account.
The performance of equity funds from 1980 to 2005 as a measured return (S&P 500 Index) averaged 12.3% per year. This is the formula that John Bogle, creator of the Vanguard 500 index fund, points to in his book The Little Book of Common Sense Investing and it looks like this:
Market return – costs – inflation = investor return
When you do the math, most funds just don't cut it?
There is also the problem of dollar-weighted returns, which is when money flows into a fund after a good performance and out on a bad performance. Essentially funds experience tides in the rate of participation in them based on how well they've done. The dollar-weighted rate is affected by the amount and the timing of cash flows during a given time period. This rate is an effective measure of the fund's rate of growth, giving full weight to the impact of cash flows on fund assets.
Breakdown of actual earnings to an individual investor:
- 12.3% – average market earnings for the past twenty-five years.
- 10% – the return on the average mutual fund
- 7.5% – the average dollar weighted return to the individual investor
- – (2.5%) – reduction from market to fund return is about the 2.5% expense ratio
- – (2.3%) – reduction for inflation
- – (1.8%) – for taxable investors (no state applied)
- Equals = 0.9% + or actual investor return (AIR) from the average mutual fund.
We cannot stress enough that you need to remain aware and understand all that little print in the prospectuses and ask your financial adviser/planner or broker to explain all the fees on each product they suggest. Otherwise, you might be better off just purchasing the stocks direct from the company under their DRIP or dividend reinvestment plan and do this through a self-directed pension plan that you set up and control.