How Some Financial Advisors Lay Termites In Your Home
December 27, 2017

How Some Financial Advisors Lay Termites In Your Home

Imagine this. You hire a homebuilder named Ricky. He’s a strange little dude. When he builds a new home, he plants termites in the walls. As neighborhood home prices rise, yours rises too. But wood-devouring devils are dining on your future. Before long, your home needs work, and it’s worth a lot less than the others on your block.

I doubt any builders would do such a thing. But that doesn’t mean financial advisors wont. They lay profit-devouring vermin in investment accounts.

Unfortunately, Laura Split (I changed her name to protect her identity) hired such an advisor. “I fired her when I saw the big picture,” said the spunky 52 year-old San Diego teacher. Laura taught most of her career overseas. As a result, she couldn’t contribute to Social Security, a defined benefit pension or an IRA while she lived abroad. That’s why most of her investments are in a taxable account.

The advisor layered two levels of termites into Laura’s future. First, she charged a 1.5 percent annual wrap fee. Second, she stuffed actively managed funds into Laura’s portfolio. Laura’s funds cost an average of about one percent per year. That means Laura paid total annual fees of about 2.5 percent. That might not sound like much. But if Laura’s portfolio earned 7 percent per year before fees, the financial services industry would have gobbled up 35.7 percent of the profits (2.5 is 35.7 percent of 7.0).

Like Laura, you might also own actively managed funds. Over time, their higher fees will likely hurt your returns. But in a taxable account, the reality is worse. Such funds provoke the IRS.

Here’s how it works. Active fund managers trade the stocks within their funds. They might buy Apple stock today. But the following week, they might sell it in favor of General Electric shares. In many cases, fund turnover could be as high as 100 percent. That’s equal to every stock getting traded at least once a year.

If the fund earns a calendar year profit, it creates a realized gain. As a result, investors would have to pay short-term capital gains tax.

Index funds are different. Fund managers don’t trade stocks in the hopes of gaining an edge. In most cases, this allows investors to defer capital gains taxes until the investor sells their shares. And when investors sell, they pay capital gains tax at the long-term rate. This is more lenient than the short-term rate that hits so many investors in actively managed funds.

As Laura Split learned, high fees and taxes gnaw away at profits. For example, Laura had more than $25,000 invested in America Century Mid-Cap Value A Fund. Its expense ratio is 1.21 percent per year. That’s seventeen times more expensive than Vanguard’s Mid-Cap Value Index (VMVAX). It costs just 0.07 percent per year.

Over the five-year period ending November 30, 2017, the America Century Mid-Cap Value A Fund averaged a compound annual return of 15.22 percent per year. Over the same time period, Vanguard’s Mid-Cap Value Index (VMVAX) averaged a compound annual return of 15.90 percent per year.

But those are pre-tax returns. In a taxable account, Morningstar estimates the America Century fund averaged a compound annual return of about 10.09 percent per year. In contrast, Morningstar estimates Vanguard’s Mid-Cap Value Index earned a post-tax compound annual return of about 15.10 percent per year. After taxes, the index beat this actively managed fund by more than five percent per year.

Five-Year Annual Returns
Ending November 30, 2017

Pre-tax Annual Return Post-Tax Annual Return
America Century Mid-Cap Value A Fund 15.22% 10.09%
Vanguard’s Mid-Cap Value Index (VMVAX) 15.90% 15.10%

Laura Split’s largest holding was Fidelity’s Advisor New Insight’s A Fund (FNIAX). Ms. Split had about $70,000 invested in this large-cap growth fund. Its five-year return was 14.94 percent per year. In contrast, Vanguard’s Growth Index Fund (VIGRX) averaged a compound annual return of 15.77 percent per year.

But once again, those are pre-tax returns. Morningstar estimates Fidelity’s Advisor New Insight A Fund earned just 11.93 percent after taxes. In contrast, Morningstar estimates Vanguard’s Growth Index Fund (VIGRX) gained about 15.31 per year (after taxes) over the same five-year period.

Five-Year Annual Returns
Ending November 30, 2017

Pre-tax Annual Return Post-Tax Annual Return
Fidelity’s Advisor New Insight’s A Fund (FNIAX) 14.94% 11.93%
Vanguard’s Growth Index Fund (VIGRX) 15.77% 15.31%

After taxes, Ms. Split’s funds were dragged through the dirt.

But that’s something Mark Hulbert might expect. In 2009, he published The Index Funds Win Again in The New York Times. He referenced a study by Mark Kritzman, the president and chief executive of Boston’s Windham Capital Management. The study compared pre-tax and post-tax returns for high-income investors in New York state. Hulbert says the typical actively managed fund, after taxes, underperformed its benchmark index by about 4.3 percent per year.

Those are big termites. Based on Morningstar’s after-tax estimates, the seven actively managed funds in Laura Split’s account underperformed their benchmark index funds by about 3.5 percent per year. If we add the 1.5 percent wrap fee that Laura paid her advisor, a portfolio of low-cost index funds would have beaten her account by about 5 percent per year.

You might wonder, “Why would a financial advisor do this to a client?” Sadly, many want their clients to think that they can beat the market. Others choose actively managed funds to pad their own wallets. After all, such funds often pay them trailer fees and commissions.

These payments might be good for advisors. But investors pay the price. As Laura Split says, “Advisors that build portfolios with actively managed funds might pretend they’re your friends. But they’re just out for their pound of flesh.”

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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 purposes, 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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