Why Minimizing the Costs of Investment Products Must be a Priority
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Readers of this publication know the costs of an investment product reduce the net return and consider cost as an important criterion for selecting investments to make up client portfolios. But how do advisors define costs, and how important is cost reduction compared to other portfolio objectives?
In practice, few advisors truly understand the full scope of costs their clients pay and just how much they and their clients are losing to unnecessary expenses, often 100 basis points or more each year. The least expensive funds dependably outperform their costlier peers, generating more wealth for investors – and assets under management for their advisors. While these observations alone could be a sufficient reason for an advisor to focus on understanding and minimizing costs, demonstrating cost control is also a powerful tool for prospect conversations and justifying one’s own fees. As Michael Kitces put it: “Advisors are defending their own fees by squeezing out the costs of the investment products they use for client portfolios!”
My firm’s most-recent analysis of 46,000 funds again confirmed a simple truth in portfolio construction: Controlling costs works better for managing a client’s portfolio than trying to predict performance. In fact, costs and fees are the most effective tool for predicting future performance. When comparing funds of the same asset class and investment style, past performance is uncorrelated with future performance. But current costs do predict future performance. With most products, such as cars, there is usually a direct relationship between cost and value. A $122,000 Mercedes E-class wagon is a better car by most criteria than a $17,000 Nissan Versa. But a 122-basis-point fund is not reliably better than one that charges 17 basis points. In fact, the opposite is true. With funds, to paraphrase John Bogle, you don’t get what you pay for; you get what you don’t pay for. Investment management costs are a zero-sum tradeoff.