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We all know that investment fees play a large role in investment returns. Much of the advice today in personal finance has been to move away from paying high fees in Mutual Funds and switching to low fee Index funds or ETFs. What is the rationale for this? Is that the best solution for you? Are there times when investment fees are actually worth paying for?
What’s in the Fee?
To dive into this question, we have to look into what exactly makes up these fees. Traditionally, mutual funds will list a fee expressed as a percentage, known as an MER. There are different components in this MER. The most common elements include a fixed expense like administration/maintenance that it uses to “keep the lights on”, a management fee and may include another fee for who sells it (a commission).
In good times, say the fund is performing well and getting returns of like 15% before fees and then they take 2%, you get 13%. 13% is a really good return! I’m happy with that. But in bad times, the fund might be returning in the negative territory and then they take another 2% off that. That blows.
Exchange Traded Funds and Index Funds on the other hand often have a lower fee and that characteristic is very attractive. It is because these vehicles usually only contain that fixed expense to keep the fund up and running. They usually don’t have a management fee or a commission. In good times, you are keeping more of those returns and in bad times, you are losing less because of the fees.
So Why Am I Paying This Fee?
Mutual funds just like Index Funds or Exchange Traded Funds are inventions. Back in the day, the only way to get into the markets was to buy things individually. You have to pick and choose which stock or bond you want to buy. But pain points started to emerge; stock picking is time-consuming and extremely effortful. To get all of the companies’ information and then doing the research to find good companies to invest in takes a lot of time and the learning curve is steep. Other pain points included not having enough money right from the start to buy more than 1 company’s stock at a time. This left people at risk of losing it all if the company fails.
Because of these pain points, the mutual fund was invented. A mutual fund is a basket of stocks or bonds that are packaged and sold in smaller quantities for the average investor. They have advantages such as being easily accessible because one didn’t need hundreds of thousands of dollars to invest; an investment of $100 was enough to get started. Another advantage was it was instant diversification. By buying the whole basket, the probability of any one company failing and wiping out the whole fund became tiny.
Most mutual funds offered in the marketplace are likely to be “actively managed“. This means a person or team, the investment manager, is doing their best to pick the best stocks and bonds out there. Again, when the mutual fund was invented, the market wasn’t quite as large as it is today and there was value in someone poring over the company financial statements and interviewing the management team. Hence the management fee was added to compensate the investment manager, either individually or the team.
The Information Age
As the markets grew and as mutual funds became more popular and profitable, more and more people got into this business. Soon there were many investment managers and equity analysts whose full-time jobs were to follow and keep up with these companies. Some of the top equity analysts followed less than 10 companies. Day in and day out, that’s all they did and the published a lot of research reports. As a result, most of the information about these companies became more readily available and in the public realm. Professional and amateur investors can now just use Google and access that information.
There is a theory that a stock’s price has all of the information baked in. And that is the definition of an efficient market. The price of that stock is at fair market. So as more and more information became public, the edge that the investment managers and equity analysts have become smaller and smaller. A few investment managers’ analysis remains extremely valuable and worth paying for. But truth is, the majority is just average.
But People are Beating the Market!
We have been in a bull market (rising stock prices) for the past 10 years. When things are going up, it’s easy to go up with the rest of the tide. Some stock pickers (like maybe your show-off brother-in-law?) or mutual funds might show them beating the market. Over longer periods of time, however, many investment managers display ‘reversion to the mean’ behavior. This means managers that are above average for a few years end up below average for a few years. Their overall results end up being average.
Average returns meaning they are the same as the overall market. Because this trend was observed to be almost universally true, people started asking, why pay those investment management fees in the first place? And now we have come to why Index funds and ETFs were invented. Index funds and ETFs both have the benefit of instant diversification and small minimum investments just like the mutual funds, but they took out the active management portion and with it, that portion of the fee. Index Funds and ETFs are “passive investments”.
The basis of investing in Index funds or ETFs is that over the long term, most of the actively managed mutual funds are returning what the market was averaging, why not just be passive and get the same results without the additional costs? It seems that a lot of people agree. In the past few years, ETFs and Index funds have captured most of the additional dollars that have been invested in the market. When people have leftover money after their expenses, they are more likely to invest in an ETF or index funds than the traditional mutual fund.
Are Investment Fees Dead?
I don’t think so. While I have outlined that information efficiency has dulled the edge of a lot of active managers, there are still areas of the market where they may provide value. Those are in the areas of the market that are not informationally efficient.
What are those you ask?
Well, I’ll answer that with a question of my own. How much did the house or condo down the street sell for? What made that one sell for more than the one listed 3 months ago? Did it have any special features? When were the upgrades done?
Don’t know? That’s because realtors have kept the information contained to a small group of people. By doing so, they keep that area of the market informationally inefficient. There are some really astute realtors that can get you the best deal, know when that coveted house is coming to market. In certain markets, there are still investment managers that have an edge like this. I didn’t use the real estate example by accident; studies have shown that some managers in the commercial real estate market still provide a lot of value over others and over the market as a whole.
Other areas where managers might have information advantages might be in certain emerging markets, either it is a developing country (like China, Brazil, India) or in emerging industries. Examples of emerging industries might include new technology start-ups (this is why venture capitalists and hedge funds still have a prestige factor).
Ok, But How Can I Use This Information?
First is to decide what kind of investor you are going to be. Do you have the time to research a lot of companies? Are you interested in doing so? Are you willing to lose some money to learn what makes a great company from one that’s not?
Yes? Then you might enjoy being your own stock picker. This method is still very popular, but not for everybody and there’s no shame in that.
No? Then I recommend looking into a fund of some kind.
Next, ask yourself do you think you can find an advisor or investment manager that can beat the market? Do they have some kind of edge that other managers don’t? Are they in a segment of the market that is highly specialized and there isn’t a lot of information that can easily be Googled?
Yes? The manager might be a really good option. What you are buying with the management fee is access to and information on a market that you might not get otherwise.
No? Then passive investing in Index funds and ETFs might be better suited for you.
Generally, I’m a proponent of the passive, ETF approach to the bulk of my investments. They are approachable for most people and anyone can get started with just a couple hundred dollars. There are now many types of ETFs, from ones that invest in the overall stock market of a country to ones that are dedicated to a certain industry. The landscape of passive investments is growing each year and more and more people are able to customize a solution that suits their particular needs.
The Most Important Thing
One thing to remember from all of this is that nothing is written in stone. People can choose to have some active investment and some passive ones at the same time. Some people can have an advisor for a while and then start doing it themselves, or vice versa if their lives become too hectic and they want an advisor to take this task off their plates. The most important decision is that you decided to become an investor. The most expensive fee is the one you are paying by sitting on the sideline.