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CHAPTER 2.2
MYTH 2: “OUR FEES? THEY’RE A SMALL PRICE TO PAY!”
The mutual fund industry is now the world’s largest skimming operation, a $7 trillion trough from which fund managers, brokers, and other insiders are steadily siphoning off an excessive slice of the nation’s household, college, and retirement savings.” —SENATOR PETER FITZGERALD, cosponsor of the Mutual Fund Reform Act of 2004 (killed by the Senate Banking Committee) INSULT TO INJURY
Nothing is more infuriating than to be told one price but then realize that you are paying another. You agree on the price of a new car, but when it comes down to signing the documents, a couple thousand in fees magically appear. Or you check out of a hotel and discover an additional resort fee, a tourism tax, a wireless internet fee, fees for towels—you get the point.
It’s frustrating. We feel trapped. We feel snowed. Strong-armed or simply deceived into paying more than we should. With the help of fine print, the $13 trillion mutual fund industry is hands down the most masterful in the craft of hiding fees.
In a Forbes article entitled “The Real Cost of Owning a Mutual Fund,” Ty Bernicke peels back the layers to dissect the actual cost and arrives at a heart-stopping total: The average cost of owning a mutual fund is 3.17% per year!
If 3.17% doesn’t sound like a big number to you, think of it in light of what we just learned about becoming or owning the market. For example, you can “own” the entire market (let’s say all 500 stocks in the S&P 500) for as little as 0.14%—or as the investment world calls it, 14 basis points (bps). That’s just 14 cents for every $100 you invest. (Just a quick FYI for you insiders: there are 100 basis points in 1%, so 50 basis points is 0.5% and so on.) Owning the entire market is accomplished through a low-cost index fund such as those offered through Vanguard or Dimensional Fund Advisors. And we already know that owning the market beats 96% of all the mutual fund “stock pickers” over a sustained period. Sure, you might be willing to pay 3% to an extraordinary hedge fund manager like Ray Dalio, who has a 21% annualized return (before fees) since launching his fund! But with most mutual funds, we are paying nearly 30 times, or 3,000%, more in fees, and for what? Inferior performance!!! Can you imagine paying 30 times more for the same type of car your neighbor owns, and it goes only 25 mph to boot!
This is exactly what is happening today. Two neighbors are both invested in the market, but one is shelling out fistfuls of cash each year, while the other is paying pennies on the dollar.
SAME RETURNS, DIFFERENT RESULTS—THE COST OF IGNORANCE
Three childhood friends, Jason, Matthew, and Taylor, at age 35, all have $100,000 to invest. Each selects a different mutual fund, and all three are lucky enough to have equal performance in the market of 7% annually. At age 65, they get together to compare account balances. On deeper inspection, they realize that the fees they have been paying are drastically different from one another. They are paying annual fees of 1%, 2%, and 3% respectively.
Below is the impact of fees on their ending account balance:
Jason: $100,000 growing at 7% (minus 3% in annual fees) = $324,340;
Matthew: $100,000 growing at 7% (minus 2% in annual fees) = $432,194;
and
Taylor: $100,000 growing at 7% (minus 1% in annual fees) = $574,349.
Same investment amount, same returns, and Taylor has nearly twice as much money as her friend Jason. Which horse do you bet on? The one with the 100-pound jockey or the 300-pound jockey?
“Just” 1% here, 1% there. Doesn’t sound like much, but compounded over time, it could be the difference between your money lasting your entire life or surviving on government or family assistance. It’s the difference between teeth-clenching anxiety about your bills or peace of mind to live as you wish and enjoy life. Practically, it can often mean working a full decade longer before you can have the freedom to quit working if you choose to. As Jack Bogle has shown us, by paying excessive fees, you are giving up 50% to 70% of your future nest egg.
Now, the example above is hypothetical, so let’s get a bit more real. Between January 1, 2000, and December 31, 2012, the S&P 500 was flat. No returns. This period includes what is often called the “lost decade” because most people made no progress but still endured massive volatility with the run-up through 2007, the free fall in 2008, and the bull market run that began in 2009. So let’s say you had your life savings of $100,000 invested. And if you simply owned, or “mimicked,” the market during this 12-year period, your account was flat and your fees were minimal. But if you paid the 3.1% in average annual fees, and assuming your mutual fund manager could even match the market, you would have paid over $30,000 in fees!!! So your account was down 40% (only $60,000 left), but the market was flat. You put up the capital, you took all the risk, and they made money no matter what happened.
