Over the last five years, 65.4% of active, large-cap fund managers failed
to outperform the S&P 500; 81.6% of mid-cap fund managers lagged behind
the S&P Midcap 400; and 77.7% of small-cap managers were outperformed by
the S&P SmallCap 600.
Since the majority of mutual funds can't beat the S&P 500 or their
respective indices, what's the point of paying 1.5% in annual fees when one
can buy the S&P 500 ETF for an annual fee of 0.1%? To be blunt, there
really isn't any point… unless one enjoys wasting money.
A common objection to my argument asks: Doesn't it make sense to pay
higher fees if a fund's performance is good? That just seems like common
sense. If someone does a good job, he should be rewarded. If the manager
grows your portfolio, it's all right for him to charge a little more.
So, is it OK to pay more for funds with a good track record? My answer is
a resounding NO.
Let me explain. Suppose that you've been reading about cheaper
alternatives to mutual funds, and you'd like your financial advisor to
suggest some options. However, at the same time, you tell the advisor that
you're willing to pay higher fees for funds with a good performance history.
Usually, the higher the fees, the higher are the kickbacks from the mutual
fund to the advisor. By telling the advisor that performance overcomes fees,
he still has the same bad incentives in place. All he has to do is find a
fund with both good performance and a high fee. Well, so what? Isn't good
performance what matters?
In any given year, some mutual funds and ETFs will do well and some will
perform badly. Some of those funds will be high-fee funds and some will be
low-fee funds. There are thousands of mutual funds and ETFs out there. It's
not particularly difficult to find one with both good performance and a high
fee. By accepting high fees on funds with solid past performance, you're
really not beating the financial advisor and the expensive mutual funds at
their game.
If past performance is an important criterion for your fund selection,
what you should really insist on is the combination of good performance and
low fees. As I said earlier, there are thousands of funds out there. Finding
a fund with good performance and low fees is hardly a difficult task,
especially with the assistance of a financial advisor.
But if both funds are performing well, does it really matter? Yes.
Remember that fees are a percentage of assets. They are not based on returns,
as is often the case with hedge funds. Sure, if the fund grows, the mutual
fund company will earn a little more. But the bulk of the fee is earned
regardless of its performance. For example, if the fee is a very large 2%,
you're still going to pay that 2% even if the fund stays flat. If the fund
drops 30%, you're still going to be paying 2%. So, in some sense, you never
pay for performance – investors always pay for assets under management.
Also, remember that past performance is just that… past performance. Each
year is a new year. Would you rather be with a fund that earned 20% but
charged 2% in fees, or a fund that earned 20% and charged 0.3% in fees? The
answer seems pretty simple to me. With the first fund, you're already down 2%
from the start. In effect, you're playing catch-up.
With all this said, there are times when high fees do make sense. If a
particular fund has exactly what you're looking for, then it might make sense
to pay more. For example, suppose I really wanted a mutual fund that invested
in Mexican dividend-paying stocks. There are no cheap options, except for a
fund with a large 2% fee. In that case, it still might be worth it – assuming
one believes that this is an incredible investment.
If your primary criterion is simply past performance, there's no reason to
pay for an expensive fund. You can always find another fund or ETF with lower
fees and good performance. There are plenty of funds in the sea. Our latest
issue of Miller's Money Forever includes nine low-cost ETFs
to replace your expensive funds. Some of the ETF fees go as low as 0.07% –
that's $7 on a $10,000 investment. For that ETF and others, sign up for a
free trial today.
It's high time investors heed the yellow caution flags waving in front of
their margin accounts. Much like the NASCAR driver who pumps his brakes to
avoid disaster when he sees the caution flag, it's time for us to slow down.
My friend and colleague Ed Steer, editor of Ed
Steer's Gold & Silver Daily, recently highlighted a must-read Wall Street Journal blog post focusing on the
record-high levels of margin debt, and it sure made me pause to think.
For those unfamiliar with margin accounts, here's an explanation in a
nutshell: margin debt is money you borrow from your brokerage based on your investments
and the balance in your account. In the US, one can legally only borrow up to
a 50% margin. For the sake of illustration, assume a hypothetical investor
(let's call him "John") buys $100,000 of a stock. If John has a
signed margin agreement with his broker, he can borrow 50% of that amount
from the brokerage. That means that John only needs $50,000 to purchase the
full $100,000 of stock. Of course, he also pays interest on his loan.
If the stock increases 10%, John has $110,000, earning a $10,000 profit.
Based on his original balance of $50,000, that's a 20% return on his initial
capital. This is the way in which margin leverages an account. Furthermore,
John could use his new equity to leverage himself even more – the more the
stock increases, the more debt he can pile on for yet more risk and leverage.
