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CHAPTER 3

HIDDEN FEES AND HALF-TRUTHS

How Wall Street Fools You into Overpaying for Underperformance

The name of the game? Moving the money from the client’s pocket to your pocket.

—MATTHEW MCCONAUGHEY TO LEONARDO DICAPRIO IN THE WOLF OF WALL STREET

I often ask people “What are you investing for?” I get a variety of answers: from “high returns,” to “financial security,” to “retirement,” to “a beach house in Hawaii.” But before long, nearly everyone’s answers begin to rhyme. What most people really want, regardless of how much money they have today, is freedom. Freedom to do more of what they want, whenever they want, with whomever they want. It’s a beautiful dream, and an achievable one. But how can you sail off into the sunset if your boat has a hole in it? What if it’s slowly but surely taking on so much water that it’ll sink long before it reaches its destination?

I hate to tell you this, but most people are in exactly this position. They don’t realize that they’re doomed to disappointment because of the gradual—but ultimately devastating—impact of excessive fees on their financial well-being. What kills me is that they have no idea this is even happening to them. They have no idea that they are victims of a financial industry that is surreptitiously but systematically overcharging them.

Don’t just take my word for it. The nonprofit organization AARP published a report in which it found that 71% of Americans believe that they pay no fees at all to have a 401(k) plan. That’s right: 7 out of 10 people are entirely unaware that they’re even being charged a fee! This is the equivalent of believing that fast food contains no calories. Meanwhile, 92% admit that they have no idea how much they’re actually paying.I In other words, they’re blindly trusting the financial industry to look out for their best interests! Yup, that’s the very same industry that brought about the global financial crisis! You might as well just hand over your wallet and the password to your debit card.

You know the old saying “Ignorance is bliss”? Well, let me tell you: when it comes to your finances, ignorance is not bliss. Ignorance is pain and poverty. Ignorance is disaster for you and your family—and bliss for the financial firms that are exploiting your inattention!

This chapter will shine a bright light on the subject of fees, so you know exactly what’s going on. The good news: once you know precisely what’s happening, you can put a permanent, life-changing stop to it. Why does this matter so much? Because excessive fees can destroy two-thirds of your nest egg! Jack Bogle spelled it out to me quite simply: “Let’s assume the stock market gives a 7% return over 50 years,” he began. At that rate, because of the power of compounding, “each dollar goes up to 30 dollars.” But the average fund charges you about 2% per year in costs, which drops your average annual return to 5%. At that rate, “you get 10 dollars. So 10 dollars versus 30 dollars. You put up 100% of the capital, you took 100% of the risk, and you got 33% of the return!” Did you get that? You forfeited two-thirds of your nest egg to line the pockets of money managers who took no risk, put up none of the capital, and often delivered mediocre performance! Now who do you think will end up with the beach house in Hawaii?

Once you’ve read this chapter, you’ll know how to take back control! By minimizing fees, you’ll save years—or, more likely, decades—of retirement income. This one move will dramatically accelerate your journey to financial freedom. But that’s not all. You’ll also learn how to slash the taxes you pay on your investments. That’s crucial because excessive taxes, like fees, are a destructive force that can overwhelm all the positive steps you’ve taken.

How do you think you’ll feel when you’ve not only identified these two enemies but also defeated them? You’ll feel truly unshakeable!

THE WOLVES OF WALL STREET

If you’re looking to achieve financial security, the obvious route is to invest in mutual funds. Maybe your brother-in-law was lucky enough to buy shares in Amazon, Google, and Apple before they skyrocketed. But for the rest of us, picking individual stocks is a losing game. There are just too many things we don’t know, too many variables, too much that can go wrong. Mutual funds offer a simple and logical alternative. For a start, they provide you with the benefit of broad diversification, which helps to reduce your overall risk.

But how do you pick the right funds? There are certainly enough to choose from. As we mentioned earlier, there are about 9,500 mutual funds in America—more than double the number of publicly traded US companies! So it’s safe to say the mutual fund market is a tad saturated. Why do so many companies want to be in this business? Yup, you got it: because it’s fabulously lucrative!

The trouble is, it tends to be much more lucrative for Wall Street than for actual customers like you and me. Don’t get me wrong. I’m not suggesting that the industry is consciously out to screw us. I’m not suggesting that this is a business full of crooks or charlatans! On the contrary, the majority of financial professionals are intelligent, hardworking, and thoughtful. But Wall Street has evolved into an ecosystem that exists first and foremost to make money for itself. It’s not an evil industry made up of evil individuals. It’s made up of corporations whose purpose is to maximize profits for their shareholders. That’s their job.

