How To Select A Financial Advisor: The Least You Should Know (Part 15 In eBook Series)

How To Select A Financial Advisor: The Least You Should Know (Part 15 In eBook Series)

Chapter 15: Actively-Managed Mutual Funds

As we learned in Chapter 6, investment fees can make a huge difference in your long-term success. Management fees, sales charges and administrative fees are strong headwinds for all shareholders to overcome.

Actively-managed mutual funds may have annual expenses of 2.0 percent or more. This does not include friction costs—any commissions as well as price slippage—incurred when large buyers or sellers move a stock up or down when buying or selling stock.

However, if you read a fund’s prospectus, you are more unlikely to see the true annual expenses because such friction costs are not included. Also, you will not see an estimate of the short-term capital gains liability that you face from the “turnover,” or frequent buying and selling of securities in the fund’s portfolio. The following illustration depicts the annual turnover experienced in various categories of mutual funds.

Tack on the hefty management fees and sales charges, and the burden is just too great—sort of like running a marathon with a monkey on your back.

In August 2010, Morningstar Inc. released a study entitled, “How Expense Ratios and Star-Ratings Predict Success.” The study indicated that low fees are the best predictor of success for mutual funds—better than Morningstar’s own star-rating system! The five-star rating system measures past returns, adjusting for risk as well as sales loads.

Specifically, the study found that from January 2005 through March 2010,low-cost funds experienced better returns than high-cost funds—regardless of asset class or data point. For example, in the domestic equity category, the category of funds with the lowest fees generated an annualized return of 3.35 percent, as compared with 2.02 percent returns for the funds in the most-expensive quintile, or category, over the five-year period.

Russell Kinnel, author of the study and Morningstar’s director of mutual fund research, concluded that expense ratios or annual expenses expressed as a percentage of assets, should be a primary test for selecting any mutual fund.

Fees are one reason why using actively-managed funds is a long-odds proposition. Consider this fact: approximately 80 percent of mutual funds fail to beat the market.

When you reflect on the odds against professional money managers outperforming the market and think about your odds of correctly selecting which ones will consistently beat the market in the future, you realize that you are looking for a needle in a haystack. Meanwhile, you will lose control over one of the few things that you can control—costs.

Paying a financial advisor to divine which funds will outperform does not make much sense, either. The fund managers themselves do not know which ones will outperform. Mutual funds are required by law to warn that past performance is not indicative of future performance.

Also, whenever mutual funds pay distributions to shareholders, there is a chance you may wind up paying taxes on gains that were accumulated before you purchased the fund. In other words, you are paying taxes on someone else’s gains.

There are other reasons to avoid actively-managed funds. Mutual funds that under perform the market in the first half of the year may assume significantly greater risk in the back half of the year in an attempt to catch up. In other words, professional money managers also become emotional investors—just like their shareholders. As stated earlier, emotions are one of the investor’s worst enemies.

Moreover, the track record for mutual funds as a whole is less than meets the eye due to what is known as “survivorship bias.” Survivorship bias is present in mutual fund performance statistics because when a failing fund is absorbed by a successful fund, the failing fund’s poor performance simply vanishes because it is no longer part of the mutual fund universe. It’s as if the fund never existed (but, of course, the losses were very real to the fund’s investors).

By absorbing the funds, the industry overall can claim better performance. Some investment researchers estimate that survivorship bias accounts for as much as 2.0 percentage points of the industry’s claimed performance.

How pervasive is survivorship bias? Morningstar revealed that only 74 of the 146 one-star equity funds in the international category survived the five-year period of one of its studies.

Understanding Mutual Fund Share Classes

Mutual funds are sold in three share classes, which differ as to their respective annual operating expenses. The investments are the same for each class within a specific fund:

1. “A” class shares or “front-end loads.” With these investments, a
portion of your investment, say 5.0 percent, is commission when you purchase the fund. Therefore, a $10,000 purchase would be worth only $9,500.

