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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  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

  11. I am curious – what’s the software you were using to figure out your asset allocation? Looks pretty nifty

  12. Very valuable points, Ramit. People who want your money for their funds often don’t have your interests as their #1 priority. Many (most?) mutual funds turn over their holdings more than once a year to try to justify their high expense ratios. This is unnecessary, as studies have shown that holding for longer than a year on average leads to stronger long-term performance.

    Another big issue is that mutual fund’s have double responsibilities: they need to provide return to their shareholders _and_ their customers. These interests are quite often not aligned.

    I was just a few months ago in a lengthy email exchange with my bank over the lack of transparency in reporting their funds’ performance. I wanted historical price data in numerical form, as they only gave tiny graphs. After numerous emails, excuses, and ridiculous explanations – “we don’t know that information” -, they only relented after I threatened them with the local equivalent of the SEC. The VP emailed me the next day, and I got my historical price data emailed to me every month until they started providing direct downloads to customers from their website. I like to think it was thanks to me :)

    So, just like with a car, you have to look at the total cost of ownership when you invest in any security. Withdrawal fees, management fees, tax issues, etc. all can break a fund with stellar performance. And don’t forget what has been said before: past performance doesn’t equal future performance.

  13. Excellent post, this is the type of stuff I enjoy on this site.

  14. I thought that, since I work in finance as well, I may weigh in a bit here.

    The bottom line is that minimum expense portfolios (like a Vanguard fund) is simply best for the average person. But for people who are financial intellegent (meaning finance, not personal finance), there can be better options. The challenge is sorting out the good options from the bad options, which is something that 99% of the population simply can’t do.

    I agree that mostly everyone ought to be investing in low-cost funds. But there are higher-cost funds that are worth every penny, so don’t be so quick to condemn anyone who is investing in one. It may simply be that they understand something that you don’t.

    Personal finance and finance are different. I could teach a 3-year-old personal finance. I sometimes struggle to teach a 30-year-old some basic concepts of finance.

  15. [...] Why My Friend Invests In An Insanely Expensive Fund – And Why I Don’t People who are willing to invest in such funds are often rate chasers – they turn investing into a form of gambling, much like blackjack, where the player has partial information. (@ i will teach you to be rich) [...]

  16. Daniel, I would say that the burden of proof is on you for that one. At 4.5%, no manager could ever beat its benchmark in after tax returns without luck. There are some good actively managed funds out there, but they aren’t the ones with 4.5% ER’s. There are great ones at Vanguard at 50 bp ER.

  17. Great post! I agree 100%. These funds target individuals who are enticed by Wall Street lure and want to believe that there are people – smarter than themselves – whose work they can leverage.

    As a graduate of Chicago’s school of economics, I believe in perfect markets. Sure, there are inequities not represented in market economies, but overall, markets are efficient. They have become even more efficient with the emergence of the Internet and the increased dissemination of information. To think that ANY individual can routinely beat the market is foolhardy.

    The argument most employees of the industry make in favor of their exorbitant fees is: Our funds are for sophisticated investors. I find this response to be condescending and patronizing. I also find it flawed. Why would any large, for-profit institution claim a tiny population as its market? That makes zero sense. Most large companies (Ford, Sony, IBM, the Gap) will do the opposite. They posit that anyone with a pulse is a potential customer. Wall Street demands large market potential. Small market = small stock price.

    Keep up the good work, Ramit! This is great stuff.

  18. I actually enjoy doing the research on my own, so I pick stocks and pay myself the management fee! As far as mutual funds go, 1% should be the highest expense ratio you pay, although you might go as high as 1.5% for specialty funds.

  19. hi

    Can you cover california bonds. The rates seem to be good nowadays and it is all tax free. But not sure how to approach this – thx

  20. I ran my own numbers and the math does not work out for me.

    I’m in a retirement saving fund (PRIDX) with a 10 average return of 16.95%. Expenses are 1.24% I have a current balance of 141K. I contribute $12,396 annually.

