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The Business Forum Journal


Erosion of Wealth – Impact of Fees and Expenses


By Guy Baker


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 risk?

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 summary:

1. 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 of markets.

2. You 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.

3. 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.

4. Risk 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 myths.

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 expectations. 

There are four basic expenses every portfolio must bear to be in the market:

1.       Asset management fees,

2.       Trading Fees,

3.       Bid/Ask Spread and

4.       Advisor fees.

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 100%.

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 cost.

If 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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