Even the best-intentioned employees are working within the confines of this system. They’re under intense pressure to grow profits, and they’re rewarded for doing so. If you—the client—happen to do well, too, that’s great! But don’t kid yourself. You’re not the priority!

When I met David Swensen, the chief investment officer for Yale University, he helped me to understand just how badly the mutual fund industry serves the majority of its clients. Swensen is the rock star of institutional investing, famous for having turned a $1 billion portfolio into $25.4 billion! But he’s also one of the most caring and sincere people I’ve ever met. He could easily have left Yale and become a billionaire by starting his own hedge fund, but he’s guided by a deep sense of duty and service to his alma mater. So I wasn’t surprised to hear his dismay at the way many fund companies mistreat their clients.

As he put it: “Overwhelmingly, mutual funds extract enormous sums from investors in exchange for providing a shocking disservice.”

What service is it that funds are supposed to provide? Well, when you buy an actively managed fund, you’re essentially paying for the manager to generate market-beating returns. Otherwise wouldn’t you be better off just sticking your money in a low-cost index fund, which attempts to replicate the returns of the market?

As you can imagine, the people who run actively managed funds are no fools. They aced their math tests in high school, studied economics and accounting, and earned MBAs from the world’s best graduate schools. Many of them even wear suits and ties! And they’re dedicated to researching and selecting the very best stocks for their funds to own.

So what could possibly go wrong? Pretty much everything . . .

The Human Factor

Fund managers try to add value by predicting which companies will perform best in the weeks, months, or years to come. They can avoid or “underweight” particular sectors (or countries) that they believe have unattractive prospects. They can build up cash if they can’t find stocks worth buying—or they can invest more aggressively when they’re feeling bullish. But it turns out that the professionals aren’t really any better at predicting the future than the rest of us. The truth is, humans are generally pretty lousy at making predictions! Perhaps that’s why you never see a newspaper headline that says “Psychic Wins the Lottery!” When active fund managers trade in and out of stocks, there are plenty of opportunities to make mistakes. For example, they don’t just have to decide which stocks to buy or sell, but when to buy or sell them. And every decision obliges them to make another decision. The more decisions they face, the more chances they have to mess up.

To make matters worse, all this trading gets expensive. Every time a fund trades in or out of a stock, a brokerage firm charges a commission to execute the transaction. It’s a bit like gambling at a casino: the house gets paid no matter what. So the house always wins in the end! In this case, the house is a brokerage firm (like the Swiss financial company UBS or Merrill Lynch, the wealth management division of Bank of America) that charges a toll every time the fund manager makes a move. Over time those tolls add up. As it happens, I’m working on this chapter while staying at a hotel in Las Vegas run by my buddy Steve Wynn, who became a billionaire by creating some of the world’s most popular casinos. As Steve will tell you, it’s much better to be the one who collects the tolls than the one who pays them!

Like poker, investing is a zero-sum game: there are only so many chips on the table. When two people trade a stock, one must win and one must lose. If the stock goes up after you buy it, you win. But you’ve got to win by a big enough margin to cover those transaction costs.

Wait, it gets worse! If your stock goes up, you’ll also have to pay taxes on your profits when you sell the stock. For investors in an actively managed fund, this combination of hefty transaction costs and taxes is a silent killer, quietly eating away at the fund’s returns! To add value after taxes and fees, the fund manager has to win by a really big margin. And, as you’ll soon see, that ain’t easy.

Do your eyes glaze over when we start talking about taxes? I know, I know! This isn’t the sexiest topic. But it should be! Because the largest expense in your life is taxes, and paying more than you need to pay is insane—especially when it’s absolutely avoidable! If you’re not careful, taxes can have a catastrophic impact on your returns. Here’s an extreme yet surprisingly common example: Let’s say you invest in a fund in December. Then, the next day, the manager sells a stock that’s shot up over the past 10 months. Since you’re now an owner of the fund, you’ll be getting a tax bill for those gains, even though you didn’t benefit one bit from the stock’s meteoric rise!II Nobody said the tax code was fair.

Another common problem has to do with how long actively managed funds hold their investments. Most are trading constantly. They sell many of their investments in less than a year. That means you no longer benefit from the lower capital gains tax rate. So regardless of how long you hold the fund, you’ll be taxed at your higher ordinary income tax rate.

Why should you care? Because your profits could be slashed by 30% or more, unless you’re holding the fund inside a tax-deferred account such as an IRA (individual retirement account) or a 401(k) plan. Not surprisingly, fund companies don’t like to dwell on these tax issues, preferring to tout their pretax returns!

