I know that you're laser focused on cost containment in your business. You know full well there is no surer way to improve the bottom line than to push expenses as low as possible without impacting your value proposition to clients.
Are you just as focused on keeping your investment expenses down? If you are using actively-managed mutual funds inside your 401(k) and IRA accounts I think you are leaving significant money on the table. You wouldn’t do that with your own business, so why are you doing it with your investments?
All mutual funds and exchange-traded funds (ETFs) have an annual set of fees you pay, called the expense ratio. Problem is, it doesn't show up as a line item in your year-end statement. The fee is taken off of a portfolio's gross return, before reporting the net return to shareholders. It's not entirely stealth; you can easily find the info online by logging into your account. Or head over to Morningstar.com, plug in the ticker and on the quote page you will see Expenses in the data cluster at the top of the page.
The average expense ratio for an actively managed stock fund was 0.93 percent in 2011, according to the latest data available from Investment Company Institute.
The One Time to Get Passive
Funds and ETFs that simply track a given benchmark index are the smarter investment. The average stock index fund expense ratio is 0.14 percent. Expenses for ETFs can be even lower.
As someone with the wherewithal and drive to run your own business, you may think index funds are for settlers. You’re more interested in sticking with a fund where a smart manager is actively making investment decisions, rather than settling for a computer that hugs a benchmark index. You believe in the power of passion and talent. It’s working for you, after all. And you’re content to pay up for that active-edge.
Thing is, there’s no consistent edge to be had. S&P Dow Jones Indices keeps a running tally of how active fund managers fare relative to passive benchmark indices. Over the five years through mid-2012, barely 30 percent of actively managed U.S. stock funds outperformed their index. Among international stock funds just 26 percent of actively run funds outperformed. There are nuances within sub categories--for example, small cap managers tend to have a better track record than managers surfing among well-trod large caps--but the message is clear: It’s hard for a hired hand to do better than its target benchmark index.
For the skeptics out there, the five-year data I used is not an aberration. No matter how you slice and dice the data, active managers have a very hard time beating their benchmark index in any given year, let alone consistently beating it.
You’re far better off getting passive: using low-cost index mutual funds and ETFs. On a $100,000 portfolio that earns a 6 percent gross annualized return over 30 years, the end balance net of an annualized 0.93 percent fee haircut is $441,000. Pay just 0.14 percent in annual expenses and your net balance is going to be around $552,000.
I was encouraged to see recent fund flow data from Morningstar that showed a net outflow of $112 billion from actively managed funds through the first 11 months of 2012, and a net $50 billion inflow into passively managed stock mutual funds and ETFs. That’s one investing trend to jump onto.
As an entrepreneur you’d never knowingly take the deal that costs more and delivers less. But if you’re relying on actively managed mutual funds, chances are that’s what you’re signing up for. Take the time to make sure your investments aren’t falling into the same trap. Switch to low cost ETFs or funds and you’re likely freeing up six figures or more that will float to your accounts’ bottom line between now and a retirement that is a few decades off.