Paying a mutual fund expense fee of 0.5% per year in this scenario leaves the investor with $60,858 in 20 years, which equates to a 9.45% annual rate of return. The fund with the 1.5% annual expense fee grows to only $49,725 in 20 years, and that whittles the annual return down to 8.35%. Now throw in an additional 2% per year in advisor fees, and the mutual fund with the 0.5% fee becomes in effect a 2.5% annual fee, and that grows the initial $10,000 investment to just $40,546 in 20 years, further reducing the annual rate of return to 7.25%. The mutual fund with 3.5% in total fees yields just $32,991 in 20 years, good for an annual rate of return of just 6.15%. So, in this particular scenario, moving from a low cost mutual fund that you could buy yourself to a higher cost mutual fund that is managed for you by a financial professional cuts the amount of money you would have had at the end of 20 years by nearly one-half. OUCH.

Now granted, the previous example may be a bit extreme, as the fees financial professionals charge will depend on a number of factors, such as account size and the types of services you choose. But this should help drive home point that fees can really undermine investment returns, especially over the long haul. Every bit you pay in fees is money that will not be invested going forward, so you not only don’t get that money, but also don’t receive the money it earns in the future. I like to call this “negative compounding.” As the charts above show, this creates a substantial opportunity cost in what you could have earned. Even mutual funds with higher expense ratios can negatively impact returns over time versus those with lower expenses. If you pay an investment professional, he or she will have to help you select a portfolio allocation and individual securities that beat the overall market, in order to overcome the negative impact that fees have on investment performance. As I explained in Part 5, this is extremely difficult to do, especially over the long run.

Two other things to consider about financial professionals: they may not always have your best interests in mind, and at some point, they may be replaced by someone who is less qualified. All financial professionals are supposed to have a fiduciary responsibility to exercise proper caution and care and make prudent decisions when it comes to your money. But here are two real world examples when that didn’t happen. I know a then 55-year old woman whom I’ll call Shirley whose financial representative put her entire retirement account into highly speculative technology mutual funds at the height of the dot com bubble, and sold her funds that had the highest sales loads to boot. When the market crashed several years later, the guy who sold Shirley those funds was nowhere to be found, and no one from his firm returned any of her calls.

Then there was 34-year old Ed (also not his real name), who had an insurance agent sell him a variable annuity for his individual retirement account that netted the agent a big fat commission. The problem, other than that Ed didn’t really need the annuity to begin with, is that the agent took the variable annuity, which is tax deferred, and put it in an account that was already tax deferred, just so he could make the sale. There really is no need to pay the particularly high fees of a variable annuity to set up a tax advantage for an account that was already tax advantaged. A few years later, when Ed was threatening to cancel this annuity he didn’t really need after he began experiencing cash flow problems, the agent recommended that Ed stop contributing to his 401k so he could afford the premiums in order to keep the policy alive and keep generating fees for the agent’s company. But that would have meant Ed would have missed out on the matching funds his employer made to his 401k. Turning away free money is about the worst financial advice I have ever heard. Finally, when it was clear to this agent that Ed would never be as wealthy as he had hoped, unbeknownst to Ed, the agent pawned him off on an associate who was fresh out of college, and who had no real experience. Nice, huh? How is any of this acting in the client’s best interest?

Look, I’m not saying financial advisors and other investment professionals have no value, and are all a bunch of greedy bastards. Despite the examples I just cited, and the negative reputation that many retail stock brokers and the like have garnered from unflattering movies such as Wall Street, The Wolf of Wall Street, and Boiler Room, most of the industry is made up of smart, good-hearted, knowledgeable, and hard-working investment professionals who actually do give a hoot about you and your well-being. Shocking, I know. Plus, these are real people who can help guide you through the investment process, answer your questions along the way, help keep you focused, and act as a sounding board during more turbulent times. These are all good things. If paying investment professionals is what it takes to get you to invest, and if this is what will help you sleep at night, then it is money well spent. After all, the only thing costlier than racking up extra fees is not investing at all. Moreover, you would likely to do well to seek professional advice when considering more complex investment opportunities and scenarios, such as LLCs, tax structured vehicles, and as I explain in Part 8, in creating an optimal plan for withdrawing money in retirement.

