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Why my friend invests in an insanely expensive fund and why I don’t

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I was working on my asset allocation this weekend — something I haven’t written about in detail yet — and had something interesting happen.

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One of my friends works in finance and was hanging out with me. He told me that I should look at look at one of his company’s funds, which was doing really well. I checked it out and saw a 4.5% (!!) expense ratio, which means they charge a ton of fees. I felt ill. By comparison, some of my funds have a .18% expense ratio.

I told my friend that fund was nuts. For individual investors, passive management crushes active management over the long term. (I’ve written about Warren Buffet’s opinions on that here.) And yet my friend responded with something fascinating: “Working in the industry I’m in, you’ll never convince me of that.” To him, it really is about how “smart” the portfolio manager is. I covered “experts” here, here, and here.

To tell you the truth, the fund is doing great. But so are most funds over the last five years. And a 4.5% expense ratio is insane for the long term. Why don’t I just hand over my money in a God damned wheelbarrow, adding all of my pens on top too as icing on the cake, and have it couriered over to you in exchange for the chance to have my money managed by you? Oh, because I prefer not to hand my most treasured possessions over in exchange for seeming cool and for gains of questionable sustainability.

Interestingly, while my friend may have an understandable reason to believe what he does — he works in finance and works with Very Large Institutions — there’s an additional wrinkle. I asked what kind of funds his 401(k) offers. Surprise, surprise: His company only offers company funds to choose from. That means his funds charge a 4.5% expense ratio to him, too. So while there may be a difference between institutional investors and individual investors, in this case I wanted to see how he’d resolve the dissonance of having to choose an insanely expensive investment. I didn’t find a satisfactory answer because the fund’s been doing so well. But wait a few years until double-digit returns aren’t the norm and I’ll report back.

If everybody thinks something is true…
… chances are they’re right. When you think your performance — or the performance of someone you’re associated with — is likely to be wildly above others, you’re probably wrong. I mean that statistically, not pejoratively. As we know from Psych 101, “the Lake Wobegon effect is the human tendency to overestimate one’s achievements and capabilities in relation to others” — which we do in spades.

I read a site called Overcoming Bias, which recently featured a fascinating story by Kahneman and Lovallo:

In 1976 one of us (Daniel Kahneman) was involved in a project designed to develop a curriculum for the study of judgment and decision making under uncertainty for high schools in Israel. When the team had been in operation for about a year, with some significant achievements already to its credit, the discussion at one of the team meetings turned to the question of how long the project would take. To make the debate more useful, I asked everyone to indicate on a slip of paper their best estimate of the number of months that would be needed to bring the project to a well-defined stage of completion: a complete draft ready for submission to the Ministry of education. The estimates, including my own, ranged from 18 to 30 months.

At this point I had the idea of turning to one of our members, a distinguished expert in curriculum development, asking him a question phrased about as follows:

“We are surely not the only team to have tried to develop a curriculum where none existed before. Please try to recall as many such cases as you can. Think of them as they were in a stage comparable to ours at present. How long did it take them, from that point, to complete their projects?”

After a long silence, something much like the following answer was given, with obvious signs of discomfort: “First, I should say that not all teams that I can think of in a comparable stage ever did complete their task. About 40% of them eventually gave up. Of the remaining, I cannot think of any that was completed in less than seven years, nor of any that took more than ten.”

In response to a further question, he answered: “No, I cannot think of any relevant factor that distinguishes us favorably from the teams I have been thinking about. Indeed, my impression is that we are slightly below average in terms of our resources and potential.”

Facing the facts can be intolerably demoralizing. The participants in the meeting had professional expertise in the logic of forecasting, and none even ventured to question the relevance of the forecast implied by our expert’s statistics: an even chance of failure, and a completion time of seven to ten years in case of success. Neither of these outcomes was an acceptable basis for continuing the project, but no one was willing to draw the embarrassing conclusion that it should be scrapped.

So, the forecast was quietly dropped from active debate, along with any pretense of long-term planning, and the project went on along its predictably unforeseeable path to eventual completion some eight years later.