I AM SMARTER THAN THAT
Now, you might be reading along and thinking, “Tony, I am smarter than that. I looked at the ‘expense ratio’ of my mutual fund(s), and it’s only one percent. Heck, I even have some ‘no load’ mutual funds!” Well, I have some swampland in Florida to sell you! In all seriousness, this is the exact conclusion they want you to arrive at. Like the sleight-of-hand magician, the mutual fund companies use the oldest trick in the book: misdirection. They want us to focus on the wrong object while they subtly remove our watch! The expense ratio is the “sticker price” most commonly reported in the marketing materials. But it certainly doesn’t tell the whole story . . .
And let me be the first to confess that at one stage in my life, I thought I was investing intelligently, and I owned my share of the “top” five-star actively managed mutual funds. I had done my homework. Looked at the expense ratios. Consulted a broker. But like you, I am busy making a living and taking care of my family. I didn’t have the time to sit down and read 50 pages of disclosures. The laundry list of fees is shrouded within the fine print. It takes a PhD in economics to figure it out.
PhD IN FEES
Just after the 2008 crash, Robert Hiltonsmith graduated with a PhD in economics and decided to take a job with policy think tank Deēmos. And like all of us, nothing he learned in college would prepare him for how to create a successful investment strategy.
So, like most, he started making dutiful contributions to his 401(k). But even though the market was rising, his account would rarely rise with it. He knew something was wrong, so he decided to take it on as a research project for work. First, he started by reading the 50-plus-page prospectus of each of the 20 funds he invested in. Incredibly boring and dry legalese designed to be, in Hiltonsmith’s words, “very opaque.”5 There was language he couldn’t decipher, acronyms he hadn’t a clue what they stood for, and, most importantly, a catalogue of 17 different fees that were being charged. There were also additional costs that weren’t direct fees per se but were passed onto and paid for by the investors nonetheless.
To better shroud the fees, Wall Street and the vast majority of 401(k) plan providers have come up with some pretty diverse and confusing terminology. Asset management fees, 12b-1 fees/marketing fees, trading costs (brokerage commissions, spread costs, market impact costs), soft-dollar costs, redemption fees, account fees, purchase fees, record-keeping fees, plan administrative fees, and on and on. Call them what you want. They all cost you money! They all pull you backward down the mountain.
After a solid month of research, Hiltonsmith came to the conclusion that there wasn’t a chance in hell that his 401(k) account would flourish with these excessive and hidden fees acting as a hole in his boat. In his report, titled The Retirement Savings Drain: The Hidden & Excessive Costs of 401(k)s, he calculated that the average worker will lose $154,794 to 401(k) fees over his lifetime (based on annual income of approximately $30,000 per year and saving 5% of his income each year). A higher-income worker, making approximately $90,000 per year, will lose upward of $277,000 in fees in his/her lifetime! Hiltonsmith and Deēmos have done a great social good in exposing the tyranny of compounding costs.
DEATH BY A THOUSAND CUTS
In ancient China, death by a thousand cuts was the cruelest form of torture because of how long the process took to kill the victim. Today the victim is the American investor, and the proverbial blade is the excessive fees that slowly but surely bleed the investor dry.
David Swensen is the chief investment officer of Yale’s endowment. He has grown the fund from $1 billion to more than $23.9 billion, and he is considered to be the Warren Buffett of institutional investing. When I sat down with him in his Yale office, I was enlightened yet angered when he shared the real truth regarding the “fee factories” that are slaughtering Americans. David shared, “Overwhelmingly, mutual funds extract enormous sums from investors in exchange for providing a shocking disservice.” Later in the book, we will sit down and look over David’s shoulder at his portfolio recommendations, but it doesn’t matter how great your strategy is if excessive fees are eroding the path beneath your feet.
The “asset gathering” complex and the actively managed mutual funds they peddle are, for the most part, a disastrous social experiment that began with the advent of the 401(k) in the early ’80s. The 401(k) was not a “bad” concept. It was a good idea for those who wanted to put extra money away. But it was just meant to be a supplement to a traditional pension plan. Today there is over $13 trillion in managed mutual funds, much of which is held in retirement accounts such as 401(k)s and IRAs. They were supposed to get us to our retirement goals. They were supposed to beat the market. But not only do they rarely beat the market, a significant majority are charging astronomical fees for their mediocrity. The aggregate of these fees will ultimately cost tens of millions of people their quality of life and could very well be the number one danger and destroyer of your financial freedom. Sound like an overstatement?
