"… I could only agree with your yardsticks of 1, 2, and 3% (for management expenses) with the assumption that all investment advisors and their resources are created equal---but that isn't the case. I would gladly have given 3% to an investment advisor who was more attuned with what was going on rather than have given 1% to an advisor who, say, kept me in Tech (stocks) way past general consensus."
--- a reader
Well, of course. If we knew that a 3 percent annual fee guaranteed we were going to get a superior investment advisor, we'd all pay the fee happily.
Unfortunately, while investment advisors aren't created equal, we can't find the best ones simply by selecting the highest fee. We can, however, be certain that a long period of high fees will reduce the return on our investments.
It's simple math, the more the advisor keeps, the less we keep.
Let me demonstrate with historical figures.
The Morningstar database currently contains 607 domestic equity funds that have been in operation for 15 years or more. They have expense ratios that range from a low of 0.13 percent to a high of 8.83 percent. If you rank order them by expense ratio and divide them into five equal groups you'll find an interesting relationship between expense ratios and annualized returns.
The low expense funds have higher returns than the high expense funds.
The most expensive funds have expense ratios of 1.45 percent or more. Their average return is 8.34 percent and their average expense ratio is 1.96 percent. While some did better than others, only 20 of 120 high expense funds beat the Vanguard 500 Index fund.
Funds in the middle expense group had expense ratios of 1.06 to 1.21 percent and averaged 1.13 percent in expenses. They had a higher average return, 10.09 percent, and twice as many beat the Vanguard 500 Index fund--- 40 of 121.
Funds in the least expensive group had expense ratios of 0.87 percent or less and averaged expenses of 0.65 percent a year. They provided an average return of 10.73 percent. In this group 49 of 121 beat the Vanguard 500 Index fund. The figures are presented in the table below.
|Low Fund Expenses Raise the Odds of High Returns|
|Expensive funds tend to have lower returns; inexpensive funds tend to have higher returns.|
|Fund Group||Avg. Exp. Ratio||15 Year Annual Return||No. Beat Index||% Beat Index|
|Entire group (607)||1.19%||9.78%||178 of 607||29%|
|Least Expensive 20%||0.65||10.73||49 of 121||40.5|
|Middle Fifth||1.13||10.09||40 of 121||33.1|
|Most Expensive 20%||1.96||8.34||21 of 120||17.5|
|Source: Morningstar Principia, January 31, 2003 data|
The reason high expenses may seem reasonable is that most of us focus on the last year or two and on a few funds that post extraordinary returns. Funds in the top 10 percent of Morningstar's Large Blend fund category in the 12 months ending January 31, for instance, averaged losses of 'only' 15.15 percent while the entire category averaged a loss of 22.82 percent. That's a difference of 7.7 percent, well over a 3 percent fee.
Extend the same examination out to 15 years and the average performance of the top 10 percent is 13.60 percent while the average of all large blend funds is 9.65 percent, a difference of 3.95 percent. In less volatile periods, the difference is still smaller.
Still tempted to believe that a high fee will guarantee you quality and smarts?
Then consider this reality. Hedge funds, the investment vehicles of the rich and near rich, generally charge management fees near 2 percent a year plus about 20 percent of the profits. Warren Buffett's investment partnerships in the 60's gave investors the first 6 percent of profits without fees and gave Buffett 25 percent of the excess.
If fees are an indication, every hedge fund manager in operation today is vastly superior to Warren Buffet.
Scott Burns is the retired Chief Investment Officer of AssetBuilder, the creator of Couch Potato investing, and a personal finance columnist with decades of experience.