What did it cost to manage his money?
His advisor responded with a long missive. It took swipes at managed mutual funds, saying they cost 3.5 percent a year. It also took a swipe at index funds, saying they had invisible costs. Finally, he took a swipe at brokerage wrap accounts, which often charge over 2 percent a year. Indeed, about the only reasonable service appeared to be his.
Funny how that works out, isn't it?
If you, like D.O, have suffered through some confusion, let me walk you through how to make an apples to apples comparison of money management costs. We'll start with the investment everyone knows best, mutual funds.
Mutual funds have three clearly reported costs: the managers fee, fund reporting and related expenses, and possibly a 12b-1 marketing fee. Add the three costs and you get the annual expense ratio for the fund. You can find the three items that add to the expense ratio in the fund report or on www.morningstar.com.
Mutual funds also have the expense of brokerage commissions. This can be found deep in the fine print of the prospectus. These explicit expenses, however, tend to be quite small as a percentage of assets managed.
The largest cost of fund trading is implicit. It's the difference between the bid and ask price in a transaction. This cost is difficult to estimate. But it is a substantial multiple of the explicit commissions. It also depends on the size of the trade and the liquidity of the stock. If a fund manager wants to buy or sell an illiquid stock, his implicit trading costs will be large.
Finally, there is the portfolio advisors fee. Whether your money is in funds, unit trusts, or individual securities, there can be a fee for the person responsible for your entire account. Most of the major brokerage firms now have "wrap accounts" where all of these costs, with the exception of implicit trading costs, are included in one figure. Small wrap accounts can cost as much as 2.5 percent. Individuals with large amounts of money can negotiate lower wrap fees, often below 2.0 percent, excluding implicit trading costs.
Vanguard founder John C. Bogle has a rule of thumb for estimating the implicit cost of portfolio turnover. He starts with the portfolio turnover rate, doubles it, and multiplies that figure by 0.60 percent. The result is the trading cost for the fund. Using the Morningstar Principia database, I found that the average turnover rate for a "large blend" fund is 84 percent. That implies implicit trading costs of 1.0 percent a year. Many managed funds have much higher portfolio turnover rates and, therefore, much higher effective trading expenses.
One of the big advantages of some (but not all!) index funds is that they have low turnover rates. Vanguard Total Market, for instance, has a turnover rate of only 9 percent. This means its implicit trading costs are only 0.1 percent--- a savings of nine-tenths of a percent over the average managed fund. Fidelity Spartan Total Market Index fund has a turnover rate of only 3 percent, indicating still lower trading costs.
You can start to see the advantage of some index funds by doing some comparisons. If the average domestic equity mutual fund has an expense ratio of 1.27 percent and a turnover rate of 84 percent, its total expenses will be about 2.27 percent.
Invest the same money in Fidelity Total Market Index fund, and your costs will be the 0.25 percent expense ratio plus another 0.04 percent for implicit trading costs. That's a total of 0.29 percent--- a fraction of what the average managed fund costs.
As a practical matter, it means the average managed fund is at a cost disadvantage of 1.98 percent a year. It needs to make that much more simply to keep up with a broad passive fund.
If there is also a portfolio advisor fee, that cost must be recouped through improved performance as well.
Many advisors talk about having "competitive" fee structures. Unfortunately, their notion of competitive is defined entirely by the standards of the investment industry. Those standards are dictated by industry goals for profits and advisor income. They have nothing to do with your investment success. The advisor may say that they only succeed if you succeed, but when push comes to shove that isn't true: industry income always comes first.
|Comparing Money Management Costs|
|This table compares the cost elements of four different ways to manage investments, a non registered investment fund, a registered investment company fund, a brokerage wrap account, and an index fund held by an individual investor who acts as his own advisor.|
|Non-Fund Managed Account||Domestic Equity Fund||Typical Wrap Account||Independent Index Fund Investor|
|Fund Management fee||0.50||Varies||In wrap||Varies|
|+ Other fund expenses||0.50||Varies||In wrap||Varies|
|+12b-1 fee, if any||0.00||Varies||In wrap||None|
|= Annual Expense ratio||1.00||1.27 percent||2.00||0.25|
|+Brokerage commissions||In other||Nominal||In wrap||Nominal|
|= Total Cost of Fund||2.00||2.27||3.00||0.29|
|+Account manager||1.50||1.00||In wrap||None|
|Total Cost of Management||3.50||3.27||3.00||0.29|
|Sources: Morningstar Principia, John C. Bogle|