Millionaire Teacher (7 page)

Academics refer to something they call “reversion to the mean.” In practical terms, actively managed funds that outperform the indexes typically revert to the mean or worse. In other words, buying the top historically performing funds can end up being the kiss of death.

If an adviser had decided to purchase Morningstar's five-star rated funds for you in 1994, and if he sold them as the funds slipped in the rankings (replacing them with the newly selected five-star funds), how do you think the investor would have performed from 1994 to 2004 compared with a broad-based U.S. stock market index fund?

Thanks to
Hulbert's Financial Digest,
an investment newsletter that rates the performance predictions of other newsletters, we have the answer which is emphasized in
Figure 3.2
.

Figure 3.2
Five-Star Funds vs. Total Stock Market Index (1994–2004)

Source:
John C. Bogle
, The Little Book of Common Sense Investing

One hundred dollars invested and continually adjusted to only hold the highest rated Morningstar funds from 1994 to 2004 would have turned into roughly $194, averaging 6.9 percent annually.

One hundred dollars invested in a broad-based U.S. stock market index from 1994 to 2004 would have turned into roughly $283, averaging 11 percent annually.
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If you add further taxable liabilities, the results for the Morningstar superfunds would look even worse. You might as well be running with a monkey on your back.

One hundred dollars invested and continually adjusted to only hold the highest rated Morningstar funds from 1994 to 2004 would have turned into roughly $165 after taxes, at 5.15 percent annually.

One hundred dollars invested in a broad-based U.S. stock market index from 1994 to 2004 would have turned into roughly $271 after taxes, at 10.5 percent annually.

Interestingly, more than 98 percent of invested mutual fund money gets pushed into Morningstar's top-rated funds
25

But choosing which actively managed mutual fund will perform well in the future is, in Burton Malkiel's words: “. . . like an obstacle course through hell's kitchen.”
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Malkiel, a professor of economics at Princeton University and the bestselling author of
A Random Walk Guide to Investing
, adds:

There is no way to choose the best [actively managed mutual fund] managers in advance. I have calculated the results of employing strategies of buying the funds with the best recent-year performance, best recent two-year performance, best five-year and ten-year performance, and not one of these strategies produced above average returns. I calculated the returns from buying the best funds selected by Forbes magazine . . . and found that these funds subsequently produced below average returns.
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Still, most financial advisers won't give up. Their livelihood depends on you believing that they can do it, that they can find funds that will beat the market indexes.

Before we were married, my wife Pele was being “helped” by the U.S.-based financial service company Raymond James. <
www.raymondjames.com/personal_investing/
> She was sold actively managed mutual funds, and on top of the standard, hidden mutual fund fees, she was charged an additional 1.75 percent of her account value every year. An ongoing annual fee such as this—called a wrap fee, adviser fee, or account fee—is like a package of arsenic-laced cookies sold at your local health food store. Why did her adviser charge her this extra fee? Let's just say the adviser was servicing my wife the way the infamous Jesse James used to service train passengers—by taking the money and running.

According to a 2007 article published in the U.S. weekly industry newspaper
Investment News,
Raymond James representatives are rewarded more for generating higher fees:

In the style of a 401(k) plan, the new deferred-compensation program this year gives a bonus of 1% to affiliated [Raymond James] reps who produce $450,000 in fees and commissions, a 2% bonus for $750,000 producers, and 3% for reps and advisers who produce $1 million. After that, the bonus, which will affect about 500 of the firm's 3,600 reps, increases one percentage point for every additional $500,000 in production, topping out at 10% for reps who produce $3.5 million in fees and commissions. That pushes those elite reps' payout to 100%—or even more—of their production, according to the company.
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With pilfering incentives like these, salespeople and advisers make out like sultans.

Looking at my wife's investment portfolio in 2004, after tracking her account's performance, I calculated that her $200,000 account would have been $20,000 better off if she had been with an index fund over the previous five years, instead of with her adviser's actively managed mutual funds. In my calculation, I included the 1.75 percent annual “fleecing” fee her adviser charged, on top of the mutual funds' regular expenses.

When Pele asked her adviser about her account's relatively poor performance, he suggested some new mutual funds. When Pele asked about index funds, he dismissed the idea. Perhaps he had his eye on a big prize: a Porsche or an Audi convertible. He couldn't afford either if he bought his client index funds. So he switched her into a group of different actively managed funds that had beaten the indexes over the previous five years—all had Morningstar five-star ratings.

