The Best of Disinfectants

A recent Frontline® documentary, “The Retirement Gamble,” broadcast on PBS, offered a sobering glimpse into the challenges facing ordinary investors as we work toward the goal of financial security. While there is only so much of a topic with such complexity and potential personal impact that one sixty-minute show can cover, the piece highlights numerous fundamental flaws in the U.S. retirement system.

Tyrannical Costs

The narrative tracks the impetus, development and release of an economic study of the excessive investment costs borne by ordinary investors via fund management fees (“fund expenses”), trading commissions, plan fees, etc. Ignoring, for the sake of simplicity, the “shadow” costs borne by ordinary investors (e.g., the “kickbacks” to fund distributors), as well as taxes, the investment parameters that ordinary investors can control starts with fund expenses.

These costs should be held to a minimum, as John Bogle said best (and has argued persuasively over a period spanning decades) so the ordinary investor can capture his or her fair share of the market return. If you think that Bogle is just saying what one would expect of the founder and former Chairman of the fund industry’s low-cost provider (Vanguard), consider the conclusion of a recent study from Morningstar, the company known for its fund ratings system. In 2010, Morningstar published a study finding the most statistically significant indicator of long-term fund performance was fund expense ratios. Specifically, the study observed that fund expense ratios were “inversely correlated” with superior long-term fund performance. In other words, when choosing among funds for your long-term investing needs, key in on the fund expense ratio, disclosed in the fund prospectus, and the lower the better.

As mentioned on the show, the average actively managed mutual fund has an annual expense ratio of 1.3% (before taking into account additional costs such as fund sales charges, known as “loads”), nearly seven times the average fund expense ratio available to retail investors through Vanguard (0.19%). As such, the 10+ trillion mutual fund industry could offer more in the way of explaining to ordinary investors as to how it prices its services. Let me explain.

Perchance Performance

Given the importance of minimizing costs to long-term fund performance, and that the average actively managed fund expense ratio is high relative to the expense ratio for most index funds, it is not surprising that actively managed fund performance frequently disappoints. For example, of the roughly 8,000 actively managed domestic stock funds (according to Morningstar data released March 31, 2013), 1,335 funds are categorized as “Large Blend.” The S&P 500 index total return index falls into this same category, and thus makes a reasonable performance benchmark for these funds. Only 349 (26%) had a 10-year total annualized return exceeding that of the index (which returned 8.53%). In keeping with Bogle’s description of the “the tyranny of compounding costs,” only 300 of those funds (22%) beat the S&P 500 index, including dividends, on a 15-year total annualized return basis (a return of 4.27%). In other words, about 1 in 4 actively managed domestic stock funds of the “large blend” variety beat their benchmark over ten years. Over fifteen years, the odds are closer to 1 in 5. Over time, costs have tended to overwhelm even the most seasoned fund manager’s ability to pick stocks and time the market.

Given the odds against picking an active fund manager who is able to overcome the performance drag of management costs in attempting to beat the market benchmark, the ordinary investor is best off investing in diversified, no-load, low-cost index funds that track broad market indices. That way, the investor will earn the market return less fund management costs. Passive fund management costs, associated with index funds, should be lower than active fund management costs, since the fund manager is not attempting to pick stocks or time the market. Additionally, through these index funds, the investor can broadly diversify his or her portfolio.

Dearth of Diversification

Having worked extensively in the field of trading risk management, my focus when advising clients is on tailoring advice to fit an objective assessment of the client’s individual risk tolerance. Most investors are risk averse, and investment portfolios should reflect the extent to which that generalization holds true for a particular investor. The unfortunate aspect of the current retirement system is that with all of the potential conflicts of interests highlighted by the show (the fund distributor “kickbacks,” the lack of a universal fiduciary standard, the list goes on), the offerings available to ordinary investors are often quite limited within a given retirement plan. Moreover, these offerings do not necessarily address the fundamental need for diversification as a means of managing the risk of capital loss.

