MONEY Master the Game: 7 Simple Steps to Financial Freedom (19 page)

David Swensen is the chief investment officer of Yale’s endowment. He has grown the fund from $1 billion to more than $23.9 billion, and he is considered to be the Warren Buffett of institutional investing. When I sat down with him in his Yale office, I was enlightened yet angered when he shared the
real
truth regarding the “fee factories” that are slaughtering Americans. David shared, “Overwhelmingly, mutual funds extract enormous sums from investors in exchange for providing a shocking disservice.” Later in the book, we will sit down and look over David’s shoulder at his portfolio recommendations, but it doesn’t matter how great your strategy is if excessive fees are eroding the path beneath your feet.

The “asset gathering” complex and the actively managed mutual funds they peddle are, for the most part, a disastrous social experiment that began with the advent of the 401(k) in the early ’80s. The 401(k) was not a “bad” concept. It was a good idea for those who wanted to put extra money away. But it was just meant to be a supplement to a traditional pension plan. Today there is over $13 trillion in managed mutual funds, much of which is held in retirement accounts such as 401(k)s and IRAs. They were supposed to
get us to our retirement goals. They were supposed to beat the market. But not only do they rarely beat the market, a significant majority are charging astronomical fees for their mediocrity. The aggregate of these fees will ultimately cost tens of millions of people their quality of life and could very well be the number one danger and destroyer of your financial freedom. Sound like an overstatement?

Jack Bogle, founder of Vanguard, says, “I think high costs [eroding already lower returns] are as much of a risk for investors as the [economic situation] in Europe or China.”

IT GETS WORSE

So let’s recap. Not only will the vast majority (96%) of actively managed mutual funds
not
beat the market, they are going to charge us an arm and leg, and extract up to two-thirds of our potential nest egg in fees. But here is the kicker: they are going to have the nerve to look you in the eye and tell you that they truly have your best interests at heart while simultaneously lobbying Congress to make sure that is never the case.

THE TRUTH/SOLUTION

First, you need to know how much you are paying! I recommend visiting the investment software website Personal Fund (
www.PersonalFund.com
) for its cost calculator, which analyzes each of your funds and looks beyond just the expense ratio to the additional costs as well.

Keep in mind, these calculators can only estimate the fees. They can’t take into account other costs such as taxes because each person’s tax bracket may differ. You may also own the mutual fund inside your 401(k), in which you won’t be paying taxes on the growth but instead will be paying a “plan administrator.” Some 401(k) plans are low-cost, while others are hefty with expenses. The average plan administrator charges 1.3% to 1.5% annually (according to the nonpartisan Government Accountability Office). That’s $1,300 for every $100,000 just to participate in the 401(k). So when you add this 1.3% for the plan administration to the total mutual fund costs of 3.17%, it can actually be
more
expensive to own a fund in a tax-free account when compared with a taxable account (a whopping total of 4.47% to 4.67% per year)!!!

Think about it: you are saving 10%, but half of it is being paid in fees. How insane is that? But as you’ll learn here, you don’t have to be caught in this trap. By becoming an insider, you can put a stop to this thievery today. Fees this high are the equivalent of climbing Everest in flip-flops and a tank top. You were dead before you got started.

ESCAPE

To escape the fee factories, you must lower your
total annual fees
and associated investment costs to 1.25% or less, on average. This means the cost of the advice (a
registered investment advisor
to help you allocate appropriately, rebalance your portfolio periodically, and so on)
plus
the cost of the investments should ideally be 1.25% or less. For example, you might be paying 1% or less to the registered investment advisor and 0.20% for low-cost index funds like
those offered through Vanguard (for a total of 1.2%).
And
the 1% paid to the advisor as a fee can be tax deductible. Which means your “net” out-of-pocket cost is close to half, depending on your tax bracket. Most Americans use a typical broker where the commissions aren’t deductible, nor are those expensive fees the mutual fund charges. (We will discuss the difference between a broker and a registered investment advisor shortly. You don’t want to miss this one!)

In section 3, we will show you step by step how to dramatically reduce your fees and legally reduce your taxes. And all that money you save will accelerate your path to financial freedom.

NEVER AGAIN

Now that you know how the game is played, now that you have looked behind the curtain, make the decision that you will never be taken advantage of again.
Resolve right now that you’ll never again be one of the many. You’re becoming an insider now.
You are the chess player, not the chess piece. Knowledge is power, but execution trumps knowledge, so it’s what you do from here that will matter. Yes, I will show you exactly
how
to reduce your fees, but you must decide to take the necessary action. You must declare that you will
never again
pay insane fees for subpar performance. And if this book can save you 2% to 3% per year in unnecessary fees, we just put hundreds of thousands of dollars, maybe even millions, back in your pocket.
Said another way, this could get you to your goal that much quicker and save you 5 to 15 years of accumulation time so that you can retire sooner if you so choose.

