Thursday, July 20, 2017

Costs Matter!

Pathways Advisory Group, Inc.
Dustin J. Smith, CFP®

People rely on a lot of different information about costs when making any major financial decision. Whether you’re buying a car or selecting an investment strategy, it’s important to be informed about the costs. When you buy a car, as my wife knows all too well, you have to be patient and flexible to maintain purchase price leverage. However, the initial sticker price is only part of the overall cost of ownership. The sales tax, vehicle insurance, fuel efficiency, routine maintenance, and potential for unexpected repairs on the vehicle also need to be considered. Some of these additional costs are easily observed, while others are more difficult to assess. Similarly, when investing in mutual funds, many different variables need to be considered to evaluate how cost‑effective an investment strategy will be over time.

Many types of costs lower the net return of an investment strategy. One important cost to consider is the internal expense ratio of a mutual fund (returns to the investor are net of this internal cost). Similar to the purchase price of a car, this expense ratio tells you a lot about what you can expect to pay for an investment strategy. Exhibit 1 helps illustrate why expense ratios are important and shows how hefty expense ratios can impact performance.

This data shows that funds with higher average expense ratios had lower rates of outperformance. For the 15-year period through 2016, only 9% of the highest-cost equity funds outperformed their benchmarks. This data indicates that a high expense ratio is often a challenging hurdle for funds to overcome, especially over longer horizons. From the investor’s point of view, an expense ratio of 0.25% vs. 0.75% means savings of $5,000 per year on a $1 million account. As Exhibit 2 helps to illustrate, those dollars add up over longer periods.

Exhibit 1

Exhibit 2 

While the expense ratio is important to evaluate, what matters most when gauging the true cost‑effectiveness of an investment strategy is the “total cost of ownership.” Similar to the car example, total cost of ownership is more holistic than any one figure. It looks at things that are readily observable, like expense ratios, but also at things that are more difficult to assess, like trading costs and tax impact.

For example, while an expense ratio includes the fund’s investment management fee and expenses for fund accounting and shareholder reporting (among other items), it doesn’t include the potentially substantial cost of trading securities within the fund. Overall trading costs are a function of turnover (the amount of trading) and the cost of each trade. If a mutual fund trades excessively, costs like commissions and the price impact from trading can eat away at investor returns. Viewed through the lens of the car analogy, these costs are similar to excessively jamming your brakes or accelerating quickly. By regularly demanding immediacy when it may not be necessary, your vehicle experiences reduced fuel efficiency and additional wear and tear. These actions increase the total cost of ownership. Additionally, excessive trading within a strategy can lead to negative tax consequences for investors holding funds in a taxable account, which further increases the cost of ownership. The best way to decrease the impact of these trading costs is to avoid trading excessively and to effectively minimize the cost per trade. Employing a flexible investment approach, as described in this previous post, helps accomplish these goals by enabling more opportunistic execution.

The total cost of an investment strategy can be difficult to assess and requires a thorough understanding of costs beyond what an expense ratio can tell you. As you can see from this discussion, however, it’s worth the effort. These costs absolutely matter. A strategy that minimizes expense ratios, limits turnover and applies a flexible trading approach (only when the potential benefits of a trade outweighs the costs) has a clear advantage with time.

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The cost of advice, relative to the value realized, is an additional factor. There are many variations (both in services and costs). Each compensation model, investment philosophy and service model differs. There is a lot to consider. At the end of the day, it’s relatively simple - the benefits realized must outweigh the costs associated with the service. 

Source: Dimensional Fund Advisors LP

There is no guarantee investment strategies will be successful. Diversification does not eliminate the risk of market loss. Mutual fund investment values will fluctuate and shares, when redeemed, may be worth more or less than original cost. The types of fees and expenses will vary based on investment vehicle. Investments are subject to risk including possible loss of principal.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.