If you are leaning on going with a professional, make sure you do your homework first. I found this website to be a particularly helpful resource in how financial advisors charge fees, which may in turn help you select which type of investment professional may be appropriate for you. There are also some advisors who charge low fees, and who only use low cost securities – I mentioned a few of them back in Part 3 of this series. Those might be a nice compromise for people who wish to avoid the fees that financial professional charge, but who have neither the time nor the desire to manage their money themselves. But for the rest of you, I believe you can seriously reduce the crippling impact that fees can have on your portfolio returns, particularly during the accumulation (pre-retirement) portion of your life, by making your own well informed asset allocation decisions, and to the extent possible, by picking low cost securities. Even if you do decide to seek the advice of a professional, you will still be well served by reading this entire series of articles, if for no other reasons than doing so will help you put his or her advice into proper context, and will allow you to ask him or her more meaningful questions.

 
Individual Securities

Choosing good mutual funds and ETFs is relatively easy and straightforward, and I covered some ideas on how to do that in Part 5 of this series. However, selecting individual stocks, bonds, investment properties, etc. is far more difficult and time consuming. These are things I believe one shouldn’t just do on a whim, or simply by following a hot tip. It is vitally important to understand the cash flows these securities generate, in order to understand whether they are good investments. Warren Buffett likens buying stocks to owning a business, and for good reason, because that is exactly what you are doing when you own stocks. If someone asks you to invest in his or her business, would you just fork over your money sight unseen? Wouldn’t you want to do some due diligence first so you could better understand how the business works, and whether it will be profitable? So why buy a particular stock without investigating it first?

These analytical techniques take time to master. Are you good at performing discounted cash flow analyses? Do you understand the nuances of relative valuation, and the proper way to use it? Do you have access to the information necessary to perform this analysis? It definitely helps if you are and if you do.  But you don’t necessarily have to be an MBA or a CFA to have success in picking individual securities. Legendary fund manager Peter Lynch preaches the notion that every day people can make sound stock selections, using a combination of what they already know and some basic financial concepts (See his books One Up on Wall Street and Beating the Street). However, even understanding these basic techniques takes time. Monitoring individual investments takes time. Managing your own portfolio of individual securities takes time, and if you don’t have it, or if you wish to spend what available time you do have on other things, then you would be better served by sticking with mutual funds and ETFs.

Of course, you could also hire a financial advisor to select those individual securities for you. As I discussed in my last article, large fund managers have a difficult time beating the market over time. However, one advantage financial advisors have that may give them a better shot at beating the market, or at least surpassing the performance of large managed mutual funds, is that they can tailor a portfolio of securities to meet your specific needs using a smaller number of securities. Perhaps just large enough an amount to still get the benefits of diversification, but small enough so the advisor can build a portfolio for you using only his or her very best ideas. This in many ways replicates the patient, value based approach to investing that Warren Buffett and his protégés have used to beat the market fairly regularly over time. Buffett, through his holding company Berkshire Hathaway, does not rush to invest in the latest growth craze, and unlike regular mutual funds, he is not forced to buy a bunch of other securities because of position limits. He and his colleagues are patient, and wait to buy stocks and companies that are priced well below their intrinsic values. By limiting their investments to their very best ideas, they are able to maximize the chances that they will beat the market, and over time, they usually have.

The tailored individual accounts that advisors offer can be a mixture of individual stocks, bonds, mutual funds, ETFs, etc. For example, at the investment advisory firm for which I used to work, another gentleman and I were tasked with analyzing and recommending U.S. and international stocks that we believed were highly undervalued. These stocks were part of our top 20 recommendations list. Our various financial advisors could then pick and choose a subset of these stocks to put into our clients’ individual portfolios, based on their specific investment goals and risk tolerances. We also recommended a list of low fee mutual funds and ETFs for clients who preferred those, based in large part on the process I described in Part 5.

These individually tailored managed, or wrap accounts as they are sometimes called, are arrangements where the advisor charges a percentage of the value of your account. This fee typically varies anywhere from 0.5%-3.0%, again depending on your account value. The advisory firm for whom I used to work would tell clients “by charging you a straight percentage fee, our interests are aligned. When you do better, we do better.”

Sounds great, right? In theory, it is. But there are still many things that can lead these accounts to underperform. One, of course, is fees, which are over and above any fees charged by the individual securities in your account, such as mutual funds and ETFs. The second is just how good are the analysts who are picking your securities? Are they seasoned professionals who can perform complicated discounted cash flow analyses, or are they novices who are basically picking names out of a hat? Are they doing an actual deep rooted analysis of the securities they recommend, or are they just putting you in the “hot names” in hopes they will continue their momentum? Are they keeping up with the latest innovations in financial theory? Finally, please understand that they are getting paid regardless of how much effort they spend on your portfolio, so your interests may not be all that aligned after all. I know one financial advisor who would charge her clients full commissions for stocks she found by simply flipping through the pages of a financial magazine. That’s full service?

