Passive is the New Aggressive (Part 3)

Key Points

  • There may be strong psychological reasons why financial firms can command such high fees.
  • Ultimately, these high fees can lead to the systematic transfer of wealth away from investors’ pockets.
  • The Efficient Market Hypothesis suggests that actively invested mutual funds face an impossible challenge in outperforming their passively invested counterparts.
  • Nevertheless, the fees for actively managed funds are much higher than those of passively managed funds.

Again: It’s. All. About. The. Fees.

As mentioned in Part 2 of this series, most of Wall Street’s substantial income comes from “fees”, one way or another.

So why can this industry command such high fees?

Great marketing? Perhaps. But also, I think there are strong psychological reasons for this phenomenon. First, fees in general are often overlooked or placed at the bottom of the list when making investment decisions. I think this relates to the fact that fees in financial products are “embedded”.

With financial products, the banks already have access to your money, so taking money out from this pool is less noticed then say having to cut a check to your gardener whenever he or she mows your lawn. As such, these fees are often noted as a line item or as a footnote and can easily be overlooked.

Second, fees are often stated in terms of percentages rather than fixed dollar amounts. For example, let’s say I stated my annual fee to manage your million dollar investment would be $8,800 a year. You might think twice about cutting a check for nearly ten thousand dollars each year, or you might think really hard what you are getting in return for this large amount of money. But let’s say, instead I told you my annual fee was only 0.88% per year. Obviously, the fee is the same in both instances, but in the latter case, most investors accept this scenario without much fuss. And of course, in the latter case, as your account grows, so do your fees. Furthermore, it’s common for an investment to grow just because the overall stock market has gone up, but even in this case, you might end up paying higher fees.

Third, given that financial products often increase in value over time, this makes it psychologically easier for clients to “pay fees”. For example, it’s less noticeable when you have to pay a 1% annual fee if by the time you get your statement your investment account has grown from $1,000 to $1,110 before fees are taken out. Having still $1,100 after fees doesn’t sound so bad from this perspective. After all, you started with $1,000 and you now have $1,100. So that ten dollars can more easily disappear without notice, as compared to having to cut a check for ten dollars after the fact.

Fourth, many investment products collect fees even if the performance of the investment is poor. For example, if your account loses money, you will likely still have to pay the stated fees. Further, if your investment fails to meet its return objective, such as outperforming the S&P 500®, you will likely still have to pay the stated fees. Not a bad business model, right?

Slow and Steady Wealth Transfer

Essentially, the more you trade, the more you transact, the more you move money from here to there and back again, the more you end up paying in fees.

The notion of Wall Street is that these firms have amassed great wealth by superior investments, with rigorous analysis and cutting-edge financial models. But at the end of the day it’s basically because of fees; essentially, the systematic transfer of wealth from your pockets to theirs.

“The Stock Market is designed to transfer money from the Active to the Patient.” —Warren Buffett

Accordingly, as we’ll soon see, when it comes to investment products, fees are the key ingredient that can often tilt the equation between a good investment and a bad one.

Mutual Funds 101

So let’s begin to investigate all this from the perspective of mutual funds.

A mutual fund is an investment vehicle made up of a pool of money collected from many investors for the purpose of investing in securities such as stocks, bonds, money market instruments and other assets. –Investopedia

When it comes to pooled investments, such as mutual funds, the main stated “fee” is the fund expense, known as an expense ratio. In the table below (Table 1), generated by Vanguard, we see that there’s a large gap between the expense ratios of Actively managed funds versus that of Index funds (which are Passively managed).

For many investors, when it comes to Actively managed funds, the prospect of “outperforming the market” is often justification enough to command high fees.

For example, the average expense ratio for a U.S stock large-cap actively managed fund is 0.67% (which is $6,700 per million invested), while for an index fund, it’s only 0.08% (which is only $800 per million invested). This is an annual difference in fees of 0.59% (or $5,900 per million invested).

All these numbers sound tiny (although, not to me!), but as we’ll soon see in Part 5, these fee differences alone can make the difference of retiring at 60 versus retiring at 65. Take that in for a second.

2018-09-19-Vanguard Fee Schedule Comparison

Table 1. Expense Ratio Comparison (Source: Vanguard)

The reason that fees for actively managed funds are so high is that these funds have teams of highly-compensated professionals that devote their lives to consistently finding investments that will provide their clients with superior risk-adjusted returns than could be obtained by just investing passively in an index fund, such as one comprised just of the S&P 500® companies.

Given all we know about efficient markets, as suggested by the Efficient Market Hypothesis, the task of active management should be impossible, but let’s actually dig into some evidence on this for more insight. Indeed, if actively invested mutual funds can consistently do better than passively invested index funds, why wouldn’t you allow them to invest your hard-earned capital?

As such, in Part 4 of this series we’ll dive into some analysis on this topic and see where it takes us.