Five Things You Can Control: Investment Costs

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In Don Phillips’ article “The Things You Can Control ” he suggests that the best advisors help their clients focus on what can be controlled and not fret about the the rest even when when uncontrollable things are what clients think are the most important. His fourth suggestion is to:

4. Control the costs. After being largely ignored for years, costs have moved center stage in the investment industry. Yet one can argue that costs are still underappreciated. If investment costs were stated in dollars or expressed as a percentage of potential gains, rather than as a percentage of assets under management, they’d receive the attention they deserve. A 1% management fee doesn’t sound like much, but if it’s in an asset class like bonds where one might reasonably expect only a 3% return, it’s a third of the potential gains given over to the provider, a party not sharing in the risk. That’s steep. Smart advisors and investors have pushed cost to the center of the investment equation, as it’s one of the things an investor can best control.

Finding cheaper investment vehicles is one of the ways a fee-only advisor earns their own fee.

If your fund has an expense ratio over 1%, you should seriously consider leaving it and the professional who sold it to you. The broker-dealers of the financial world often aim to sell expensive funds. They receive commissions from expensive funds, motivating them to peddle primarily high-cost securities.

Smart advisors help minimize investment fees, and because of this aim, according to a Morningstar study on fund fees , “the asset-weighted average expense ratio across funds, including open-end mutual funds and exchange-traded products (but excluding money market funds and funds of funds), was 0.61% in 2015, down from 0.64% in 2014 and 0.73% five years ago.”

If controlling fund costs is important, how much expense ratio is too much?

Here are the expense ratios for an age appropriate portfolio for age 40 built using the Marotta 2017 Gone-Fishing Portfolio Calculator:

Marotta's 2017 Gone-Fishing Portfolio Expense Ratios

First you will notice that every expense ratio is below average. In fact, they are all below 0.50%, an expense that we try not to exceed.

The principle of security selection is that any expense in excess of a similar low-cost fund must be accompanied by an expected mean return well above the similar fund.

For example, Vanguard Small Cap Value EFT (VBR) has an expense ratio of 0.08% while Vanguard 500 Index ETF (VOO) has an expense ratio of just 0.05%. We expect the expected mean return of VBR to be well in excess of its additional expense because it tilts small and value. And, as you can see from the results in 2016, tilting small and value paid a large premium.

You can also see the principle of security selection at work in the country specific funds of Hong Kong, Singapore, and Switzerland. These funds have the highest expense ratios of 0.49%, but we believe there is good case to investing in the countries which are high in economic freedom. In 2016, Freedom investing beat the MSCI EAFE Foreign index by 6.75%. And in 2014, Freedom beat the EAFE Index by 7.92%. We believe that paying 0.49% is worth narrowing our foreign investments to specific countries high in economic freedom. We would gladly switch funds if a cheaper comparable fund comes out.

Our Gone-Fishing Portfolio, Vanguard Mutual Fund Gone-Fishing Portfolio, and Schwab No-Transaction Fee Gone Fishing Portfolio have expense ratios of 0.17%, 0.24% (or 0.12%), and 0.22% respectively. We aim to build portfolios that average under 0.30%. The most expensive fund we used in our 2017 gone fishing portfolios was PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) with an expense ratio of 0.50%. At Schwab you can purchase a very similar fund, Vanguard Emerging Markets Government Bond ETF (VWOB), which has an expense ratio of 0.32% if you are willing to pay a $4.95 trading fee. If you are investing $2,750 the lower expense ratio of VWOB will add $4.95 to your return every year over investing in the higher expense ratio PCY. If you are investing more than $2,750 you would do better to pay the fee and buy the lower expense ratio VWOB fund instead.

You should not need to resort to any fund with an expense ratio above 0.50% in your own portfolio construction. Low fees and expenses is one of the best indicators of superior future returns.

These investment costs from fund providers due to the expenses of managing the fund is what I believe that Phillips was talking about in his article.

However, there are other costs to investing.

We have written extensively about where to find the hidden fees and expenses of commission-based firms. It is remarkable that investor still chose to work with advisors who accept commissions given all the required disclosures.

Commission-based agents and brokers get paid by the expensive funds they recommend, it is questionable if their so-called portfolio construction brings any value at all. It may simply succumb to their inherent conflict of interest, simply including funds which pay them a commission regardless of if lower cost funds were available.

Take for example the Ameriprise employees who sued their own employer for putting them in target date funds from RiverSource with expense ratios between 0.84% and 0.92% rather than using alternative funds from Vanguard. The RiverSource funds provided no advice for their excessive expense. They won their suit and Ameriprise had to pay $27.5 million in the settlement.

Unfortunately, the RiverSource funds are the exact same funds that Ameriprise’s so-called advisors sell to their own customers. RiverSource is a wholly owned subsidiary of Ameriprise Financial. Ameriprise Financial Services has selling arrangements with RiverSource and RiverSource Distributors to distribute these products. And Ameriprise has a financial interest in the sale of these products. Ameriprise receives more revenue from the purchase of RiverSource funds than from the purchase of products sponsored or managed by firms that aren’t affiliated with Ameriprise.

While Phillips was suggesting that smart advisors control the costs of the investments they use, we believe they should be doing much more than that. They should be striving to offer personalized comprehensive wealth management. We believe the value of a financial advisor offering comprehensive wealth management goes far beyond the salespeople posing as advisors.

Photo used here under Unsplash Creative Commons Zero.

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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.