Sunday, August 12, 2012

Beware of Brokers Selling Actively Managed Mutual Funds ... S&P 500 Equity Index Fund is Best Idea for Individuals Who Don't Want to Own Individual Shares of Companies Over the Long Term

A good friend mentioned to me recently that a stock broker was recommending that he consider purchasing shares in an actively managed specific energy related mutual fund.

While I have no specific knowledge as to why the broker recommended what he did to my friend, I do know this; often stock buying recommendations are based in whole or in part on what the broker receives in commissions.

Brokers are incentivized sales people, in other words. In this case, the "load" or front end sales commission is 5%. In addition to the front end charge, the fund has an annual charge of 1.44% on the  assets under management as well. That's way too expensive for me and unnecessarily so. Where's the value added?

Using MOM thinking, most individuals should much prefer to own the Vanguard S&P 500 Equity Index Fund where there is no load or sales commission and the annual expense charge is a mere ~0.17% of assets annually. That's quite a head start and ongoing savings compared to what my friend was being offered by the stock broker.

S&P 500 Equity Index Funds (Vanguard and Fidelity have the two largest such S&P 500 funds) are both passive and an extremely low cost way to invest long term in mutual funds. Essentially, we are able to keep for ourselves what the market gives us (6.7% annual inflation adjusted return and ~10% nominal annual return historically).

Meanwhile, the vast majority of "pros" and mutual funds don't even come close enough for horseshoes to matching, let along surpassing, "Mr. Market's" performance. Primarily it's the commissions and fees that the so-called experts charge that lead to their consistent and long term underperformance.

These non-managed equity index funds are generally the best way for individuals to invest for the long haul and yet they are and hardly ever mentioned, let alone recommended, by sell side brokers due to the brokerage industry's "incentive" compensation system. In other words, brokers look out for brokers and not investors. That's just a fact.

Speaking of facts, A Mutual Fund Manager, Too Worried to Rest is a lengthy and well written article about legendary Vanguard founder and long term oriented low cost fund manager John Bogle. The simple idea of Bogle's is to enable individuals to match the market returns over the long term and not incur high management costs or commissions while so doing. A penny saved is a penny earned or what we don't spend on money management or brokerage commissions adds lots to our investment returns.

So  even though following this long term low cost match the market passive approach won't make your broker or financial adviser lots of money, it will help you earn, lost of money. Thus, I say why not put your performance in  line with the market and ahead of more than 80% of the active mutual fund results achieved by the "pros." Surprised? Well, read on.

The article about Mr. Bogle and his investment philosophy says this in pertinent part:

"VANGUARD, the penny-pinching mutual fund company founded by John C. Bogle, has become a colossus. Its index funds — once derided for not even trying to beat the market — are now the industry standard.       

Mr. Bogle, 83, has written 11 books and had at least six heart attacks and one heart transplant. . . .
“It’s urgent that people wake up,” he says. Why? This is the worst time for investors that he has ever seen — and after more than 60 years in the business, that’s saying a lot.

Start with the economy, the ultimate source of long-term stock market returns. “The economy has clouds hovering over it,” Mr. Bogle says. “And the financial system has been damaged. The risk of a black-swan event — of something unlikely but apocalyptic — is small, but it’s real.”

Even so, he says, long-term investors must hold stocks, because risky as the market may be, it is still likely to produce better returns than the alternatives.

“Wise investors won’t try to outsmart the market,” he says. “They’ll buy index funds for the long term, and they’ll diversify.

“But diversify into what? They need alternatives, bonds, for the most part. What’s so frightening right now is that the alternatives to equities are so poor.”

In the financial crises of the last several years, he says, investors have flocked to seemingly safe government bonds, driving up prices and driving down yields. The Federal Reserve and other central banks have been pushing down interest rates, too.

But low yields today predict low returns later, he says, and “the outlook for bonds over the next decade is really terrible.”

Dark as this outlook may be, he says, people need to “stay the course” if they are to have hope of buying homes or putting children through college or retiring in comfort.

He is still preaching the gospel of long-term, low-cost investing. “My ideas are very simple,” he says: “In investing, you get what you don’t pay for. Costs matter. So intelligent investors will use low-cost index funds to build a diversified portfolio of stocks and bonds, and they will stay the course. And they won’t be foolish enough to think that they can consistently outsmart the market.”