Take for example, the $3+ trillion money market fund industry. At the onset of the Financial Crisis in the fall of 2008, the U.S. Treasury and the Federal Reserve intervened to stop a collapse of this fund class. While this money fund bailout garnered less attention than the bailout of numerous U.S. major banks, it was no less real. If there is one asset class that one would expect be vested in diversified, short-term securities, it is the funds whose value is assumed to remain stable over time (at a net asset value of $1). Unfortunately, the facts unearthed since the Financial Crisis suggest otherwise. Presumably chasing yield, money market fund managers took concentrated bets that put the savings of thousands of their investors at risk.

Diversification is a complex concept, but the simplest way to think about it is, as one asset in your portfolio falls, another asset, prudently selected, may not fall in value as much, or may not fall at all. With some luck, the price of one asset might actually rise while the price of the other asset falls. That way, the “ups and downs” of the various assets in your portfolio offset one another, to varying degree, and thereby dampen the otherwise volatile swings in the portfolio’s value over time. Truth told diversification is the primary means by which the ordinary investor can manage the risk of losing hard-earned savings while investing in today’s capital markets.

Arc of Asset Allocation

Prominent investment professionals and academics (e.g., Gary P. Brinson, William F. Sharpe, Roger G. Ibbotson) have published extensive research on financial securities indicating that asset allocation is a primary determinant of long-term investment performance. For example, cash held in short-term U.S. treasuries, which, after inflation, now offer investors a negative yield, are doomed to minimal long-term returns. Portfolios holding only equities are subject to the risk that, in a down year like 2008, annual losses of 38% can erase years of investment gains.

The body of research published by Brinson, Sharpe, Ibbotson, and others suggests that the mix of stocks, bonds, and cash held in portfolios is critical to a given portfolio’s long-term return. Specifically, the mix of asset types is more important to long-term portfolio performance than the individual security chosen within a given asset class. Stock-picking skill, in other words, is at best of secondary importance in determining long-term portfolio performance. As such, it is not something that fund managers ought to use to substantiate premium management fees. Then again, neither are the performance statistics, mentioned above.

Historical data has not stopped fund companies from aggressively marketing actively managed funds. Adding insult to injury, many funds charge a special fee (12b-1 fees), the express purpose of which is to pass onto fund investors the costs of — you guessed it — fund marketing and sales.

Fiduciary Duty

As highlighted on the show, there is significant industry and (via industry lobbying) political resistance to, a universal fiduciary standard. Registered investment advisors and their representatives (of which I am one) answer to regulators regarding their adherence to the Fiduciary Standard. This standard requires that we advise clients with their, not our best interests in mind. Brokers and other professionals holding themselves out as financial advisors are generally not subject to this legal and regulatory requirement. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 empowered the Securities and Exchange Commission (SEC) with the authority “to establish a fiduciary duty for brokers.” However, the glacial pace of the legislative process means the debate over the specific rules ultimately put in place pursuant to this law will engage members of Congress, industry lobbyists, the Department of Labor, and the SEC through 2014.

Bottom Line

My advice, based on twenty-five years of business experience as well as experience as a personal financial advisor, is to control those things you can control – costs, diversification, and asset allocation – and resist the temptation to pick stocks, fund managers, or time the market. As the Frontline documentary suggests, the U.S. retirement investing system’s inherent biases and conflicts of interest favor the “powers that be,” not you and me.

Last, do your homework. Anyone seeking to engage you as a financial advisor must disclose his or her income sources (e.g., fees, commissions). Take it a step further and ask for compensation amounts, and about any other fees and costs that may be involved. Get it all in writing. If you get an inadequate response, find another advisor.

We are lucky to have programs like Frontline that highlight fundamental flaws in critical social structures like the retirement system. This episode in particular reminded me of a quote from the late U.S. Supreme Court justice Louis D. Brandeis:

Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policeman.

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