    Over the next 20 years, by the numbers (pre-tax):
    Pre-expense earnings: $5,103,999
    Expense: 1.24%
    Expense total: $63,290
    After expenses: $5,040,709

    OK, let’s say the fund returns the 10 year category average (13.03%) with half the expense %:
    Pre-expense earnings: $2,771,550.84
    Expense: 0.62%
    Expense total: $17,184
    After expenses: $2,754,367

    Still, PRIDX is WAY AHEAD. Let’s say PRIDX drops to the category average with the same expense:

    Pre-expense earnings: $2,771,550
    Expense: 1.24%
    Expense total: $34,367
    After expenses: $2,737,184

    So, Yes, a higher expense ratio lowers overall return, but even a marginally better return% significantly offsets the expense difference.

    What am I missing here?
    –SW

  21. You should change the name of this blog- I Will Teach You To Be $$$exy

    In all seriousness though, facing the facts is incredibly demoralizing, but it’s something that, if done right, can be very inspiring. The key – keep it to yourself, and understand it well. If this is a team effort, it’s certainly not best to keep the rest of the team naive, but you certainly shouldn’t give them the straight facts either.

  22. I’m in the investment business. Generally speaking, most of “us” don’t add that much value. If you’re being charged more than 1%, you’re probably getting ripped off. For active funds, if you can get 0.7%, great. Probability still suggests you’re better off going with passive funds, though. There are some exceptions to that 1% rule, such as in a long/short asset that runs into liquidity issues (there are actually reasons to own assets like these, but unless one knows why, he/she shouldn’t be in them) or a skilled, wholistic asset allocator if one truly has no idea on the topic

    Keep up the good work…we need to educate others on these topics. Unfortunately, we have selection bias in audiences willing to listen. Any idea how to overcome that?

  23. Steve, what you’re missing is that the “marginally” better performance difference in your examples is anything but. Due to compounding, that 4% point difference is massive. Also, for the same reasons, putting money in a high-expense ratio fund will eat at your future earnings at a much higher rate than what a “low” figure of 1,24% suggests. Think about it, your paying the price of a nice car in expenses over the next twenty years. Similar or better net performance could be achieved with lower expense ratio funds (if available to you).

    Also, you appear to assume that actively managed funds outperform others. This is not the case. Most actively managed funds have lower performance than passive funds, and well below 50% of them outperform the market.

  24. Good post. Something tells me that your friend’s fund will not beat the S&P500 by 5%+ every year from now until the end of time, no matter what he might think about the fund manager’s purported superpowers. And every year that it DID beat the S&P by that margin, you’d have to worry about whether it was this would be the last year it would do so. There just isn’t a better, lower-cost, lower-stress investment than a basic index fund, as you repeatedly write. Maybe with a few (hopefully) well-chosen individual stocks thrown into the mix to make the investor feel smart and sexy, of course, but none of these 4.5%exp. funds. That’s ridiculous.

  25. Thank you for your responses to my post.

    2 additional questions:

    1. Are expenses calculated A) against the balance post-compounding (i.e. at withdrawal-time) OR B) on some periodic basis? (The example I saw performed the calc at the end. )

    2. If the answer is B, then where is there a Savings calculator that includes the expense ratio as part of the calculation?

  26. Cancel last request.

    Have found answers and will reply with results post calculations.

  27. [...] Why my friend invests in an insanely expensive fund and why I don’t @ I Will Teach You To Be Rich [...]

  28. I wrote a post about this about a month ago. Over the course of 30 years, assuming same rate of growth at 10% CAGR:

    0.5% ER will yield 14% lower total performance
    1.0% ER will yield 26% lower total performance
    1.5% ER will yield 37% lower total performance
    2.0% ER will yield 46% lower total performance
    2.5% ER will yield 53% lower total performance

    Most likely, your friend will not be making any money after all the expenses.

    You can link from my name to see the post I wrote.

  29. Something is not calculating correctly for me.

    20 Yr
    Scenario: A B
    Monthly: $1,000.00 $1,000.00
    E-ratio: 1.24% 0.13%
    Post-ER: $987.60 $998.70
    % returned 13.50% 13.50%
    $1,198,912 $1,212,387

    OK, all things equal except Expense Ratio, and yes, a higher ratio reduces return, but not by much (app. 14K).

