GreenThought$ readers know that one of our biggest pet peeves is the attitude that many in the investment public have taken toward mutual fund expense ratios. While I have written about this subject in past GreenThought$ issues, I am pleased to present you with a link to a recent article I was interviewed for by DailyFinance.com (an AOL Money and Finance site). The article covered a recent study by Prof. D. Bruce Johnsen of George Mason University concluding that lower advisory fees don't necessarily benefit investors. Here is the link, followed below by my rationale in agreement:
http://www.dailyfinance.com/2009/11/05/mutual-fund-fees-fight-may-be-much-ado-about-nothing/
To summarize the rationale for owning mutual funds which don't have the lowest expense ratios:
1. Beginning with the mega-bull market in the 1990s, members of the financial services industry (mostly larger firms, but more recently ETF providers, too) convinced investors that lower fund expenses for management and administration were synonymous with better investment results.
2. The investing public bought that advice and sunk hoards of cash into index funds. Some thought it was "safer" to do that, since index funds have been hailed as "smart" investments by so many "experts."
3. This advice has merit in parts of the investment world, but in our opinion, it is one of the many oversimplified, mass-produced "conventional wisdoms" of the industry. In much of the mutual fund world, you get what you pay for.
4. We have discussed in prior GreenThought$ issues the fact that the cost of investing in a mutual fund has many parts, namely:
a. The expense ratio (which covers management and operational expenses, and in some cases, a so-called 12b-1 distribution fee);
b. The tax impact of an investment in the fund - over time, this may take the form of dividend income and/or capital gains. If the fund manager does a good job of making money while minimizing taxes along the way, the cost of taxes to a taxable investor in a mutual fund is reduced. This "cost" to the investor can be much higher over time than the cost paid via the expense ratio. In our opinion, a more conscientious manager who is motivated to be aware of the tax impact and tries to reduce it, has the potential to more than make up for any fee differential versus an index fund, over time.
c. Trading and other costs - these are not part of the expense ratio. You have to look carefully at a fund's "statement of additional information" to find where these are disclosed. If you are a very cost-sensitive investor or advisor, it makes sense to do this. The information is typically found on the fund's website or certainly by contacting the fund company.
d. The cost of poor performance - yes, performance actually matters in the fund business - it's not all about costs, it's about long-term return NET of all costs. That is what the investor has to spend on their lifestyle, yet it seems to me that over the past decade, many investors (and even some financial advisors) have had a difficult time re-educating themselves about the "performance vs. cost" relationship. Simply put, if you invest in a fund that, by design, is highly correlated to the movement of the stock market, guess what: in a down market, you can lose a lot of money! Does it make you feel better that you didn't pay much for the experience? The old adage that the stock market solves all investors' problems over a long period of time has been debunked. To me, the cost-of-investing discussion goes hand-in-hand with that.
I believe "getting what you pay for" often means that those who look at mutual fund investing as a research-driven process, and not as a commoditized exercise (i.e., they are all the same, so just find the cheapest expense ratio) have a better chance of weathering investment storms. Given the possibility of a volatile environment for both stocks AND bonds over the next decade, it seems to me that a re-education of investors about the cost of investing and the risks of oversimplifying the cost discussion is imperative...right now.
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