Tuesday, April 26, 2016

For Individuals, Investing In Actively Managed Mutual Funds Should Be Avoided .... Invest Instead in a Passive Fund or a Basket of Individual Stocks ... Cost in Relation to Performance Matters Most

Individual investors in stocks have three basic choices: they can invest in (1) a diversified portfolio of individual stocks, (2) passive index funds such as the S&P 500 index from Fidelity or Vanguard, or (3) an actively managed mutual fund, which just happens to be what is most often sold to them by an insurance agent, bank trust fund or individual stock broker.

In my view, choice #1 is by far the best, choice #2 is definitely second best and #3 is the worst of all and should be avoided.

That's because over a several decade period of individual saving and investing, choices #1 and #2 are going to deliver several times more money at retirement time than will choosing #3. It's the effect of compounding and the 'rule of 72' at work, pure and simple.

But getting individuals to choose #3 is how the typical stock broker salesman, insurance company, banker and actively managed mutual fund make lots of money at the expense of trusting and unknowing individual savers and investors.

And that's also why long term oriented individual savers and investors are likely to end up at retirement time with a shortfall of 80% to 90% of what they could have had by following the #1 or #2 path to income security.

The High Fees You Don't See Can Hurt You offers this useful overview of the dangers of investing in actively managed mutual funds:

"High fees, often hidden from view, are still enriching many advisers and financial services companies at the expense of ordinary people who are struggling to salt away savings. The problem has persisted year after year. A new analysis of mutual fund data confirms its severity.

That’s why the Labor Department announcement early this month is so important. For the first time, all financial advisers dealing with retirement accounts will be required to act in their clients’ best interests. The announcement is long overdue and a big step forward.

But don’t rejoice just yet: It is only a step.

First, the Labor Department’s new rules are not yet in place. They are scheduled to take effect in 2017 and 2018 but are opposed by much of the financial services industry. They could easily be changed, weakened or blocked.

For now, even for retirement accounts that are to be covered by the rules, many advisers are not required to act in their clients’ best interests. This means that they are legally entitled to look out for themselves first and recommend investments with higher fees, to the detriment of those who have asked for help.

Second, if all goes according to plan, after the new rules take effect they will deal only with saving and investing for retirement — and not for goals like a new home, a child’s education, a wedding, a car or a vacation. . . .

Third, while the new rules are both lengthy and clear on fundamental principles, they are short on crucial details. . . .

The rules say that, with some exceptions, advisers will be required to make reasonable recommendations based on an examination of industry norms and practices. But the rules don’t detail which specific investments or fee levels are acceptable. . . .

Data provided last week by S&P Dow Jones Indices confirms that commissions and fees in actively managed mutual funds are depressing fund performance and hurting investors — while enriching fund managers and advisers. These costs are an important factor in the failure of most actively managed funds to outperform the market consistently over long periods .... even when fund managers succeed in outperforming their peers in one year, they cannot easily repeat the feat in successive years, as many studies have shown. That’s why low-cost index funds, which merely mirror the performance of the market and don’t try to beat it, make a great deal of sense as a core investment.

But whether you choose an index fund or one that is actively managed, commissions and fees provide important clues about future performance.

Low fees won’t turn intrinsically bad investments into profitable ones, of course, but they make a big difference. . . .

Mutual fund commissions, also known as sales loads, are a big drag on performance. They are often difficult to justify if an adviser is truly working in an investor’s best interest. . . .

With fees included, the average actively managed fund in each of 29 asset categories — from those that invest in various sizes and styles of stocks to those that hold fixed-income instruments like government or municipal bonds — underperformed its benchmark over the decade through December. In other words, index funds outperformed the average actively managed fund in every single category. . . .

What was striking, though, was that in some categories, fees were responsible for the actively managed funds’ mediocrity. This was true for large-cap value stock funds and international small-cap stock funds, as well as for global, general municipal, California municipal and New York municipal fixed-income funds. The average fund in these categories actually beat its benchmark when the impact of fees was removed from fund returns.

In other words, over the long run, the odds that a talented manager will beat an index fund improve when fees are low — though those odds are still quite low, and a low-cost index fund remains a safer bet. . . .

What is a reasonable benchmark for fees? Note that according to Morningstar, the median expense ratio for actively managed mutual funds is 1.2 percent. For index funds it is about 0.5 percent. The data suggests that, for the most part, the less you pay the better off you will be....

Investors who believe they have found honest and skillful advisers may still want to understand all of this. Not everyone truly has your best interest at heart."

Summing Up

Front end commissions are often as much as an immediate 7% when purchasing an actively managed mutual fund.

And funds advertised as 'no load' and 'no commission' funds usually charge .25% annually in the form of a hidden '12B-1' advertising fee as well as another ~.5% to ~1% annually for managing the fund. And to top it all off, the 'fund' also pays brokerage commissions to make trades, and which fees are embedded and undisclosed as part of the cost of the individual securities purchased in the fund from time to time.

Add all these fees together and the difference at retirement time is likely to be a huge shortfall from what easily could and should have been the far more profitable outcome.

So here's the deal: get a good low cost and fiduciary acting adviser and keep the earnings and growth of the assets over time for yourself instead of giving them to those selling and managing active mutual funds.

That's my take.

Thanks. Bob.

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