Tuesday, May 9, 2017

The Real Cost of Index Funds: 3 Ways You've Been Fooled

It's truly fascinating to see what a multi-million dollar budget can do.  The large low cost providers have used their war chests of money to manipulate and brainwash an entire generation. Before we get into that I want to start by saying I have nothing against index funds and I do use them when appropriate. I believe that index funds have a place in a portfolio, however, I do not believe they should comprise the entire portfolio. By only investing in index funds you're saying that you are satisfied with average. You would never like the opportunity to do better than the general market nor are you interested in having a manager who can make adjustments to hedge some of the downside risk in a correction or bear market.

Word Manipulation

I can already hear the objections now, "But XYZ low-cost provider says that the average mutual fund doesn't beat the benchmark 80% of the time, so why use them?". To which I always reply, "Can you please define the term 'average' for me?" and I ask this because no one knows what they're comparing their low-cost funds against. I can tell you one thing for certain, there is a large surplus of actively managed mutual funds out there that are poor, with unacceptable performance. So, when you include these funds in the comparison, suddenly these providers are able to paint the precise picture they need to convince the investing public their method is superior. Here's the catch, my clients are not investing in the "average" actively managed mutual fund. If we decide that an active manager is the right fit then we are using funds with long track records of excellent performance. Of course, any fund will have a few years that this doesn't occur but this doesn't mean the strategy should be abandoned.

One-Sided Comparisons

One thing you will never see the low-cost providers do is make comparisons in real dollar numbers. Meaning, they focus on the year to year returns when what truly matters is how much money did you start with and how much money did you end with over a period of time. They won't show you these statistics because in doing so their strategy suddenly looks far less appealing. For example, I have an actively managed mutual fund that I've been recommending to clients for over a year now. When you look at a $10K investment over a 10-year time span my fund appreciated to $21,570 (NET OF FEES) meanwhile an S&P 500 ETF from one of the leading low cost providers has only grown to $19,600. Once a client sees that our active managers have returned more real dollars, net of fees, to investors over a given time frame the decision becomes obvious. Now you understand why they will never make comparisons in real dollars even though this type of analysis is far more relevant than what an active fund did in any given year.

Hidden Agendas

Once again, the goal of this blog was not to beat up on these low cost providers but instead  it was to give the other side of the story. Hearing both sides makes you an informed investor and prevents you from relying on the headlines that these huge marketing budgets can afford to put in your face. They trick you into believing they are doing you a service by giving you a fund that costs less, when as you can see from my previous examples this isn't true whatsoever. Remember, all these low-cost providers have a hidden agenda, they aren't trying to cut your fees because they're your friend. These companies spend BIG dollars to make sure their ads are seen all over google and other places that investors frequent and there's a reason for this. One thing I hope you all take away from this, regardless of your age or investment experience, is what truly matters is how much money you end up with in the long run. Year to year calendar returns are meaningless if these low-cost funds aren't making you as much money over time as the active funds are net of their fees. Fees are only an issue in the absence of value, so long as your advisor is using active funds that bring real value their fees become an irrelevant issue. 

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 The views expressed are not necessarily the opinion of Woodbury Financial Services, Inc., and should not be construed directly or indirectly, as an offer to buy or sell any securities mentioned herein. Individual circumstances vary. Investing in mutual funds involves risk, including the potential loss of principal invested.  Risks vary depending upon the strategy used by the fund as well as the sectors in which the fund invests.  When redeemed, shares may be worth more or less than the original amount invested. 

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