Imagine that over time you’re losing two-thirds of your potential nest egg to fees—and you’re giving up another 30% in unnecessary taxes. How much will really be left for your family’s future?

So what’s the antidote?

Index funds take a “passive” approach that eliminates almost all trading activity. Instead of trading in and out of the market, they simply buy and hold every stock in an index such as the S&P 500. This includes companies like Apple, Alphabet, Microsoft, ExxonMobil, and Johnson & Johnson—currently the five biggest stocks in the S&P 500. Index funds are almost entirely on autopilot: they make very few trades, so their transaction costs and tax bills are incredibly low. They also save a fortune on other expenses. For one thing, they don’t have to pay enormous salaries to all those active fund managers and their teams of analysts with Ivy League degrees!

When you own an index fund, you’re also protected against all the downright dumb, mildly misguided, or merely unlucky decisions that active fund managers are liable to make. For example, an active manager is likely to keep a portion of the fund’s assets in cash, ready to invest if an enticing opportunity arises—or ready to meet redemption requests if lots of investors decide to sell their shares in the fund. Keeping some cash on hand isn’t a bad idea, and it’s handy when the market falls. But cash doesn’t earn a return, so it will underperform stocks over time, assuming that the market continues its general upward trajectory. Ultimately the resulting “cash drag” tends to have a negative impact on the returns of actively managed funds.

What about index funds? Instead of sitting on cash, they remain almost fully invested at all times.

“GOOD LUCK WITH THAT”

Why is it so difficult to time the market successfully, moving in and out of stocks at just the right moment so that you can benefit from the market’s upturns and avoid the pain of its downturns? Many people mistakenly assume that you just need to be right a little more than 50% of the time for this approach to pay off. But an exhaustive study by Nobel laureate economist William Sharpe showed that a market-timing investor must be right 69% to 91% of the time—an impossibly high hurdle.

In another landmark study, researchers Richard Bauer and Julie Dahlquist examined more than a million market-timing sequences from 1926 to 1999. Their conclusion: just holding the market (via an index fund) outperformed more than 80% of market-timing strategies.

If you’re feeling pissed off right now, I’m with you. You’re probably asking yourself: “What the hell am I really getting when I invest in an actively managed fund?” Well, most likely you’re buying this toxic brew of human error, high fees, and nasty tax bills! No wonder David Swensen is so skeptical about your chances of achieving financial freedom through active funds. He warns: “When you look at the results on an after-fee, after-tax basis, over reasonably long periods of time, there’s almost no chance that you end up beating the index fund.” You Get What You Pay For—Except When You Don’t

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 OF ILLINOIS, cosponsor of the Mutual Fund Reform Act of 2004 (killed by the Senate Banking Committee)

When I was a teenager, I’d sometimes take a girl out to Denny’s on a date. I had so little money that I’d order an iced tea and pretend I’d already eaten. The truth was, I couldn’t afford for both of us to eat! The experience of growing up poor left me with a keen awareness of what things should cost versus what they actually cost. If you go out for a fantastic meal in a great restaurant, you expect it to be expensive. That’s fine. But would you pay $20 for a $2 taco? No way! Let me tell you, that’s what most people are doing when they invest in actively managed mutual funds.

Have you ever tried to figure out the actual fees you pay for the funds you own? If so, you probably zeroed in on the “expense ratio,” which covers the fund company’s “investment advisory fee,” its administrative costs for stuff such as postage and record keeping, plus critical office expenses like free sodas and cappuccinos. A typical fund that invests in stocks might have an expense ratio of 1% to 1.5%. What you probably didn’t realize is that this is just the start of its fee bonanza!

A few years ago, Forbes published a fascinating article entitled “The Real Cost of Owning a Mutual Fund,” which revealed just how expensive funds can truly be. As the writer pointed out, you’re not only on the hook for the expense ratio, which the magazine estimated conservatively at just less than 1% (0.9%) a year. You’re also liable to pay through the nose for “transaction costs” (all those commissions your fund pays whenever it buys or sells stocks), which Forbes estimated at 1.44% a year. Then there’s the “cash drag,” which it estimated at 0.83% a year. And then there’s the “tax cost,” estimated at 1% a year if the fund is in a taxable account.

The grand total? If the fund is held in a nontaxable account like a 401(k), you’re looking at total costs of 3.17% a year! If it’s in a taxable account, the total costs amount to a staggering 4.17% a year! By comparison, that $20 taco is starting to look like a real bargain!