Still, because the market and the economy are deeply troubled, it’s time for action on many fronts, he says: “We’ve really got no choice. We’ve got to fix this system. All of us, as individuals, need to do it.”

That’s the message of his latest and 11th book, “The Clash of the Cultures: Investment vs. Speculation” (Wiley & Sons, $29.95). It offers a scathing critique of the financial services industry and updated guidance for investors. “A culture of short-term speculation has run rampant,” he writes, “superseding the culture of long-term investment that was dominant earlier in the post-World War II era.”

Too much money is aimed at short-term speculation — the seeking of quick profit with little concern for the future. The financial system has been wounded by a flood of so-called innovations that merely promote hyper-rapid trading, market timing and shortsighted corporate maneuvering. Individual investors are being shortchanged, he writes. . . . 

The American retirement system faces a train wreck. America’s fundamental values are threatened. Mr. Bogle remains a dyed-in-the-wool capitalist but says the system has “gotten out of balance,” threatening our entire society. “You can always count on Americans to do the right thing — after they’ve tried everything else,” he says, quoting Winston Churchill. Now, he says, it’s time to try something else. . . . 

He wants limits on leverage, transparency for financial derivatives, stricter punishments for financial crimes and, perhaps most urgently, a unified fiduciary standard for all money managers: “A fiduciary standard means, basically, put the interests of the client first. No excuses. Period.”

Those clients — the ordinary people to whom he has always appealed — need to protect themselves from peril, he says: “In an ideal world, Adam Smith-like, individuals would recognize what they need to do in their own self-interest, and they will make changes happen and look after themselves.”

MR. BOGLE sometimes disagrees with current Vanguard management, but he remains proud of the company he created. Index funds are ever more popular, and Vanguard is gushing money, torrents of it. Thanks largely to its various index funds, Vanguard, which is based near Valley Forge, Pa., pulled in a net $87.7 billion in cash this year through June, excluding money market funds. That’s nearly 40 percent of the cash flow of the entire mutual fund industry.
Burton Malkiel, the Princeton economist and author of “A Random Walk Down Wall Street,” says: “Index funds are so popular now that it’s easy to forget how courageous and tenacious Jack Bogle was in starting them. They were called Bogle’s Folly because all they did was replicate the returns of the market. But, of course, that’s a great deal. In the academic world many people saw the wisdom of this — but Jack is the guy who actually made it happen.”

Mr. Bogle also tried to ensure that Vanguard funds would always be cheap to buy and hold. While Vanguard is his baby, he has never had an ownership stake in it aside from the shares he holds in its mutual funds. Vanguard fund shareholders own the place collectively because he planned it that way.

“Strategy follows structure,” he says, explaining that with no parent company or private owners to siphon profits, Vanguard can keep costs lower than anyone else. That was always his goal. “The only way anyone can really compete with us on costs is to adopt a mutual ownership structure,” he says. “I’ve been waiting all these years for someone to do it, but no one has.” . . ." 

Summing Up

Mr. Bogle is one-of-a-kind. He cares about the success of his fellow mutual fund owners.

While I currently own individual shares of companies and not a passive S&P 500 Equity Index Fund, I also owned and regularly contributed to (dollar cost averaging really works) the S&P 500 Equity Index fund for several decades. I simply have more time now, so I do it myself.

In any case, index funds represent a very low cost, straightforward and "don't even try to outsmart the market" buy-and-hold approach. Mine is similar, but I do try to beat the market over a long period of time. Not much trading involved in either case. Thus, not many commissions and fees for the discount brokers involved either.

Over many years, low cost passive index funds are definitely the way to go unless individuals want to and have the time to spend managing their own portfolio of individual stocks.

Take what the market gives you over time, in other words, and don't pay front end commissions or annual investment manager fees.

In the long term, it will make a huge difference to the costs not incurred and, consequently, what the rule of 72's compounding effects will deliver by "staying the course."

Index investing is a proven winner, except for the stock brokers, "professional" money managers and "expert" financial advisers.

Thanks. Bob.

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