CommonSense InvestSense About…Returns

As an attorney that specializes in wealth management/preservation and asset protection, I often see investors who have suffered unnecessary financial losses due to poorly designed and/or poorly managed investment portfolios. This is especially troubling, for as legendary investment expert Benjamin Graham once noted in his classic, “The Intelligent Investor,”

To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.

Three key concepts can help investors avoid unnecessary financial losses and help maximize an investor’s returns:

  1. Front-end loads dramatically reduce an investor’s end returns.
    Most stockbrokers and financial advisers recommend actively managed mutual funds for the commissions such products pay them. Commissions on actively managed mutual funds are commonly known as “front-end loads.” Under current law, the maximum front-end load that funds can charge is 5.75 percent of the total purchase price of the mutual fund.

Front-end load charges are automatically deducted at the time of the purchase of the fund, reducing the actual amount of a customer’s actual investment. So, on a $100,000 purchase of a mutual fund that charges a 5.75 percent front-end load, only $94,250 would actually go into a customer’s account.

Many investors are unaware of the cumulative impact of a front-end load. In our example, if we assume an annual return of 10 percent over ten years, the reduced initial investment due to the front-end load reduces an investor’s annualized return to 9.35 percent and a reduced actual dollar amount of almost $15,000 due to the impact of compounding.

Mutual funds are required by law to provide their return information net of fees, including any the impact of a front-end load. That information must appear in any ads published by a fund, as well as in a fund’s prospectus. The problem is that evidence shows that few investors actually look at a fund’s prospectus, and the load-adjusted return information is often buried in an ad’s small print.

2. Expense ratios and so-called “invisible” costs further reduce an investor’s returns. The impact of front-end loads is not the only factor that investors need to consider when selecting mutual funds. Studies have shown that most actively managed mutual funds are not cost-efficient, consistently underperforming comparable no-load index mutual funds due to the impact of the extra costs associated with active management, e.g, higher annual expense ratios and trading costs. Samples of the findings of such studies include the following:

  • 99% of actively managed funds do not beat their index fund alternatives over the long term net of fees.
  • Increasing numbers of clients will realize that in toe-to-toe competition versus near–equal competitors, most active managers will not and cannot recover the costs and fees they charge.
  • [T]here is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.
  • [T]he investment costs of expense ratios, transaction costs and load fees all have a direct, negative impact on performance….[the study’s findings] suggest that mutual funds, on average, do not recoup their investment costs through higher returns.

As a result, index funds are usually the better choice for investors. Since mutual funds are not legally required to disclose their actual trading costs, these added costs are often referred to as “invisible” costs that investors forget to factor into their investment decision.

3. The actual contribution of an actively managed mutual fund’s management team is often negligible and, in some cases, actually cost investors. While many investors select mutual funds based on Morningstar’s famous “star” system, the most valuable information provided by Morningstar may actually be an actively managed fund’s R-squared correlation number.

Morningstar defines R-squared as

the relationship between a portfolio and its benchmark…. R-squared is not a measure of the performance of a portfolio….It is simply a measure of the correlation of the portfolio’s returns to the benchmark’s returns…. An R-squared measure of 35, for example, means that only 35% of the portfolio’s movements can be explained by movements in the benchmark index.

While actively managed funds like to tout the presumed advantages of the active management their fund allegedly provides, the evidence suggests that many funds’ returns are due more to the movement of the stock market than an actively managed fund’s management team. Evidence of this fact is supported by the percentage of actively managed funds with R-squared correlation numbers of 90 or above.

As index funds have consistently outperformed their more expensive actively managed counterparts, many actively managed funds have seemingly adopted a “if you cannot beat them, join them” approach to investing in hopes of minimizing both the extent of any potential underperformance relative to index funds and the potential loss of customers from such differences in performance.

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This article is for informational purposes only, and is neither designed nor intended to provide legal, investment, or other professional advice since such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

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