Vanguard crushes costs

Behold Moore's Law at work with scale:

Expense ratio changes announced for a number of Vanguard funds and ETFs.

The diversification of the S&P 500 now costs only .05% pa in fund expenses! On a percentage basis these reductions are huge.  This puts more and more pressure on active managers by increasing the amount of sustainable alpha they need to generate to carry their costs. Conversely, indexing makes more & more sense, but we already knew that, yes?

Expense ratios as predictors

Morningstar just came out with a nifty analysis of mutual funds: cheaper is better. We believe by proxy the same analysis & concepts extend to ETF's, although liquidity and transaction costs need to be considered.

"Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two quintiles, and you’ll be on the path to success." - How Expense Ratios and Star Ratings Predict Success, Russell Kinnel, Director of Fund Research & Editor, in Aug. 2010 Fund Investor

Update on Tuesday, September 14, 2010 at 12:18PM by hb

What are the odds of picking a winner? Over 15 years some 71% of mutual funds either underperformed or simply went away.

"of the 3,842 funds that were available on January 1, 1995, 1,646 (43%) underperformed the Dow Jones U.S. Total Stock Market Index through 2009, and another 1,071 (28%) were merged or liquidated along the way." source: Vanguard, Commentary, Aug 2010, fund data from Morningstar's 9 box system

S&P indices vs actively managed funds

The March 2010 issue of Research Insights from S&P Indices puts forth some interesting results of an analysis of 5 years of data ending 12/31/2009:

"The S&P Indices Versus Active Funds (SPIVA) Scorecard reports performance comparisons corrected for survivorship bias, shows equal- and asset-weighted peer averages, and provides measures of style consistency for actively managed U.S. equity, international equity, and fixed income mutual funds... The CRSP Survivor-Bias-Free U.S. Mutual Fund Database provides the underlying data…

 Over the last five years,

• the S&P 500 has outperformed 60.8% of actively managed large-cap U.S. equity funds;
• the S&P MidCap 400 has outperformed 77.2% of mid-cap funds; and
• the S&P SmallCap 600 has outperformed 66.6% of small-cap funds.
• results are similar for actively managed fixed income funds. Across all categories, with the exception of emerging market debt, more than 70% of active managers have failed to beat benchmarks.

Free alpha or expensive beta? Either way costs matter.

This is a picture about a wealth transfer from an investor to a broker dealer done under color of 'incidental' advisory service.

It's a real story, unfortunately, and in many ways has come to represent the state of the financial services industry where the interests of the client are subordinate to the revenue preferences of a firm operating on a 'suitability' standard.  An unsophisticated investor will get harvested.

By the way, the difference in the picture is just fees. It is the 'wealth transfer' of your money to the financial services industry. Ever wonder who's paying for the mahogany offices?

It's old fashioned, but costs matter and compound over time. More often they're hidden to some extent, certainly not transparent.  In this case the investor was paying a private banking group (of a broker dealer affiliated with a major US global bank) 3% p.a. for separately managed accounts.  The result was about 1,000 trade confirmations a year and unfathomable account statements some 60+ pages long. What to do?

Analysis revealed it would be possible to 'clone' the performance characteristics of the managed portfolio with a diversified portfolio low cost indexed product comprising some nine distinct asset classes. The comparative analysis above assumes an alternative total cost structure of .80% pa, and the results over 15 years increase the wealth of the portfolio by more than 30%. 

For another perspective, think of it this way: if you expect

• an 7% equity return (on the S&P 500 or the Wiltshire 5000) and
• the 10 year Treasury is paying 3% and
• you have a 50/50 debt/equity portfolio, then
• you have an expected return of 5% before fees on the portfolio

Let's pretend this is your Roth, so there are no taxes (taxes, of course, make everything worse). 3% pa fees consume 60% of your expected pre-tax return.

Some friends came to us, and this is their story. Unfortunately, it is true.  The private banking group was charging excessive fees for under performing product. As you can see it has significant adverse long term implications for wealth creation. 

It is your money. Make your story end well.  It's too important.