    However, with a 1/2 better % return, and the higher ration fund significantly Outperforms (by ~67K):

    20 Yr
    Scenario: A C
    Monthly: $1,000.00 $1,000.00
    E-ratio: 1.24% 0.13%
    Post-ER: $987.60 $998.70
    % returned: 13.50% 13.00%
    $1,198,912 $1,131,769

    What am I missing here?

  30. @Steve: The expense ratio is not just a one-time hit on investments. It’s an annual deduction from the balance of your account. At the roughest level, a 1% ER reduces an annual 13% gross return into a 12% net return.

    So in your example, you could basically just compare the compounding on:
    A: 13.5% return – 1.24% ER = 12.21% annual return
    with
    C: 13.5% return – 0.13% ER = 13.37% annual return

    The exact numbers you come up with will depend on if the ER is assessed annually, quarterly, or whatever.

  31. Understood — I front-load deducted the 1.24% monthly. That is, I calculated that if I saved $1000 monthly, then $987.60 was what was invested and what compounded. Again, am I missing something in my math here?

    At this point, many are arguing for a sub-1.0 ER, but my calculations still show that a 1/2 point additional return improvement more than over-compensates for the higher ER.

    In fact, by my math, I’m showing that it only takes ~.07% return (front-loading ER deduction) to compensate for the difference in a full 1.0% ER, and only a .30 difference to overcome 4.0% increase in the expense ratio:

    20-Yr
    Scenario: D E F
    Monthly: $1,000.00 $1,000.00 $1,000.00
    E-ratio: 0.24% 1.24% 4.24%
    Post-ER: $997.60 $987.60 $957.60
    % returned: 13% 13.073458% 13.297850%
    $1,130,523 $1,130,521.37 $1,130,522

    So, unless my math is wrong, then the Expense Ratio is a very small factor (.07%) compared to historical (at least 10 Years) returns.

    Again, I will be happily proven wrong, but so far, I have not been.
    –SW

  32. Your friend should read “the Black Swan” and “Fooled by Randomness”.

    These books (by the same person and covering some of the same ground) explain why fund managers are just dead weight.

  33. Steve, you’re still not deducting the expense ratio annually. You’re only taking it off new investments. Forget the monthly contributions for a second – they just make the calculation a little more complicated.

    Investment: $1000
    Scenario A: 13.5% return, 0.24% ER
    Balance after 20 years: $12,065
    Scenario B: 13.5% return, 1.24% ER
    Balance after 20 years: $10,104

    An expense ratio is an annual fee charged to an account. I believe (without trying to duplicate your numbers) that you are treating it as a front-end load that is charged only once to new investments.

  34. I’m confused (though not about your description of how I’m calculating).

    $1000 over 20 years at 13.5% returns $14,657.10.

    How exactly does .24% and 1.24% reduce the return by $2,592.10 and $4,553.10?

    At what places are you taking out the ER? Is there an online calculator where I can enter these data points to retrieve these numbers? I just don’t understand how exactly the math is working in your example.

    Thanks.
    –SW

  35. $1k at 13.5% annual return over 20 years:
    $1,000 x (1.135)^20 = $12,587.

    $1k at 13.5% annual return over 20 years w/1%ER:
    $1,000 x (1.135)^20 x (0.99)^20 = $10,295.
    (This assumes the ER is taken out annually. Some places take it out quarterly, so it compounds as well.)

    Also, I usually just get sloppy and subtract the ER from the rate of return to get a rough idea (which is what I did the examples I gave in previous comments).

  36. Steve, don’t lose sight of something you cannot quantify: the ineffectiveness of fund managers to outperform, year after year, the index their fund is benchmarked to by more than the delta of ER between their fund and an index fund of that index.

    You may not have seen this play out in the early ’00s, but unfortunately I had to learn the hard way that fund managers look like genuises in a bull market, but once it switches to bear their luck runs out and guess who’s left holding the bill?

    You are, in the form of lower (or wiped out) returns and still paying that expense ratio.

    There are precious few exceptions to this rule.