You’ve got to look very carefully at the small print. I don’t like things that require small print, by the way.

—JACK BOGLE

I hope you’re paying really close attention right now, because the knowledge about all these hidden fees will save you a fortune! But what if you’re reading this and thinking “Yeah, but we’re only talking about 3% or 4% a year. What’s a few percentage points between friends?” 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

It’s true that the numbers look small at first glance. But when you calculate the impact of excessive costs multiplied over many years, it takes your breath away.

Here’s another way to put this in perspective: an actively managed fund that charges you 3% a year is 60 times more expensive than an index fund that charges you 0.05%! Imagine going to Starbucks with a friend. She orders a venti caffé latte and pays $4.15. But you decide that you’re happy to pay 60 times more. Your price: $249! I’m guessing you’d think twice before doing that.

In case you think I’m being too extreme, let’s consider the example of two neighbors, Joe and David. Both are 35 years old, and each has saved $100,000, which they each decide to invest. Over the next 30 years, the universe smiles on them, and each achieves a gross return of 8% a year. Joe does it by investing in a portfolio of index funds that costs him 0.5% a year in fees. David does it by owning actively managed funds that cost him 2% a year. (I’m being generous here by assuming that the active funds match the performance of the index funds.) Check out the chart that follows, and you’ll see the results. By the age of 65, Joe has seen his nest egg grow from $100,000 to approximately $865,000. As for David, his $100,000 has grown to only $548,000. They both achieved the same rate of return, but they paid different fees. The outcome? Joe has 58% more money—an additional $317,000 for retirement.

As the chart also shows, these two neighbors then start to withdraw $60,000 a year to support themselves in retirement. David runs out of money by the age of 79. But Joe has an entirely different life experience. He’s able to withdraw $80,000 a year—33% more—and his money lasts until he’s 88! Hopefully, Joe lets David live in his basement. For free.

Now do you see why you need to pay such close attention to the fees you’re being charged? This one crucial factor might make all the difference between poverty and comfort, misery and joy.

Overpaying for Underperformance: The Five-Star Trap

Here’s a question you probably never thought to ask: How do you find an active fund manager who will not only charge you those outrageous fees but also provide you with mediocre returns in exchange? Don’t worry. The financial services industry has you covered. If there’s one thing in plentiful supply, it’s active managers who’ll overcharge you for underperformance!

That’s the incredible thing. It’s not just that actively managed funds are overcharging their customers. It’s that their long-term performance is appalling. It’s like a double insult. Imagine that you just bought that caffé latte for $249, took a sip, and discovered that the milk had gone bad.

One of the most shocking studies I’ve seen on this topic of mutual fund performance was by an industry expert named Robert Arnott, the founder of Research Affiliates. He studied all 203 actively managed mutual funds with at least $100 million in assets, tracking their returns for the 15 years from 1984 through 1998. And you know what he found? Only 8 of these 203 funds actually beat the S&P 500 index. That’s less than 4%! To put it another way, 96% of these actively managed funds failed to add any value at all over 15 years!

If you insist on buying an actively managed fund, what you’re really betting on is your ability to pick one of the 4 percent that outperformed the market. This reminds me of a gambling analogy that appeared in a Fast Company magazine article entitled “The Myth of Mutual Funds.” Its authors, Chip and Dan Heath, highlight the absurdity of expecting to pick a fund from that 4% group: “By way of comparison, if you get dealt two face cards in blackjack [each face card is worth 10, so now your total is 20], and your inner idiot shouts, ‘Hit me!’ you have about an 8% chance of winning.” I don’t know about you, but I prefer not to let my inner idiot run the show! So why would I bet on my ability to identify the tiny minority of fund managers who’ll outperform over many years?

You might be a hard-core researcher who loves to read the Wall Street Journal and Morningstar, searching for the illustrious five-star fund—the outperformer. But there’s another problem that few anticipate: today’s winners are almost always tomorrow’s losers. The Wall Street Journal wrote about one study that went all the way back to 1999 and looked at what happened over the next 10 years to all of the top-performing funds that had received a “five-star” rating from Morningstar. What did the researchers discover? “Of the 248 mutual stock funds with five-star ratings at the start of the period, just four still kept that rank after 10 years.” The fancy term for this process is “reversion to the mean”: a polite way of saying that most highfliers will eventually fall, reverting back to mediocrity.

