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The Business Forum
Erosion of Wealth – Impact
of Fees and Expenses
When you evaluate the wealth
erosion occurring in most investment portfolios, there is NO greater cause
than fees and expenses. What if you discovered your current portfolio was costing you 300% to
400% more than a comparable portfolio with a financial professional who
managed costs? What if you knew there was an alternative strategy based
on research and historical data available that had 40% to 50% less inherent
A quick review of the
lessons learned from Critical Factors #1 and #2 are pretty stark. Think back
on what we have already learned through our studies. Here is a quick
Volatility is actually your friend. Markets go up and markets go down.
But investors will always make their biggest gains coming out of a down
market as it recovers its losses and moves to a new high. This is the nature
make most of your returns coming out of a down cycle. How do you make
money coming out of a down cycle? Your portfolio has to be constructed to
suppress the amount of decline you experience as much as possible, so when
the up cycle comes, you are able to capture as much of it as possible.
Portfolio Construction manages Volatility. We saw portfolio construction
is not only critical to controlling volatility, but it is essential to
achieving meaningful returns consistently. You need a widely diversified
portfolio of asset classes with a bias towards value and small cap, the
asset classes which have performed the best over long periods of time.
Is INHERENT in every portfolio. We saw every portfolio has some measure
of risk attributed to it. The question is, "Do you know how much risk you
are buying?" Most investors don't think about the fact they are buying risk.
They have no idea whether the risk they have bought is commensurate to the
return they are expecting. More important, they do not KNOW how much the
risk is costing them.
These FOUR key points are
extremely important for every investor to understand and engrain in their
thinking. To be successful, investors must learn to manage risk. But
remember, the average investor, according to Dalbar, has only earned 3.49%
over the last 20 years. While these four factors explain some very important
reasons investment portfolios lag market returns, they are not the WHOLE
story. The next part of the story lies in understanding the economics of
fees and expenses attributed to mispriced portfolios, especially actively
managed ones. To understand how Wall Street is converting your capital to
their income, it is important to study the facts and separate them from the
MYTH - Active Managers Grow Assets Better Than Passive Managers?
You may recall the term
"active management” from our discussion in Critical Factors #1 and #2. The
term describes the process of hiring professional managers to identify and
buy stocks with the highest probability of growing in the near term.
Investors pay significant fees to their advisors for the opportunity to gain
access to these top money managers. These managers, in turn, are paid
significant salaries to deliver on the promise. You will need to decide
whether this is a promise is real and whether these advisors can fulfill the
are four basic expenses every portfolio must bear to be in the market:
The inability of the actively
managed markets to beat their benchmarks has been known for years. A careful
investigation of historic performance shows passive managers beat the active
manager in all asset classes but small international stocks. In some cases,
only 20% of the active managers exceeded the passive benchmarks.
Is it worth the fee multiplier, to bet on a money manager who is more likely
to under-perform the benchmark? That is the question every investor should
ask and answer.
Look at the trading costs
and the bid/ask spread in combination. The total impact is close to 2.5%.
The real cost is influenced by the turnover. If turnover is 100%. The
portfolio would feel the full impact of the 2.5%. If turnover is only 10%,
then the hit to your portfolio would be a lot less. It would only be 0.35%.
Please understand, there
will always be trading costs and a bid/ask spread. There is always going to
be turnover in a portfolio. That is not the point. Even the S&P 500 Index
has turnover. The list of 500 top stocks is not static. The holdings in the
fund change as the market moves. So even a set index fund will have some
turnover, hence some expense for trading the stocks. However, this cost is
de minimus compared to active management fees.
An actively managed
portfolio is expensive to own and does NOT necessarily deliver additional
value for the additional expense. Here is an example. Suppose we look at a
diversified, $1,000,000 portfolio managed by a well know wire house or
registered representative. If it is entirely invested in mutual funds, here
is a breakdown based on the Morningstar statistics assuming the turnover is
If we assume the historic
market return of 10% over for a twenty five year period, the impact of these
fees can be substantial. Look at the chart. What is effect on total return
when there is only 10% turnover? Compare this to what happens if turnover is
100%. A passively managed fund portfolio using our balanced market
methodology suggested earlier in the book has minimal turnover. The
difference is remarkable. Is it any wonder Wall Street wants to manage your
money? There is a 10% to 30% loss of portfolio value directly attributed to
trading the account. All of this is based on the bid/ask spread cost,
commissions and the trading costs. Add in the higher asset management fees
for an actively managed portfolio and the loss could be substantial.
This is a LOSS you can NEVER
regain. Unlike the Law of Markets and the BOUNCE, these fees are not
recoverable. What is the lesson you can take from that?
If you are a trustee for a
401k plan – it would be in the plan’s best interest to study the fee
structure – both direct and indirect. As fiduciaries, there is an obligation
to the participants to provide the BEST investment options at the lowest
you have question you would like to ask in confidence. Send me an
Email and I will get back to you - in confidence.
Guy Baker is a Fellow of The Business Forum
Institute. He is the Managing Director of Wealth Teams Solutions, a
family office and wealth management company. Guy has been listed among
the 250 top Advisors nationwide by Worth Magazine and recognized as one
of the 5 star advisors in Orange County by OC Metro. He graduated from
Claremont McKenna College (BS/Economics-1967) and the University of
Southern California (MBA Finance-1968). Guy holds a Master's degree in
Financial Services (MSFS), a Masters in Management (MSM) and earned the
Chartered Life Underwriter (CLU) in 1972 and Chartered Financial
Consultant in 1981. He is also a Registered Health Underwriter (RHU).
Elected President of the Million Dollar Round Table, Guy traveled to
over 40 countries visiting many of the MDRT's 35,000 members. He has
written five books, including the business best sellers "Why People Buy
and "Baker's Dozen - 13 Principles for Financial Success." The BOXTM,
a discussion about the fundamentals of life insurance, has sold over
50,000 copies. In addition, he developed an MP3 business training
program, called "Market Tune-up", to assist professional advisors in
their quest to increase sales productivity and two popular investment
books, "Investment Alchemy" and "Manage Markets Not Stocks".
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