But what happens when the price of one of John's stocks drops? The losses
are similarly doubled as well. Furthermore, if John's equity reaches the
maintenance margin, his broker will issue a margin call, and he will have to
come up with the cash immediately to meet the minimum level of the
maintenance margin. The maintenance margin is also a percentage and varies
from broker to broker. If John can't come up with the money, his broker has
the right to sell part or all of his stock at its current price to bring his
account back within the margin requirements.
Margin debt is a unique sort of loan:
- The interest rate is
changed by the lender (in this case the broker), and fluctuates with the
current cost of money.
- The amount one can
borrow fluctuates minute by minute as stock prices rise and fall.
- The broker can take an
investor out of his equity position at its discretion, and sell his
stock at the worst possible time if he goes outside of the agreed-upon
margin requirements.
- The Securities and
Exchange Commission sets the maximum margin requirements and can change
them at will. Brokers and their customers must comply immediately.
- Investors can pay off
the loan by selling their stock. Their broker will deduct whatever
amount was owed at the time of sale.
Now, why are more investors borrowing increasing amounts against their
investment accounts? The author of the WSJ post had one suggestion:
"Some see the increase as a sign of speculation, particularly if the
borrowed money is reinvested in stocks."
If investing in stocks is not speculative enough for you, you can add to
the excitement (and your blood pressure) by speculating with borrowed money.
The time to do that is when you have a "sure thing" – an investment
that you just know is going to skyrocket. I've been there before and learned
my lesson the hard way.
Don't Bet
the Farm
In 1977, I moved to Atlanta. One of the coaches of my son's baseball team
worked for Scientific Atlanta, a hot new technology company at the time. He
kept touting the company's stock, and we watched it go from $16 to $32 per
share and split twice in a fairly short time period. He convinced me it was a
great opportunity.
I took out a second mortgage on my house, borrowed $32,000, and bought
1,000 shares. I figured it would split and double, and I could quickly pay
off the mortgage. I would be playing on the house's money, so to speak.
I was right about one thing: the stock was soon selling for $16 per share,
but not because it had split. The price dropped in half because they were
having serious production problems with one of their main products.
Eventually, I sold it off, paid off part of the second mortgage, and cussed
at myself for being greedy and stupid for the next several years as I wrote
checks to pay off the balance of the loan. I was playing on the house's money
all right – my house!
I'm sure we have all heard the stock market described as a house of cards.
The increasing level of margin debt is certainly a prime example. Retirees
are pouring money into the market because really, there are few other options
left for finding decent yield. Now we're learning that the number of stocks
bought on margin is at a record high, meaning a lot of those stocks were
purchased with borrowed money. In turn, this has helped push the stock market
to all-time highs.
Hello! Does anyone remember the Internet boom… and bust? How about the
market crash when real estate prices plummeted?
A sudden dip in the stock
market would mean an awful lot of margin calls. More than likely, few folks
would have enough spare cash to put up the additional capital requirements. Brokerage
firms would then enter sell orders, at market price, to bring their clients'
accounts back in balance. Those massive sell orders would drive prices down
further, causing more sell orders, and soon it would be a full-blown crash.
Boom! Just like a house of cards tumbling to the ground.
And what happens to the
retiree who had invested his life savings, hoping to watch it appreciate
while collecting dividends in the process? You know, we old people who bought
our stocks with real money, the kind we earned and saved – not the borrowed
kind. Our account balances will plummet right along with those of the
market speculators. The only difference is that we won't have the opportunity
to recover.
The
Solution for Conservative Investors
Retirees and other conservative investors can protect themselves with a
multipronged approach. First, diversification – a topic Vedran and I covered
at length in the April issue of Miller's
Money Forever – will help prevent a total wipeout. And while the
market may crash, there are still many solid companies making plenty of money
and paying fine dividends. Those companies usually rebound much more quickly
from a crash or downturn than speculative investments do.
Second, stop
losses can limit the damage. Stocks don't all fall at the same rate when
the market drops. Many big-name companies owned by pension funds pay good
dividends and are less likely to be sold, even in a rapid down cycle.
In addition, the Money Forever team also recommends having at
least 30-35% of your portfolio in cash and short-term, near-cash instruments.
Those contrarians with the courage to buy good companies when others are
selling may find themselves in the buying opportunity of a lifetime. If
you're one of these folks and you have the cash to buy, you can profit in a
down market.
In short, survival comes down to limiting exposure, allocating capital
properly, and controlling our emotions. Panic is our worst enemy when times
get tough.
I was 37 when I gambled with that second mortgage, and I have had 35 years
to recover from it. Investors near the retirement cusp cannot afford to
borrow money to speculate; the risks are just too high. At this point in
life, we have learned the hard lessons. For seniors and folks approaching
retirement, preservation and return of capital always trumps return on
capital.
In Miller's Money Forever, we cover almost every topic
under the sun when it comes to the financial risks facing retirees and those
planning for retirement. Whether it's margin debt, annuities, reverse
mortgages, or just finding some good, high-dividend-paying stocks, we leave
no stone unturned. Sign up for a free trial today.
