One of the most mundane, but most important, issues when choosing a mutual fund is the issue of fees. I know very few people who can tell me what their mutual fund fees are, but they should take a good long look at them. The same holds true with ETFs, which also charge management fees.
First, let's talk about why you should care. This is because fee differentials can do murder on your long term wealth. Let's take a large cap value fund at random, say the Janus Perkins Large Cap Value Fund. It has an expense ratio, the percentage of the fund's assets it collects as fees, of 1.12%. Compare that to the Vanguard Value Index Fund, which has an expense ratio of 0.26%. The Janus fund slightly outperformed the Russell 1000 Value Index since December 2008 (13.87% vs 13.65%) and actually underperformed the Vanguard Value Index Fund over th past year by over 300 basis points. This highlights the issue that most actively managed funds cannot (I should say "will not") beat index funds. However, even if it did maintain that 0.22% outperformance over a long period, that fee differential would wreak havoc.
Let's use a ten year example where the value index does 8.00% and the Janus fund does 8.22%. At the beginning of the period you invest $10,000 and the expense ratios are assessed at the end of each year. In the case of the Janus fund you end up with $19,487 and with the Vanguard fund you end up with $21,034, a difference of over $1,500 or nearly 8%. That's even with the Janus fund's small margin of outperformance before fees. Add in the issue that actively managed funds generate more problems with pass-through capital gains and the problem compounds.
None of this is to say that there aren't good actively managed funds that can, reasonably consistently, beat the S&P 500 or any other index that they may track over time. They might not beat it every year, but over the course of several years they do. Of course, do they beat it after fees and pass-through capital gains? That's possibly another story altogether.
What this all gets at is look at the fee schedule you are paying. If the expense ratio is much over 0.70%, you are probably paying way too much unless you have a truly exceptional manager or if it is a fund that gives you exposure to some esoteric market that doesn't have a good index proxy that you can invest in. Also, very importantly, pay attention to the pass-through capital gains that are generated when the fund liquidates positions where they have made a profit. These gains get passed on to you and you have to pay, depending on the situation, either 15% or your highest marginal tax rate. One would be wise to sack fund managers who are not tax efficient.
Disclaimer: I do not own positions in any of these funds. Any advice given here is not to be taken as professional financial advice.
Showing posts with label Fees. Show all posts
Showing posts with label Fees. Show all posts
Thursday, October 21, 2010
Sunday, July 4, 2010
Strategy: How to manage future transaction costs in a small portfolio
As I am not a wealthy man, nor will I likely be working for my state's government, I, like many others, must pay a great deal of attention to transaction costs when executing trades. In what follows, I try to provide a few examples, all reasonably straightforward, of how to reduce the potential for ruinous costs.
Let us take the example of a brokerage account with $5,000 in it. You have this divided among five holdings at $1,000 each because you took the advice previous mentioned on this blog and attempted to build out core, meso, exploratory, and speculative holdings. That's all well and good, but let's say that you suddenly decide that you think all hell is about to break loose and you want to shield your assets in a bond ETF, say TLT. For the purposes of this demonstration, I'll say brokerage fees are $10 per trade just because it makes the math easier. First, in your initial sales, you incurred $50. Then, in your purchase of the bond ETF you incurred another $10. When the crisis passes you sell your bond ETF, incurring another $10, and then you buy back into your original five positions at another $50. Your total fees were $120 or 2.4%.
Now, you might say that 2.4% is not so bad because you may have averted far worse in the market as a result of your move. However, even among the best portfolio managers are wrong about as often as they are right. Over time, these decisions, even executed properly, are likely to be a wash for the typical investor. I know, speaking for myself, that they have been for me. The cumulative effect of multiple swaps over several years' time can be the loss of multiple percentage points of your assets with a devastating effect on your total return over the long run.
Even in a larger portfolio, if one divides their positions too thinly, the situation repeats itself. For example, the costs as a percent of assets for a $50,000 portfolio divided amongst 25 holdings at $2,000 a piece works out to be $520 total or slightly over 1% of total assets lost via fees. If this person is an active trader and does this a few times a year on average attempting to pick each point at which the market might turn, they could rack up 3 or 4% in fees. That's to say nothing of bad capital gains management, which I will discuss at some other point.