By simply removing expensive mutual funds from your life and replacing them with low-cost index funds you will have made a major step in recouping up to 70% of your potential future nest egg! How exciting! What will that mean for you and your family? Vanguard has an entire suite of low-cost index funds (across multiple different types of asset classes) that range between 0.05% and 0.25% per year in total “all-in” costs. Dimensional Funds is another great low-cost index fund provider. If you don’t have access to these low-cost providers in your 401(k), we will show you how to make that happen. And while low-cost index funds are crucial, determining how much of each index fund to buy, and how to manage the entire portfolio over time, are the keys to success. We will cover that in the pages ahead.

Now that you have resolved to take action, to whom do you turn? Who do you trust as a guide? Going back to your broker to help you save on fees is like going to your pharmacist to help you get off meds. How do you find conflict-free advice? And how do you know that the guidance you’re getting isn’t in the best interest of the person on the other side of the desk? Turn the page to uncover Myth 3, and let’s get answers to these pressing questions. . . .

BREAK IT DOWN

If you really want to know how badly you’re being abused through hidden fees, take a moment and review a sample list below of some of the core fees and costs that impact your mutual fund investments:

BREAKOUT OF FEES

1. 
Expense Ratio.
This expense is the main “price tag”—the number they want us focused on. But it certainly doesn’t tell the whole story. According to Morningstar, US stock funds pay an average of 1.31% of assets each year to the fund company for portfolio management and operating expenses such as marketing (12b-1 fees), distribution, and administration. Many of the larger funds have realized that a 1% ballpark expense ratio is where they want to come in so that investors don’t flinch and brokers have a good story to sell—I mean,
tell.

2. 
Transaction Costs.
Transaction costs are a broad, sweeping category and can be broken down further into categories such as brokerage commissions, market impact costs (the cost of moving the market as mutual funds trade massive market-moving positions), and spread costs (the difference between the bid-and-ask or the buy-and-sell price of a stock). A 2006 study by business school professors Roger Edelen, Richard Evans, and Gregory Kadlec found that US stock mutual funds average 1.44% in transaction costs per year. This means that these transaction costs are
perhaps the most expensive component of owning a mutual fund, but the industry has deemed it too tough to quantify, and thus it goes unreported in the brochures.

3. 
Tax Costs (or 401[k] Costs).
Many people are excited about the “tax-deferred” treatment of their 401(k), but for most employees, the tax cost has been swapped out with “plan administrative” fees. These are charged
in addition
to the fees paid to the underlying mutual funds, and according to the nonpartisan GAO (Government Accountability Office), the average plan administrator charges 1.13% per year! If you own a mutual fund in a taxable account, the average tax cost is between 1.0% and 1.2% annually, according to Morningstar.

4. 
Soft-Dollar Costs.
Soft-dollar trading is a quid pro quo arrangement whereby mutual fund managers choose to pay inflated trading costs so that the outside firm executing their trades will then rebate the additional cost back to the fund manager. It’s a rewards program for using a particular vendor. The frequent flier miles of Wall Street. The fund manager can use these funds to pay for certain expenses such as research and reports. These are costs the fund manager would otherwise have to pay, so the net result is that you and I pay! These are simply well-disguised increases in management revenue that hit the bottom line. They’re unreported and nearly impossible to quantify, so we aren’t able to include them in our equation below, but make no mistake, it’s a cost.

5. 
Cash Drag.
Mutual fund managers must maintain a cash position to provide daily liquidity and satisfy any redemptions (selling). Since cash is not invested, it doesn’t generate a return and thus hurts performance. According to a study titled “Dealing with the Active,” authored by William O’Rielly, CFA, and Michael Preisano, CFA, the average cost from cash drag on large-cap stock mutual funds over a ten-year time horizon was 0.83% per year. It may not be a direct fee, but it’s a cost that takes away from your performance.

6. 
Redemption Fee.
If you want to sell your fund position, you may pay a redemption fee. This fee is paid to the fund company directly and the US Securities and Exchange Commission (SEC) limits the redemption
fee to 2%. Like the world’s most expensive ATM, it could cost you $2,000 to get back
your
$100,000!

7. 
Exchange Fee.
Some funds charge a fee to move or exchange from one fund to another within the same family of funds.

8. 
Account Fee.
Some funds charge a maintenance fee just to have an account.

9. 
Purchase Fee.
A purchase fee, not to be confused with a front-end sales load (commission), is a charge to purchase the fund that goes directly to the fund company.

10. 
Sales Charge (Load) or Deferred Sales Charge.
This charge, typically paid to a broker, either comes out when you purchase the fund (so a smaller amount of your initial deposit is used to buy shares in the fund)
or
you pay the charge when you exit the fund and redeem your shares.

5
. Robert Hiltonsmith and his research were featured on a terrific
Frontline
documentary called
The Retirement Gamble,
which first aired on PBS on April 23, 2013.

CHAPTER 2.3

MYTH 3: “OUR RETURNS? WHAT YOU SEE IS WHAT YOU GET”

Surprise, the returns reported by mutual funds aren’t actually earned by investors.

—JACK BOGLE, founder of Vanguard

Most people are familiar with the boilerplate disclaimer that past performance doesn’t guarantee future results. Far fewer are aware of how past performance numbers themselves can be misleading.