Overpaying for low-cost money management?
Burton Malkiel, author of “A Random Walk Down Wall Street,” one of the most influential investment books, wrote an op-ed piece for The Wall Street Journal headlined “You’re Paying Too Much For Investment Help,” in which he ripped the mutual fund business for overcharging customers for active management.
He’s right, of course, but investors already knew that, which is why virtually all money going into funds today is headed for low-cost issues, index and exchange-traded funds, or into institutional share classes that are now made available to many investors through retirement plans.
But he’s also wrong, to a degree, because “paying too much for investment help” translated into “buying costly actively managed mutual funds.”
Malkiel, like many others, is beating the drum for index investing, saying passive, broad-based market index portfolios have “substantially outperformed the average active manager since 1980.” There’s no denying that case. But in today’s investment world, many individuals are paying someone to actively manage their passive and low-cost mutual funds. Throw that fee on top of the performance record of the passive funds, and that margin of victory becomes razor thin or disappears altogether.
In the past 15 years, the mutual fund industry has changed in a lot of ways, but none more than in how it compensates advisers. Where front- end loads were once the norm, today they are far more rare. Instead, many advisers now are compensated through 12b-1 fees. Those costs, technically for the sales and marketing of the fund that typically run around 0.25 percent, are lumped into a fund’s expense ratio. That affects the average expense ratio and makes it look like costs have not fallen; in reality, the operating savings behind funds probably have been passed to investors, on average, but have been outstripped by the additional charges of paying for advice.
Here’s the thing: Plenty of investors hire financial advisers who charge, say, 1 percent of assets under management, and who then build an investment portfolio of low-cost funds, or share classes that do not have 12b-1 fees. You pay that for management services above and beyond the costs of the fund.
That said, if an investor is hiring a money manager or financial adviser who builds a portfolio of lowcost funds, and then actively manages that portfolio, tilting the entire mix to or away from indexes hoping to improve returns, they almost certainly are applying a losing strategy to a winning element. You get the funds on the cheap, but pay full price for the investment help, and it may not be such a bargain.
By comparison, an investor might be able to get similar results from actively managed funds, and at a lower price, once all costs affecting the whole portfolio are factored in.
So a passive investor would see that the Vanguard Index 500 (VFINX) has beaten, say, Alger Capital Appreciation (ALVOX) over the last three years, thanks to an expense ratio that is roughly 0.8 percent lower; but if the index investor pays an adviser outside of the fund, the costs for the adviser more than erase the difference.
Low-cost funds do give investors a significant edge, but if that benefit is blown on ancillary costs, it’s no bargain. Chuck Jaffe is senior columnist for MarketWatch.