PRI Perspectives: Consider Costs First
Jun 1, 2009
These days, a lot of people ask us what they should be doing with their investments. My answer is strikingly simple: you need to find an investment philosophy that you believe in and stick with it, rather than reacting to fluctuations in the market. For example, you should not rush into real estate when it’s hot or dump stocks after the market collapses. A good investment plan is one that carries you through market changes.
But what are these good investment plans? There are plenty of strong strategies out there, but they all seem to have one common characteristic: they push you toward the lowest cost options. In many industries, a “cheaper the better” outlook does not work out well, but in the investment industry, it’s a rule to live by. The most expensive and well-known Wall Street firms consistently under-perform their lower cost counterparts.
What do I mean when I talk about costs?
In the mutual fund industry, costs are generally referred to as the expense ratio. On a periodic basis, the mutual fund is pulling money out of the fund without you seeing it. This money goes to cover the fund’s expenses such as paying the portfolio manager, as well as costs associated with administration, operations, and marketing, among other things. These fees range from below 0.1% to above 2.0%.
Brokerage firms charge fees that can come in the form of commission and/or advisory fees. Be aware that if brokers have varying fees based on the product they sell you, they may not have your best interests in mind. Brokerage fees can be extremely high and customers are often not aware of them or their effect on their returns.
Investment Advisors, like PRI Investments, generally charge a fixed fee for service. In this case, the advisor should be looking for the lowest cost solution to execute the strategy; no conflicts of interest should exist. However, this isn’t always what happens. In particularly egregious cases, high fee advisors select expensive funds and then receive a commission on top of their fees. These types of problems, combined with excessive and often unnecessary fees, can prove insidious over time.
One way to help ensure your advisor’s interest in line with yours is to use a fee-only advisor. A fee-only advisor is only compensated directly from their clients. This ensures that your advisor is not just selecting funds that make them additional money and cost you performance.
What are the long-term effects of these costs?
The financial services industry has gone to great lengths to conceal the answer to this question. Thus most people do not realize how detrimental paying 1.50% for an investment product can be on their investment performance. I want to emphasize that these fees are quite different than a realtor’s fee, for example. When you buy a house, your realtor helps you get a good price and then takes a one-time 6.0% fee. However, in the financial services industry, the fees are perpetual. They are not just charged once; they are charged quarter after quarter, year after year, decade after decade.
The following table illustrates the dramatic effect of high fees on a long-term investment.
EFFECT OF FEES ON TOTAL RETURN OVER 5 TO 25 YEARS
(Assumes a 7.5% Annual Rate of Return)
The table, as you read left to right, first illustrates the effect of costs, but as you can see in the next column, the loss of performance can have a much greater impact. The column “Return Lost” shows the returns you would have earned if no fees had been taken. Note that under the “Total Cost” column you lose an amount equal to your entire principal investment (100% loss) somewhere between year 20 and 25. Under a 2% Cost, this happens somewhere between year 15 and 20. Investment products with high costs are simply not worth it.
To further illustrate the effect of costs, below is a chart of a hypothetical investment in the S&P 500 over the past 20 years. Once again, the loss of returns over time is dramatic.
S&P 500 TOTAL RETURN WITH FEES
The Effect of Fees over 20 Years on the S&P 500 Total Return Index (1989-2008)
What should you do to control costs?
On the equities side of the spectrum, I’m a big believer in using index funds. Vanguard and Fidelity both offer index funds that cover broad based equity indices with expense rations as low as 0.07%. In place of fixed income funds, I like to buy individual bonds.
In the case of individual bonds, costs can be evaluated by measuring liquidity in the market, or the difference in the costs to buy versus the costs to sell. Spreads in these markets, which act somewhat like fees, can range from zero all the way to greater than five (5) percent. I prefer to buy United States Treasuries because they are the most liquid and there is virtually no cost to investing.
It helps to have an experienced investment advisor when purchasing individual bonds. Bonds are not nearly as straight forward as equities and can carry very high levels of risk despite their appearance. If you choose to invest without an advisor, remember to keep costs in mind and stick with firms like Vanguard.
Why would I choose to purchase US Treasuries, the bonds with the lowest yield? That’s a topic that I’ll address in another blog.
In conclusion, I have long been convinced that it is almost impossible to achieve success with your investments without aggressive monitoring of costs.
I’m not trying to imply that something sinister is going on in the financial services industry – many firms and advisors are fair, upfront, and do outstanding work. However, their work could be of little worth if they do not use low cost investment products. If you address this issue of cost now, you will greatly improve your chances of long-term investment success.
Andrew Blass
Managing Director
PRI Investments, Inc.
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