If you do decide to hire an investment advisor to actively manage at least part of your portfolio, make sure you get a good one. You should meet with him or her in person first. After all, you are hiring this person to do a job for you, so think of it as a job interview. Here are things to look for in a money manager:

1.) What is their fee structure? -  Obviously, the lower the better.
2.) Exactly what is their approach to selecting securities? – A good financial advisory firm should clearly spell out its approach to selecting securities. “We use a detailed discounted cash flow approach to look for value based stocks that we believe trade at a 25% or greater discount to intrinsic value” is far better than “we buy stocks we believe are undervalued.” Feel free to ask for examples of their previous analysis.
3.) How many financial professionals do they employ? – The more, the better, everything else being equal, since they will generate more investment ideas, and can serve as a check and balance on each other.
4.) Are their return goals realistic? – If they are promising you a minimum return, especially if it seems too good to be true, then it probably is. You might even be looking at a Ponzi scheme. If you don’t know what I’m talking about, watch a few episodes of American Greed on CNBC.
5.) Are they GIPS compliant? – This one has to do with how the company reports its prior investment returns. GIPS stands for Global Investment Performance Standards, and was created by the CFA Institute to be “a set of standardized, industry-wide ethical principles that guide investment firms on how to calculate and present their investment results to prospective clients.” Basically, it prevents money management firms from simply cherry picking their best security selections to make its past performance look better than it really was. If an advisor you are considering has never heard of GIPS, or at the very least doesn’t have an audited performance history, then run away as far and fast as Tom Hanks did in Forrest Gump.


Target Date Funds: Putting Your Asset Allocation Decisions on Autopilot

Target date funds are another potential compromise for those who don’t wish to use investment professionals but also don’t want or feel they can create and monitor their investment portfolios themselves. These are mutual funds and ETFs that will automatically change their asset allocation from something more aggressive/growth oriented to a mix that is more conservative and designed to preserve investment principal the closer time approaches a targeted date in the future.  Many employer sponsored retirement plans offer target date funds.

But as you can imagine, target date funds aren’t perfect, and have considerable costs, both direct and those that are not so obvious. The direct cost are their fees. As shown in Part 5 of this series, target date funds had a median expense ratio of 94 basis points (0.94%) in 2014, versus just 44 basis points for equity index funds that year. While that may not be as much as an investment professional might charge, it is still considerably above what you would pay to be in index funds. If you need a reminder of what fees can do to your long-term investment returns, then take another look at the beginning of this article.

The not so obvious, and perhaps bigger issue with target date funds, is that they follow a more or less pre-determined, cookie cutter, one-size fits all asset allocation strategy, which may not be right for you, especially if your needs change over time. Yet another potential risk is what happens if the target fund you select closes its doors before reaching its target date? Then you’re right back at square one. This is more of a risk than you may think. In August 2014, BlackRock’s IShares unit, then the largest issuer of ETFs, announced it was closing 10 target date ETFs because of “limited investor interest in the funds.”

Overall, I’m not a big fan of target date funds, as I believe the methods I have described in this series will serve you far better. However, if target date funds are what it takes to get you to invest, then go for it. Once again, the only thing worse than paying higher fees is not investing at all. Or, you could just mimic the asset allocation of a particular target fund you like, and populate that allocation yourself using low cost index funds.

 
Next Time

In my next article, I describe a few other concepts that may improve the performance of your portfolio over time.


Patrick Rau, CFA, is a former equity research analyst, both on the sell-side specializing in energy and the buy-side as a generalist for a financial advisory firm. He holds a B.A. in Economics from the College of William & Mary, and an MBA in Finance from Georgetown University. He is married to Brenda Rau, Licensed Real Estate Salesperson with Compass Real Estate in New York City.

Disclaimer: All information and calculations are based on information deemed to be reliable. Patrick Rau, CFA is not an investment advisor, and this paper is for educational purposes only. Nothing herein should be considered financial or investment advice. Moreover, Patrick Rau, CFA shall not be held liable for any losses or damages that may result from any decisions you make based on any of this content.