Q: I like my broker, but she and I differ on what type of fund to be in. I prefer a low-expense fund. She says: Forget expenses if the 10-year returns bear more fruit.

I have $400,000 to invest. I want to do the following: 35 percent in Vanguard Total Stock Market Index, 20 percent in Vanguard Total International Stock Index, 20 percent in T. Rowe Price New Horizons and 15 percent in Vanguard Value Index.

This gives me exposure to a large domestic blend, an international fund, a mid-cap and a value fund. All are low-expense funds. She wants me in Hancock Large Cap Equity C, Goldman Sachs BRIC C, Blackrock U.S. Opportunities Inv. C, Fidelity Advisor Canada C and Fidelity Advisor Small Cap C. All are high-expense funds.

I am 55, married and own my own business with no debt. I have an additional $800,000 in four accounts (including two IRA accounts) invested in about 18 different stocks from all sectors except financials. -- N.C., San Antonio

A: Have you ever heard the expression "To a hammer, everything is a nail"? Well, that's what is happening here. Your broker needs to make a living. Her income comes from adviser fees on those "C" share funds. Her world is defined by the funds she can make a living selling.

This isn't evil. But it sure blunts her sensitivity to statistical reality.

These fees have to be added to the basic expense ratio of the funds she recommends. Those C shares include a large 12b-1 fee (0.75 percent to 1 percent). That's why every single one of the funds she suggests costs more than 2 percent a year. That's 10 times as much as the cost of most of the funds you want to buy.

She can't make a living at her current firm by putting you into low-cost index funds. She's part of the outmoded legacy distribution system that I wrote about earlier this year.

I've heard brokers say that "expenses don't matter if the return is there" for more than 40 years. It's absolutely true, except for one problem. Expenses are constant. Performance is uncertain. Invariably, today's top manager outruns his selection luck and performance deteriorates. Long-term, odds are that managed fund performance will be well below the performance of an index fund.

It helps to understand the math and probability behind this. Historically, about 70 percent of all managers fail to beat their appointed index. So when you pick managers -- or pay someone to pick them for you -- you have only a 30 percent chance of beating an index fund.

Those aren't very good odds, particularly when the additional expense is considered. Over the 15 years ending March 31, for instance, the Vanguard Balanced Index fund provided an annualized return of 8.30 percent. It outperformed 64 percent of its managed moderate allocation competitors. It did this with an expense ratio of only 0.20 percent.

Just to overcome the 1 percent added cost of C shares, your broker would have to find a fund with a pre-fee return of 9.30 percent. Only 20 percent of the managed funds did that. Basically, the odds are 5-to-1 against just recovering the cost of having your broker make the selection. She, of course, is willing to take the chance because your money is her lunch.

Worse, the higher the expense ratio of a fund, the worse the odds it will provide a superior performance. The average expense ratio in the top 20 percent of moderate allocation funds, for instance, was 1 percent. The average expense ratio in the bottom 80 percent was 1.41 percent. As I've written before, you can raise the odds of achieving superior performance simply by having a bias toward low-expense funds. Since your broker is selecting from a tool box of funds that already have above-average costs, the odds of achieving superior long-term performance are really, really poor.

My suggestion: You're already doing the right thing on your own. Keep doing it. If you want to gamble on your broker, sell some of your individual stocks and let her suggest a small portfolio of funds. Then track it against your portfolio of index funds. Just remember you are betting on a long shot and that the odds are better than 5-to-1 against her. Personally, I don't think it's a good idea to bet your retirement on a long shot.


"What 'Financial Adviser' Means 95 Percent of the Time" (2/29/08)

"Measuring the Cost of the Legacy Distribution System Over Your Working Career" (3/7/08)

"Fees and the Top and Bottom 25 Percent" (3/14/08)

"How to Improve the Odds of Selecting a Superior Mutual Fund" (8/3/07)