2. “C” class shares, or “level- load funds,” impose no immediate hair cut to your investment, but annual expenses are high and there is a surrender charge. Commissions to brokers for “C” class shares might amount to 1.0 percent annually. Surrender charges for these investments are calibrated to ensure that you hold the investment long enough for the issuer to cover the commissions paid at the point of sale. “C” class shares are the most popular form of shares today. They are easier because ongoing sales charges, or 12(b)-1 fees, are hidden. Typically, C shares convert to “A” shares after 8-10 years, depending upon the fund company or broker-dealer.

4. “Advisor” class shares, which are used by investment advisors in
fee-based accounts. This class of shares does not pay commissions. Consequently, the annual operating expenses are lower than the share classes of the same fund that do. As the name implies, invest- ment advisors buy these shares on behalf of their clients; clients
can’t buy them directly.

Even if mutual fund performance is accurately reported, and costs and survivorship bias are accounted for, the average investor has another factor to consider—his own behavior. Mutual funds traditionally report their performance using what are known as “time-weighted” methods, which include all dividends and capital gains distributions over a specific period of time, but time-weighted reporting fails to identify the returns experienced by the average mutual fund investor, which are much lower. Why? Investors chase funds with good performance, and sell after performance sours. If investors do not stay the course over the period of time in which the time-weighted fund performance is measured, their returns will not be the same as the fund’s returns.

According to Vanguard founder John C. Bogle, author of The Little Book of Common Sense Investing:

“When we compare traditionally calculated fund returns with the returns actually earned by their investors over the past quarter century, it turns out that the average fund investor earned, not the 10 percent reported by the average fund, but 7.3 percent—an annual return fully 2.7 percentage points less than that of the fund. (In fairness, the index fund investor, too, was enticed by the rising market, and earned a return of 10.8 percent, 1.5 percentage points short of the fund return itself.) Yes, during the past 25 years, while the stock market index fund was earning an annual return of 12.3 percent and the average equity fund was earning an annual return of 10 percent, the average fund investor was earning only 7.3 percent a year.

Compounded over the full period, the 2.5 percent penalty incurred by the average fund because of costs was huge, but the dual penalties of faulty timing and adverse selection were even larger. $10,000 invested in an index fund grew to $170,800; in the average equity fund, to $98,200—just 57 percent of what there was there for the taking. But the compound return earned by the average fund investor tumbled to $48,200, a stunning 28 percent of the return on the simple index fund.”

And once again, the value of all those dollars tumbles because we must take inflation into account. The index fund real return drops to 9.0 percent per year, but the real return of the average fund investor plummets to just 4.0 percent. On a compounded basis, $76,200 of real value for the index fund versus just $16,700 for the fund investor—only 22 percent of the potential accumulation was there for the taking. Truth told, it’s hard to imagine such a staggering gap, but facts are facts.”

Although index fund investors also suffer from faulty timing, their suffering is not compounded by hefty operating expenses and adverse selection, or picking a fund that performs poorly.

Target-Date Funds

Target-date mutual funds are popular. These are funds that change an investor’s allocation automatically over time, to alter financial risk as a person nears retirement or another defined goal (a child’s college education, for example).

All target-date funds are not created equally. Some have done a poor job of making the necessary adjustments to the asset allocation. For example, during the 2008-09 market crash, it became apparent that some target-date funds had failed to reduce investors’ exposure to the market in accordance with their stated aims, based on the investor’s age and risk tolerance. This is all it takes to turn a retiree into a would-be retiree.

Many retirement plans have target-date funds on the menu. The asset allocation of the target-date fund should be in harmony with your desired asset allocation for all of your assets as a whole. To put it another way, you should know what you own. You should understand the weightings of the various asset classes, such as stocks, bonds and cash. For example, if you look to retire in thirty years, you should consider a 2050 target-date fund.

It is very important to know the target-date fund’s “glidepath”—the method by which the fund will roll down equity allocations, as well as the fund’s policy regarding tactical allocations. Compare the target-date funds of various mutual fund companies for these metrics as well as expenses and historical performance. Vanguard offers low-cost target-date funds.

Target-date funds feature three basic glide paths—linear, steep, and stepped. Consider the exhibit on the following page.

Have a question? Contact Ed Mahaffy.

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