What if I told you that I am a world-class coffee brewer and my coffee tastes wonderful, better than all my competitors. Since my coffee is so amazing I command a premium of over 17 times the national average price of $1.38 for a medium cup of coffee. I charge between $24.00 and $34.00 per cup depending on the flavor. That’s how freaking good my coffee is!
However, Here’s the embedded risk that you won’t know unless your read my product offering memorandum:
- If I am able to pick the right coffee beans, at the right time and brew them correctly, then you will likely have above-average coffee for long periods of time.
- I can’t guarantee my coffee will be “the best” all the time, in fact my coffee could taste far worse than the average cup of coffee on any given day. Although, I believe it to be unlikely.
- There is upwards of a 50% chance my coffee will taste the same or worse that the average cup of coffee.
Knowing what I just told you, would you pay $24.00+ for a cup of my “maybe it will be great, maybe not” coffee?
Well Ladies and gentlemen: Welcome to the asset management business!
Please come and purchase my active mutual fund (i.e. premium coffee), but here’s what you won’t know unless your read my prospectus:
- If I pick the right investments and buy and sell them at the right time, you will likely earn a superior return on your investment.
- I can’t guarantee your investment returns will be above greater market returns.
- There is an upwards of 50% chance that I will underperform the s&P 500 index.
Knowing what I just told you, would you pay $1,500+ for my “I think I can beat the market” investment services?
Not All Returns are Created Equal
Consider the chart below I created using FINRA’s Fund Analyzer Tool, which shows the returns, fees and expenses for 3 randomly chosen U.S. large cap mutual funds. The first fund, the Vanguard 500 Index Fund, tracks the S&P 500 Index and is passive investment fund. The other two funds are actively managed funds from Putnam and American Funds. The fund managers for these funds are trying to “beat” the S&P 500 index returns through investment selection or “stocking picking”.
Using the tool I assumed a $10,000 initial investment, a 10-year holding period and a 5.0% annual return for each fund. Take a look at the section I highlighted, it shows that the much cheaper Vanguard fund charging only $77.09 in fees dramatically outpaces the “premium funds” that focus on stock picking. Notice that I did not use the word “outperform”, this is because the funds actually “performed” the same, earning a 5% return. Only the fees are different. In a nutshell, the two active funds spend more money to generate the same return. Correction, spend more of your money to generate the same return.
Ok, so what if an actively managed fund outperforms?
Well, based on the chart above an active manager would have generate an average return of almost 6% to give an investor the same profits as the Vanguard fund when it returns 5%. Generally speaking, this means an active manager has to outperform just to keep up with an index fund.
The reality is that active managers are paid higher fees even if they underperform the market. The below shows the 10 year performance of the two active funds above versus the S&P 500 Index. Over the 10-year period the Putnam fund generally underperformed in the first 6 years and has outperformed the index ever since, where as the American Fund has been a consistent lagger. This means investors in the American Fund likely did even worse over the past ten years than the FINRA tool could have predicted.
According to S&P’s 2011 “S&P Persistence Scorecard” very few fund managers remain consistent performers with only 9.72% of large capitalization funds maintaining a top-half ranking over 5-years. The bottom-line; it is extremely hard to beat the market consistently, so why pay a premium price for managers to “try”?
1) Fee management is SUPER important, not just for mutual funds, but also for financial advisors or wrap accounts (separate accounts). Make sure you understand the impact of fees over the long-term.
2) Professional investment managers have a very hard time consistently outperforming the markets. Don’t over-pay them to underperform, it will cost you more than simply buying the S&P 500 index tracking ETFs or mutual funds.
Do you own index funds? Are you a believer in actively managed funds or costly financial advisory services?