We don't need this money, but we would like to beat inflation or do better with little risk. The rest of our money is earning 4.5 percent in a one year CD. We're attaching the investment plan we were sent.
---J.V., by email from Ft. Walton, FL
A. The problem here is called fee pyramiding, adding a fee for the selection of funds to the cost of the funds themselves. It may be the only way to provide service to a $50,000 account, but the fee is likely to be self-defeating.
Another issue is that the advisory firm is offering an insane level of diversification, dividing your $50,000 over 26 different mutual funds. Each fund has its own expense ratio, and your largest investment would be only 9 percent of your money. Your smallest would be only 2 percent of your money. I guess that makes it look like they're doing a lot of work, but it's highly unlikely that you'll get much advantage out of having your money spread over so many funds.
Diversification is good. But there are limits.
The bigger issue, however, is fee pyramiding. While 1.1 percent a year may not seem like much, it can do major damage over a long period of time. You can get an idea by examining some Morningstar data with me.
Taking the entire universe of "moderate allocation" funds--- the ones that typically have a 60/40 stock/bond split--- and rank ordering their performance over the 15 years ending December 31, 2005, I found that funds at the 25th percentile provided an annualized return of 10.80 percent. Funds at the 50th percentile provided an annualized return of 9.43 percent. And funds at the 75th percentile provided an annualized return of 8.32 percent.
So do the math. The difference between the 25th and 50th percentile is a mere 1.37 percent. The difference between the 50th and 75th percentile is only 1.11 percent. Compare that to the annual fee for selecting a portfolio of funds to create a moderate allocation portfolio--- 1.1 percent.
In medicine there is a problem called iatrogenic illness--- a malady that arises from the treatment given the patient. That's what we have here. The additional cost of selecting the funds, by itself, is likely to drop performance significantly. If the future contains a period of relatively low returns, the impact will be worse. If the future contains a period of relatively high returns, the impact won't be as bad.
The medical profession has recognized this problem and even has an association, The American Iatrogenic Association, to deal with the issue. Sadly, there is no counterpart organization in the financial services industry.
If you happen to think I'm just another ink-stained wretch jealous of the salaries pulled down in financial services, then I suggest you ignore me but read a little essay by billionaire Warren Buffett. Titled "How to Minimize Investment Returns," it starts on page 17 of his recently released annual letter to shareholders.
Stretch the investing period longer--- like for a 25 year retirement--- and the difference between the top 25 percent and the median will likely be still smaller. As the investing period lengthens, the burden of the fee becomes larger and larger.
Advisors, of course, argue that their adroit selections will offset their fees and more. But they will be collecting fees today. You, meanwhile, will wait years to see if they deliver the promised value added.
Either way, you'd be better off selecting a single balanced fund with a similar asset allocation or, at most, selecting a domestic equity fund, an international fund and a fixed-income fund.
On the web:
The American iatrogenic Association
Warren Buffett's 2005 annual letter to shareholders
This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational puposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.
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