Brutal honesty is hard. Instead, we choose to ignore the hard facts and keep plowing ahead. It’s sexier to buy high-cost investments backed with a Big Brand Name that cost lots of money and trust that a Very Smart Expert will get you market-beating gains. It’s even more complicated when you get great returns for the past five years. But stop for a second. Did you systematically ignore the fact that most other funds have had a great run? Did you sit down and calculate how much that 4.5% expense ratio is actually costing you? Did you model out how much it will cost you for the next 30 years? If you haven’t done that, then why on earth would you pay such high fees? As always, would you rather be sexy or rich?

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46 Comments

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  1. Sure, and the minute the fund managers leave, things change. Of course your friend is excited about a fund his company provides, he is biased and likely hasn’t had much experience yet being in the market. Everyone is a genius in a good market, and most funds make money in a good market.

    Fund managers are really only tested in a bad market, which we haven’t seen since ’00-’03.

    No way will I ever be in any fund over 1% ever again. The vast majority of my funds are index funds (Vanguard and Fidelity Spartan). The only exceptions: Fidelity Balanced, Oakmark E&I, and Fidelity Overseas (Fidelity Oversease I do not recommend for int’l, we have this one because it’s only int’l offering in hubs 401k. )

    Also don’t lose sight of the fact that there’s a direct correlation between expense ratio and fund performance.

    It’s a random correlation but the higher fee funds tend to also be the worst performing funds.

  2. For actively managed funds, expense ratios are just tip of the iceberg. Consider taxes that you must pay from excessive trading. Over the long term, active funds cannot beat a diversified passive portfolio once expenses and taxes have been accounted for. Yes, there may be a handful of fund that do manage to beat passive funds but you have no way of know that. You might as well bet on the horses.

    Anyway, in addition to this site, I suggest hanging out on http://www.diehards.org/ for sane investment advice.

  3. Great example of cognitive dissonance. Having been invested for 5 years, who wouldn’t unconsciously devalue information that contradicted anything but that they had made a good decision.

    Facing the fact that you made a mistake is terribly hard for that same reason. Only in the face of irrefutable truth do we admit the error, and even then only some people will do this. Others will disbelieve information regardless of it’s credibility.

    Daniel Kahneman is my favorite psychologist. My undergrad thesis had a lot to do with his work.

  4. I wholeheartedly agree with you… an interesting article on the same subject

    http://www.sanfran.com/content_areas/home/view_printable.php?story_id=1507

  5. Excellent post, Ramit. Too many folks that I know only look at the return and never the mgmt. fees. If I were to use Mutual Funds I’d only look at Vanguard due to the lower fees, for thier actively manged funds. However I’d simply get into Index funds and be done with it if your going the Mutual Fund route.

    If you want to take 1 more step and have more control over your IRA funds and have the specific knowedge it takes to manage your own fund consider opening a Self Directed IRA. It doesn’t take much knwoedge to make it grow quickly to tell you the truth. Here’s an example: http://www.willsugg.com\irablog

    Will Sugg

  6. I always look at return net of management fees.
    That includes my evaluation of the effectiveness of financial advisors (I use them).

    Off topic but any updates on the book?

  7. Fascinating article Ramit! I wish I could take that class in judgment and decision making. It always amazes me how reluctant we humans are to plan and predict the future — especially if it might require a little math. At the same time, we like to cling to the predictions and plans we do have. Life makes it hard to act rationally.

  8. Wow, I don’t think I could ever stomach a 4.5% expense ratio, no matter how well the fund was doing. I’ll be interested to see how well the fund performs in a down market after expenses like that!

  9. How has that fund performed over the past 10 years? How about over its life? Your friend may be biased, but he may still be earning acceptable returns over the long-term, especially if he takes a hands-off approach to it.

  10. I concur. I’m a Vanguard guy ever since I rolled my old company’s 401K into an IRA with Vanguard years ago. Been enjoying their no load, low expense mutual funds ever since.

    Ramit, wondering if you’d be interested in sharing your thoughts on two subjects on my mind these days:

    1. Exchange Traded Funds (the good, the bad, the ???)
    2. The Fed’s recent rate cut and it’s timing

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