And how did those new funds do from 2004 to 2007? Badly. Despite the strong track records of those funds, they performed poorly, relative to the market indexes, after he selected them for Pele's account. So Pele fired the guy, and I married Pele.

Over an investment lifetime, it's a virtual certainty that a portfolio of index funds will beat a portfolio of actively managed mutual funds, after all expenses. But over a one-, three-, or even a five-year period, there's always a chance that a person's actively managed funds will outperform the indexes.

At a seminar I gave in 2010, a man I'll call Charlie, after seeing the returns of an index-based portfolio, said: “My investment adviser has beaten those returns over the past five years.”

That's possible, but the statistical realities are clear. Over his investment lifetime, the odds are that Charlie's account will fall far behind an indexed portfolio.

In July 1993,
The
New York Times
decided to run a 20-year contest pitting high-profile financial advisers (and their mutual fund selections) against the returns of the S&P 500 stock market index.

Every three months, the newspaper would report the results, as if the money was invested in tax-free accounts. The advisers were allowed to switch their funds, at no cost, whenever they wished.

What started out as a great publicity coup for these high-profile moneymen quickly turned into what must have felt like a quarterly tarring and feathering. After just seven years, the S&P 500 index was like a Ferrari to the advisers' Hyundai Sonatas, as revealed in
Figure 3.3
.

Figure 3.3
The New York Times
investment Contest

An initial $50,000 with the index fund in 1993 (compared with the following respective advisers' mutual fund selections) would have turned into the preceding sums by 2000.
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Mysteriously, after just seven years,
The
New York Times
discontinued the contest. Perhaps the competitive advisers in the study grew tired of the humiliation.

Finding help without a conflict of interest

I'll liken the average financial adviser to chocolate cake. Can following a decadent nutritional plan of sugary baked goods make you feel good? Sure, for about 30 seconds as your taste buds relish the sticky sweetness. But the average financial adviser is as good for your long-term wealth as a chocolate cake diet is to your long-term health.

That said, there are financial advisers who charge by the hour for objective advice. While no one wants to add another bill to the pile, a “fee-only” financial planner charging an hourly rate can be a professional partnership that helps you create a successful portfolio of index funds.

For Americans, there's an easy option. You can give your money to Vanguard, <
www.vanguard.com
> a U.S.-based, nonprofit financial service company that happens to be the world's largest provider of index funds. You pay a small fee of $250 a year, and an adviser working for Vanguard will help you invest your money. When your account exceeds $250,000, the service is free.

AssetBuilder <
www.assetbuilder.com
> is another option. Based in Texas, this company charges low fees to operate as a broker that purchases index funds through a group called Dimensional Fund Advisors <
www.dfaus.com/
>. The small annual percentage fee for the service allows you to wipe your hands clean of managing your money yourself.

The following companies also charge low fees to build accounts of index funds for U.S. clients: RW Investments <
www.rwinvestmentstrategies.com/background.html
> (based in Maryland), Aperio Group <
www.aperiogroup.com/
> (based in California), and Evanson Asset Management <
www.evansonasset.com/
> (based in California).

There are other companies offering similar services. But be careful. Not all “fee-only” businesses offer low-fat services.

Where hidden calories lie

The number of fee-only, certified financial planners is increasing in the U.S. But you have to be careful. Fee-based adviser, Bert Whitehead, says in his book,
Why Smart People Do Stupid Things with Money
, that there are many organizations (such as American Express) that offer supposedly fee-based services, charging a small fee for a consultation, but they actually stuff investment accounts with their own brand of actively managed mutual funds and insurance products.
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Actively managed mutual funds pad the coffers of investment service companies, so they are good for the businesses that sell you such products, but they're not good for you.

My hope, though, is that this book will give you every tool required to build portfolios of index funds yourself. Then you can hire a trustworthy accountant to provide advice on tax-sheltered accounts. Seeking an accountant's advice, you'll confidently avoid every conflict of interest corrupting the financial service industry—as long as your accountant doesn't sell financial products on the side.

For a review, however, let's take another look at total stock market index funds and actively managed mutual funds with a side-by-side comparison.

Table 3.1 Differences between Actively Managed Funds and Index Funds