Now, the lower proportion of fees in the second example makes the point I would like to make. If you wish to engage in more active market timing, keep your number of holdings down significantly. In the first example with the $5,000 brokerage account, if you have only two holdings at $2,500 each your transaction costs for the whole series of transactions are only $60 or 1.2% of your portfolio. It's still a steep price to pay, but with larger portfolios keeping the number of holdings down drives these costs right through the floor. In the $50,000 portfolio example, if that investor only had five holdings at $10,000 a piece, they incur $120 in transaction costs or 0.24% in fees for a whole cycle of transactions. As such, the lesson is that consolidated, larger holdings give you a greater ability to engage in market timing if you feel that's what you should be doing. The risk is that, depending on how you do it, you lose out on diversification. You can make up for this in choosing broad market index ETFs and then have both flexibility and diversification.
Now, as to whether or not market timing is a good idea, that's a tricky one. There were people who sold out after the first 10% up from the March lows of last year waiting for a correction that never came. Even with the recent rout, we are still far above the levels that these traders were waiting for. At the same time, selling in early April of this year would have been a very prudent thing to do especially if you then stuck that money in TLT. You would have a spread of something like 2600 basis points over where your money would have been otherwise. Not bad.
Let us take the example of a brokerage account with $5,000 in it. You have this divided among five holdings at $1,000 each because you took the advice previous mentioned on this blog and attempted to build out core, meso, exploratory, and speculative holdings. That's all well and good, but let's say that you suddenly decide that you think all hell is about to break loose and you want to shield your assets in a bond ETF, say TLT. For the purposes of this demonstration, I'll say brokerage fees are $10 per trade just because it makes the math easier. First, in your initial sales, you incurred $50. Then, in your purchase of the bond ETF you incurred another $10. When the crisis passes you sell your bond ETF, incurring another $10, and then you buy back into your original five positions at another $50. Your total fees were $120 or 2.4%.
Now, you might say that 2.4% is not so bad because you may have averted far worse in the market as a result of your move. However, even among the best portfolio managers are wrong about as often as they are right. Over time, these decisions, even executed properly, are likely to be a wash for the typical investor. I know, speaking for myself, that they have been for me. The cumulative effect of multiple swaps over several years' time can be the loss of multiple percentage points of your assets with a devastating effect on your total return over the long run.
Even in a larger portfolio, if one divides their positions too thinly, the situation repeats itself. For example, the costs as a percent of assets for a $50,000 portfolio divided amongst 25 holdings at $2,000 a piece works out to be $520 total or slightly over 1% of total assets lost via fees. If this person is an active trader and does this a few times a year on average attempting to pick each point at which the market might turn, they could rack up 3 or 4% in fees. That's to say nothing of bad capital gains management, which I will discuss at some other point.
Now, the lower proportion of fees in the second example makes the point I would like to make. If you wish to engage in more active market timing, keep your number of holdings down significantly. In the first example with the $5,000 brokerage account, if you have only two holdings at $2,500 each your transaction costs for the whole series of transactions are only $60 or 1.2% of your portfolio. It's still a steep price to pay, but with larger portfolios keeping the number of holdings down drives these costs right through the floor. In the $50,000 portfolio example, if that investor only had five holdings at $10,000 a piece, they incur $120 in transaction costs or 0.24% in fees for a whole cycle of transactions. As such, the lesson is that consolidated, larger holdings give you a greater ability to engage in market timing if you feel that's what you should be doing. The risk is that, depending on how you do it, you lose out on diversification. You can make up for this in choosing broad market index ETFs and then have both flexibility and diversification.
Now, as to whether or not market timing is a good idea, that's a tricky one. There were people who sold out after the first 10% up from the March lows of last year waiting for a correction that never came. Even with the recent rout, we are still far above the levels that these traders were waiting for. At the same time, selling in early April of this year would have been a very prudent thing to do especially if you then stuck that money in TLT. You would have a spread of something like 2600 basis points over where your money would have been otherwise. Not bad.
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