Jack Bogle, founder of Vanguard, says, “I think high costs [eroding already lower returns] are as much of a risk for investors as the [economic situation] in Europe or China.” IT GETS WORSE
So let’s recap. Not only will the vast majority (96%) of actively managed mutual funds not beat the market, they are going to charge us an arm and leg, and extract up to two-thirds of our potential nest egg in fees. But here is the kicker: they are going to have the nerve to look you in the eye and tell you that they truly have your best interests at heart while simultaneously lobbying Congress to make sure that is never the case.
THE TRUTH/SOLUTION
First, you need to know how much you are paying! I recommend visiting the investment software website Personal Fund (www.PersonalFund.com) for its cost calculator, which analyzes each of your funds and looks beyond just the expense ratio to the additional costs as well.
Keep in mind, these calculators can only estimate the fees. They can’t take into account other costs such as taxes because each person’s tax bracket may differ. You may also own the mutual fund inside your 401(k), in which you won’t be paying taxes on the growth but instead will be paying a “plan administrator.” Some 401(k) plans are low-cost, while others are hefty with expenses. The average plan administrator charges 1.3% to 1.5% annually (according to the nonpartisan Government Accountability Office). That’s $1,300 for every $100,000 just to participate in the 401(k). So when you add this 1.3% for the plan administration to the total mutual fund costs of 3.17%, it can actually be more expensive to own a fund in a tax-free account when compared with a taxable account (a whopping total of 4.47% to 4.67% per year)!!!
Think about it: you are saving 10%, but half of it is being paid in fees. How insane is that? But as you’ll learn here, you don’t have to be caught in this trap. By becoming an insider, you can put a stop to this thievery today. Fees this high are the equivalent of climbing Everest in flip-flops and a tank top. You were dead before you got started.
ADD ‘EM UP
Nontaxable Account
Taxable Account
Expense ratio, 0.90%
Expense ratio, 0.90%
Transaction costs, 1.44%
Transaction costs, 1.44%
Cash drag, 0.83%
Cash drag, 0.83%
—
Tax cost, 1.00%
Total costs, 3.17%
Total costs, 4.17%
“The Real Cost of Owning a Mutual Fund,” Forbes, April 4, 2011
ESCAPE
To escape the fee factories, you must lower your total annual fees and associated investment costs to 1.25% or less, on average. This means the cost of the advice (a registered investment advisor to help you allocate appropriately, rebalance your portfolio periodically, and so on) plus the cost of the investments should ideally be 1.25% or less. For example, you might be paying 1% or less to the registered investment advisor and 0.20% for low-cost index funds like those offered through Vanguard (for a total of 1.2%). And the 1% paid to the advisor as a fee can be tax deductible. Which means your “net” out-of-pocket cost is close to half, depending on your tax bracket. Most Americans use a typical broker where the commissions aren’t deductible, nor are those expensive fees the mutual fund charges. (We will discuss the difference between a broker and a registered investment advisor shortly. You don’t want to miss this one!) In section 3, we will show you step by step how to dramatically reduce your fees and legally reduce your taxes. And all that money you save will accelerate your path to financial freedom.
NEVER AGAIN
Now that you know how the game is played, now that you have looked behind the curtain, make the decision that you will never be taken advantage of again. Resolve right now that you’ll never again be one of the many. You’re becoming an insider now. You are the chess player, not the chess piece. Knowledge is power, but execution trumps knowledge, so it’s what you do from here that will matter. Yes, I will show you exactly how to reduce your fees, but you must decide to take the necessary action. You must declare that you will never again pay insane fees for subpar performance. And if this book can save you 2% to 3% per year in unnecessary fees, we just put hundreds of thousands of dollars, maybe even millions, back in your pocket. Said another way, this could get you to your goal that much quicker and save you 5 to 15 years of accumulation time so that you can retire sooner if you so choose.