  37. I want to make one point on the fees of mutual funds. The returns you see as an investor already have the fee taken out. So if the performance is beating the index or its peers, then the fee was worth it. I see other contributors saying they will only use Vanguard…or insert fund company here. This is as bad as using a proprietary fund as your friend did. Fees are important, but no fund company does everything well. It is muchwiser to find the one or two funds that each company does well and include those in your possbile investment universe. I pick mutua funds for a living ( I am not an advisor…so not selling anything.)
    Remember, index funds almost guarantee you to underperform…index returns minus fees. And be wary of index funds like Vanguard who do not replaicate the index, but sample the index to try re-create the benchmark with fewer holdings.

    Fees can be worth it, if the fund is outperforming. Just don’t assume that because it has a low fee structure, that that is the way to go. Vanguard fires just as many bad managers as the more expensive fund companies.

  38. Ramit, Is there a way to make sure that the money you invest in the mutual funds don’t go to certain companies ? For example, I don’t want to invest in any oil/gas companies. My financial consultant suggested that I use the China or BRIC funds. I am very new to investing with risk, I have only been using CDs so far. But I am not sure that by investing in the above mentioned funds will ensure that my money gets invested in “clean” companies. I would appreciate any advice you can offer.

  39. 4.5% is a little hard for me to believe! Are you sure this isn’t a front-end load? Wow… I hope it’s not both a front-end load fund AND a fund with that high an expense ratio.

  40. I manage multi-million dollar portfolios for a living and I can tell you that a 4.5% expense ratio is ludicrous. Any joker out there slinging his companies proprietary product at 4.5% is either getting incredibly rich or living with his/her parents. There are many many other options.

    Like Ramit mentioned, over the long term, passive management will beat active. However, I step in and manage portfolios within say 10 yrs of retirement. If you have a 98% correlation to the S&P (which is the case with most low expense mutual funds managed by recent Ivy League grads) and the indice takes a dive at year 6 or so….you may not have time to make it up. In this scenario, paying a higher cost to have your positions hedged by professional traders is very beneficial. Furthermore, I would argue that adding non-correlated asset classes as about 10% of your porfolio is a great way to avoid large market swings. Oil/Gas partnerships, REIT’s, TIC’s, Futures or Options funds, Currency funds, etc are examples of non-correlated (no benchmark or tied in any way to an indice) investment options. And absolutely do not forget over-seas exposure of 20-30%.

    Great discussion!

  41. Where can I find some basic information on investing on this site? I don’t need a trading account, $ manager, etc…. I am looking for some simple explanations to understand the basics of world of investing. Just basically looking for en simple education that I can understand at my level.
    I applaud your passion for money, especially yours! I’m just starting to wake up and smell the coffee in my own life and I have to get my affairs in order before I jump into anything but I find your opinion invigorating and motivational !

    Thank you for the jolt !

    AM

  42. [...] Ramit Sethi has a great article warning against expensive funds versus index funds. [...]

  43. This is an interesting post. What it does reveal is not so much that some firms are willing and able to charge ridiculous fees for often mediocre performance but that humans are subject to several behavioral flaws that show up frequently in our investment decision-making.

    Yes, studies after studies have demonstrated conclusively that the primary determinant of portfolio returns over a long investment horizon is asset allocation with little benefit ascribed to stock selection. Of course, in any given year, you will get a few managers that will achieve exceptional performance. However, an overwhelming amount of studies have demonstrated that most fund managers are unable to outperform the market index on a consistent basis.

    That is not to say that there is no room for short term trading or stock picking – just that it should represents a small potion of ones overall portfolio.

  44. Why would anyone invest in mutual funds at all?

    When the game is rigged so only those high up in the corporate
    structure,or those who invest millions prosper only.

    While you dumb,dumbs get flogged with el stupido MER’s,and
    a mutual fund consultant who says you can’t possibly lose
    over the long haul.

    That’s BS. Most people shouldn’t invest in stocks or funds
    because they don’t understand it either.You’d have to spend
    hours every day to get it.

    It’s up to you.I just save my moula in ING high interest accounts
    and CD’s. I may never get 7 or 8 percent,but I won’t wonder where
    the hell my money went,and still get a mutual fund huckster saying,
    the market I’ll go up,just be patient.

    Yeah,right. Maybe I’m deluded. But you’re all lemmings going to the
    slaughter.

    Have fun.

  45. [...] « Why my friend invests in an insanely expensive fund and why I don’tdon’t [...]