Unfortunately, many people pick top-rated funds without realizing that they’re falling into the trap of buying what’s hot—usually right before it turns cold. David Swensen explains: “Nobody wants to say, ‘I own a bunch of one- and two-star funds.’ They want to own four-star funds and five-star funds and brag about it at the office. But the four- and five-star funds are the ones that have performed well, not the ones that will perform well. If you systematically buy the ones that have performed well and sell the ones that have performed poorly, you’re going to end up underperforming.”

COULD IT GET ANY WORSE?

Mutual fund companies are notorious for opening lots of funds in hopes that a few of them might outperform. They can then quietly close all the funds that did badly and heavily market the few that did well. After all, they can’t sell shoddy past performance, no matter how glossy the brochure. Jack Bogle explains: “A firm will go out and start five incubation funds, and they will try and shoot the lights out with all five of them. And, of course, they don’t with four of them, but they do with one. So they drop the other four and take public the one that did very well, with a great track record, and sell that track record.” Bogle adds that, statistically, you’re bound to have a few outperformers if you create enough funds: “Tony, if you pack 1,024 gorillas in a gymnasium and teach them each to flip a coin, one of them will flip heads ten times in a row. Most would call that luck, but when that happens in the fund business, we call him a genius!” Does all of this mean it’s impossible to beat the market over long periods of time? Actually, no. It’s extremely hard, but there are a few “unicorns” out there who have outperformed the market by a mile over several decades. These are superstars such as Warren Buffett, Ray Dalio, Carl Icahn, and Paul Tudor Jones, who not only are brilliantly clever but also have ideal temperaments, enabling them to remain calm and rational even when markets are imploding and most people are losing their minds. One reason why they win is that they base every investment decision on a deep understanding of probabilities, not on emotion or desire or luck.

But most of these unicorns run enormous hedge funds that are closed to new investors. For example, Ray Dalio used to accept money from investors who had a net worth of at least $5 billion and who entrusted him with a minimum of $100 million. Nowadays he won’t accept any new investors, regardless of how many billions you’ve got hidden under your mattress!

When I asked Ray how hard it is to beat the market over the long run, he didn’t pull his punches. “You’re not going to beat the market,” he told me. “Competing in the markets is more difficult than winning in the Olympics. There are more people who are trying to do it and much bigger rewards if you succeed. Like competing in the Olympics only an infinitesimal percentage succeed, but unlike winning in the Olympics, most people think they can do it. Before you try to beat the market, recognize that your likelihood of being successful is extremely small and ask yourself if you spent the time to train and prepare to be one of the few who actually wins.”

You can’t ignore it when one of the giants who has actually beaten the market over decades tells you that you shouldn’t even bother trying but should stick instead with index funds.

Warren Buffett, who has outpaced the market by a huge margin, also advises regular people to invest in index funds, so they can avoid the drain of excessive fees. To prove his point that almost all active managers underperform index funds over the long run, he made a $1 million bet in 2008 with a New York–based firm called Protégé Partners. He challenged Protégé to select five top hedge fund managers who could collectively beat the S&P 500 over a 10-year period.

So what happened? After 8 years, Fortune reported that these hedge funds were up only 21.87%, versus 65.67% for the S&P 500! The race isn’t over yet. But as it stands, these active managers look like contestants in a three-legged race trying to catch Usain Bolt, the world’s fastest man.

Meanwhile, Buffett says he’s left instructions that, after his death, the money he leaves in trust for his wife should be invested in low-cost index funds. His explanation? “I believe the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions, or individuals—who employ high-fee managers.” Even from his grave, Buffett is absolutely determined to avoid the corrosive effects of high fees!

Brilliant guidance from the Oracle of Omaha himself.

Do you remember when I told you earlier that knowledge is merely potential power? It’s only when you take your knowledge and act on it that you possess true power. In this chapter, you’ve learned what an astounding impact fees can have on your financial future. But what will you do with that knowledge? How will you act on it and benefit from it?

Imagine for a moment that you stop buying actively managed funds that charge exorbitant fees. Instead, from now on, you invest only in low-cost index funds. What’s the result? At the very least, I would estimate that you can cut your fund expenses by 1% a year. But as you know, that’s not the only benefit of switching to index funds. Hypothetically, let’s imagine that your index funds outperform those actively managed funds by 1% annually. In total, you’ve just added 2% a year to your returns. This alone can give you 20 years of extra retirement income.III Now do you see how much power you possess to take charge of your financial future? Take that power and use it to dramatically drive down your costs. This will help you immeasurably to become unshakeable!

Meanwhile, let’s take a breath. Then let’s step into another area where you can save yourself a fortune: your 401(k). Turn the page. . . . We’re about to embark on a mission to rescue your retirement account.

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