Investors are shrugging off the suggestion that stocks are over-valued or that the technology innovators are a one-way path to riches if the year-to-date performance of Tesla Motors (TSLA) and Facebook (FB) are any indication. Twitter’s stock (TWTR), which soared from a $45 closing price on its first day of trading (November 7, 2013) to a high of $73.30 on December 26, has fallen 32% since the start of 2014. Twitter is now trading at slightly below $45. Given the excitement surrounding the Twitter IPO less than six months ago, what does this apparent reversal of (expected) fortunes suggest? It is certainly too soon to conclude that a business model that made sense at the IPO has proven to be faulty. Does Twitter’s dramatic decline signal a shift in investors’ willingness to bet heavily on a future earnings stream that is almost impossible to predict? Continue reading
Income inequality is increasingly acknowledged as a key economic issue for the world. The topic is a major theme at Davos this year. Economic inequality is also an increasingly common topic in U.S. politics.
A new study has found that economic mobility does not appear to have changed appreciably over the past thirty years, even as the wealth gap has grown enormously. The authors analyzed the probability that a child born into the poorest 20% of households would move into the top 20% of households as an adult. The numbers have not changed in three decades.
On the other hand, there is clearly a substantial accumulation of wealth at the top of the socioeconomic scale. The richest 1% of Americans now own 25% of all of the wealth in the U.S. The share of national income accruing to the richest 1% has doubled since 1980. In contrast, median household income has shown no gains, adjusted for inflation, since the late 1980’s and has dropped substantially from its previous peak in the late 1990’s.
Why is this happening?
One of the least-understood aspects of investing among individual investors is the total costs associated with building and maintaining a portfolio. In comparison to the huge rises and falls that we see in the market, the expenses associated with mutual funds or brokerage costs may sound small. Over long periods of time, however, the ups and downs of the market tend to average out. The effect of those costs however is persistent and continuous.
There are a range of costs associated with investing in funds beyond the stated expense ratio. In a new article in the Financial Analysts Journal, John Bogle presents a new summary of the average all-in costs associated with investing in stock index funds and in actively-managed stock funds. Mr. Bogle is a long-term and tireless advocate of the idea that actively-managed mutual funds are a mistake for investors, so the content of the article is not surprising. He has written similar pieces in the past. In this article, he provides updated numbers, backed up by a range of academic analysis. His summary of costs is provided in Table 1 of his article:
There are three types of expenses, in addition to the standard expense ratio. First are transaction costs, which are simply a fund’s trading costs. This cost includes brokerage fees incurred by the fund, the impact of the bid-ask spread, and related expenses. Mr. Bogle estimates this cost at 0.5% per year for active funds and at 0% for index funds. He justifies the zero cost for index funds on the basis of the fact that the long-term returns of index funds are essentially identical to the performance of the index net of the index funds’ expense ratio. The second source of additional cost for active funds is cash drag. Many actively managed funds are not fully invested all of the time and carry a portion of their assets in cash. To the extent that this cash does not accrue returns comparable to the equity index, this is a drag on performance. Mr. Bogle estimates this lost return due to cash holdings at 0.15% per year. The final additional cost that Mr. Bogle includes is sales charges / fees. This cost is supposed to capture sales loads and any incremental costs associated with an investment advisor such as advisory fees. Mr. Bogle freely acknowledges that this cost estimate is exceedingly open for debate.
When he adds all of these costs together, Mr. Bogle estimates that the average actively-managed fund costs investors 2.27% per year as compared to the market index, while the index fund costs only 0.06% per year.
The Investment Company Institute (ICI) estimates that the asset-weighted average expense ratio of actively-managed mutual funds is 0.92% per year, for reference. The ICI also reports that the most expensive funds can have much higher expense ratios. They find that the most expensive 10% of equity funds have an average expense ratio of 2.2%.
Mr. Bogle, in his examples, assumes that stocks will return an average of 7% per year. This number is highly uncertain. The trailing 10-year annualized return of the S&P500 is 6.8% per year, but the trailing 15-year annualized return for the S&P500 is 4.2%. A 2.2% total expense is more than 30% of the total return from investing in the stock market if the market returns 7%. Because of compounding, the long-term impact of these costs increases over time.
The average costs from Mr. Bogle’s article are not unreasonable. There are probably many investors paying this much or more. On the other hand, there are plenty of investors in active funds paying considerably less.
Where does all of this leave investors? First and foremost, it should be clear that costs matter a great deal. There will always be expenses associated with investing, but they vary widely. Over a lifetime, managing the expenses of investing can have a dramatic impact on your ability to build substantial savings. Whether or not you believe that actively-managed funds are worth their cost, every investor should know their own asset-weighted expense ratio.
- It’s Different This Time for Tech Stock Valuations
- Why Investing in Stocks in the Headlines Is Not a Good Idea
- The Inflation Paradox at the End of 2013
- The Facebook IPO: Why Gambling with Your Portfolio Rarely Pays Off
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As the market rally persists, many investors will no doubt be kicking themselves and wishing that they had bought in earlier. Some will convince themselves that they better get on board or risk missing out on this bull market. There are many good reasons to invest money, but choosing to get in because of the potential gains that you could have made is not one of them. In the same way that people capitulate and sell out near market bottoms, there is also a big behavioral driver that seems to make people capitulate and join the herd towards the end of big bull markets. I am not saying that we are poised for decline (I am not a good market timer), but simply noting that buy or sell decisions made on the basis of what you wished you had done last month or last year is often truly dangerous. Continue reading
Folio Investing’s Successful ETF-Based Alternative to Legacy Target-Date Funds Offers Superior Diversification, Risk Targeting and Flexibility; Firm Seeks Distribution Partner to Broaden Availability
Folio Investing announced today that, over the five years since they were brought to market in December 2007, its Target Date Folios have significantly outperformed traditional target-date funds. The Folios have provided both higher returns and lower volatility than the competing funds during this tumultuous period. Continue reading
About four and a half years ago, Folio Investing launched an equity (e.g. stock) portfolio that focused on reducing the impact of market volatility. So-called defensive stocks are those which tend to be fairly insensitive to the mood of the market as a whole. Conventional wisdom suggests that demand for band-aids, electricity and paper does not go up when the market is exuberant, but neither does it collapse when the market swoons. The conventional wisdom also suggests that these stocks will tend to under-perform the broader market during rallies and, over the long-term, that a portfolio of these stocks will deliver modest returns. Our research suggested, however, that it was possible to create a portfolio of defensive stocks that would provide returns to keep up with rallies in the broader market, while still substantially reducing the impact of market volatility. Folio Investing launched the Defensive Strategy Folio that incorporated this research on February 28, 2008. Continue reading
Utility companies are expected to provide fairly stable performance, without too much downside risk. Utilities are also typically expected to provide lower average returns than the broader market. In the last decade, however, utilities have out-performed the broader stock market as investors have become increasingly risk-averse and worried about the prospects for sectors that depend largely on robust economic growth in order to meet their earnings targets. Continue reading