By simply removing expensive mutual funds from your life and replacing them with low-cost index funds you will have made a major step in recouping up to 70% of your potential future nest egg! How exciting! What will that mean for you and your family? Vanguard has an entire suite of low-cost index funds (across multiple different types of asset classes) that range between 0.05% and 0.25% per year in total “all-in” costs. Dimensional Funds is another great low-cost index fund provider. If you don’t have access to these low-cost providers in your 401(k), we will show you how to make that happen. And while low-cost index funds are crucial, determining how much of each index fund to buy, and how to manage the entire portfolio over time, are the keys to success. We will cover that in the pages ahead.
Now that you have resolved to take action, to whom do you turn? Who do you trust as a guide? Going back to your broker to help you save on fees is like going to your pharmacist to help you get off meds. How do you find conflict-free advice? And how do you know that the guidance you’re getting isn’t in the best interest of the person on the other side of the desk? Turn the page to uncover Myth 3, and let’s get answers to these pressing questions. . . .
BREAK IT DOWN
If you really want to know how badly you’re being abused through hidden fees, take a moment and review a sample list below of some of the core fees and costs that impact your mutual fund investments: BREAKOUT OF FEES
Expense Ratio. This expense is the main “price tag”—the number they want us focused on. But it certainly doesn’t tell the whole story. According to Morningstar, US stock funds pay an average of 1.31% of assets each year to the fund company for portfolio management and operating expenses such as marketing (12b-1 fees), distribution, and administration. Many of the larger funds have realized that a 1% ballpark expense ratio is where they want to come in so that investors don’t flinch and brokers have a good story to sell—I mean, tell.
Transaction Costs. Transaction costs are a broad, sweeping category and can be broken down further into categories such as brokerage commissions, market impact costs (the cost of moving the market as mutual funds trade massive market-moving positions), and spread costs (the difference between the bid-and-ask or the buy-and-sell price of a stock). A 2006 study by business school professors Roger Edelen, Richard Evans, and Gregory Kadlec found that US stock mutual funds average 1.44% in transaction costs per year. This means that these transaction costs are perhaps the most expensive component of owning a mutual fund, but the industry has deemed it too tough to quantify, and thus it goes unreported in the brochures.
Tax Costs (or 401[k] Costs). Many people are excited about the “tax-deferred” treatment of their 401(k), but for most employees, the tax cost has been swapped out with “plan administrative” fees. These are charged in addition to the fees paid to the underlying mutual funds, and according to the nonpartisan GAO (Government Accountability Office), the average plan administrator charges 1.13% per year! If you own a mutual fund in a taxable account, the average tax cost is between 1.0% and 1.2% annually, according to Morningstar.
Soft-Dollar Costs. Soft-dollar trading is a quid pro quo arrangement whereby mutual fund managers choose to pay inflated trading costs so that the outside firm executing their trades will then rebate the additional cost back to the fund manager. It’s a rewards program for using a particular vendor. The frequent flier miles of Wall Street. The fund manager can use these funds to pay for certain expenses such as research and reports. These are costs the fund manager would otherwise have to pay, so the net result is that you and I pay! These are simply well-disguised increases in management revenue that hit the bottom line. They’re unreported and nearly impossible to quantify, so we aren’t able to include them in our equation below, but make no mistake, it’s a cost.
Cash Drag. Mutual fund managers must maintain a cash position to provide daily liquidity and satisfy any redemptions (selling). Since cash is not invested, it doesn’t generate a return and thus hurts performance. According to a study titled “Dealing with the Active,” authored by William O’Rielly, CFA, and Michael Preisano, CFA, the average cost from cash drag on large-cap stock mutual funds over a ten-year time horizon was 0.83% per year. It may not be a direct fee, but it’s a cost that takes away from your performance.
Redemption Fee. If you want to sell your fund position, you may pay a redemption fee. This fee is paid to the fund company directly and the US Securities and Exchange Commission (SEC) limits the redemption fee to 2%. Like the world’s most expensive ATM, it could cost you $2,000 to get back your $100,000!
Exchange Fee. Some funds charge a fee to move or exchange from one fund to another within the same family of funds.
Account Fee. Some funds charge a maintenance fee just to have an account.
Purchase Fee. A purchase fee, not to be confused with a front-end sales load (commission), is a charge to purchase the fund that goes directly to the fund company.
Sales Charge (Load) or Deferred Sales Charge. This charge, typically paid to a broker, either comes out when you purchase the fund (so a smaller amount of your initial deposit is used to buy shares in the fund) or you pay the charge when you exit the fund and redeem your shares.
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