Why shouldn’t you trust your money to a broker or agent who claims to be able to successfully pick winning stocks or funds?
Let’s say you have $100,000 to invest. An investment manager – a mutual fund manager, stock broker or private account manager – will offer, for a fee, to manage your money. That’s active professional investment management. The typical fee for this management is 1 percent of the account’s balance per year, but this rate can vary widely and often runs up to 1.5 to 2 percent. Mutual fund managers typically take their fee daily, while private money manager usually bill quarterly.
Why would you agree to pay? What are you paying for? Going down this path requires that you pay, without regard to results. On a $100,000 balance, at 1 percent, you’re agreeing to pay $1,000 per year, period. For what? The manager will say it’s for “professional management”, but there is no universal definition for professional management. The fact is that you’re agreeing to pay for something without any real knowledge about what you’ll get in return. You’re making an expensive bet, and like all bets, you shouldn’t make it unless you know its odds.
You have the option of investing in the market its self through index funds, like the funds offered in your TSP account. My aggressive advocacy for the TSP over past fifteen, or so, years is largely based upon its use of index funds. Index funds give you lowest cost access to the investment risk and return of the entire investment market, or any sub-market you might want, in a single security. In the TSP, you can invest in the stock and bond markets, easily and almost for free. If the S&P 500 index of stocks goes up by 10 percent next year, your C Fund shares will increase in value by that same 10 percent, less the tiny 0.05 percent they bear. You’ll realize a 9.95 percent return. If, instead, you invest in that same market and pay 1 percent in management fees, your realized return will drop to 9.0 percent, a decrease of nearly 9.5 percent compared to the C Fund. The extra 0.95 percent fee you pay for active investment management – stock picking and timing – becomes a hurdle that must be overcome by the manager just to break even with the C Fund. You will lose money by paying for active investment management unless the manager is successful enough to make it over the cost hurdle.
The cost of active professional investment management is 100 percent certain. You will pay,
regardless of the manager’s performance. But, what are the odds of the bet paying off – the
odds that the manager will produce enough return, above what the market produces on its own,to overcome the fee you’ve paid? It’s hard to say. The investment management business is frustratingly opaque and verified long-term track records are rare. What is there, however, isn’t inspiring. Charles D. Ellis, a leading institutional investing consultant, and author of “Winning the Loser’s Game”, research the track record for mutual fund managers and found that 60 percent failed to clear the hurdle in any given year, 70 percent failed over 10 years, and 80 percent failed over 20 years. He found that before accounting for cost of fees, active professional management is about as likely to lag the market as to beat it. Why is this? Why can’t the best minds in the investing world, with the best resources and access to information and analysis reliably beat the market? The answer is actually fairly simple, and the results just what we should expect.
Investing is a zero-sum game. Take the S&P 500 index tracked by the C Fund as an example. That market for the stocks of 500 leading U. S. based corporations will produce some return over the coming 12 months. You can own very nearly all of this return by investing in the C Fund. And, this return is the aggregate return for all of the investments in this market. The market is the investors. And, like a poker game, every dollar made by one investor is a dollar taken from another. If the S&P 500 produces a 10 percent return for the year, that’s the average return all the investments made in that market during the year. For every investor who makes more than 10 percent, there must be another who makes less. For everyone who beats the market, there must be someone who lags it. The investment markets are a competitive game for profits that is dominated by professional institutional investment managers. For any of these managers to consistently win the game, year after year, they would have to corner the market on some special skill or resource. They would need to be, in effect, the best player in the game.
Among the large institutional investment managers, the playing field is remarkably level. This is because there is plenty of talent available and the market for this talent efficiently spreads it around. Every year, there will be winners who beat the market average, and losers who lag it. Accurately predicting who will win or lose, and when, is impossible, and in the end it’s up to chance. Over 20 years, any professional manager will win some years and lose some. In the end, the wins and losses will tend to even out and a good manager’s performance will likely wind up matching the market’s average, before costs and fees.
After costs and fees, all portfolios are more likely to lag the market than to beat, or even match it. The expected return for any portfolio, managed or index, is the market’s return for the period, minus the costs and fees. So, the smart bet is on the investment portfolio with the lowest cost, and on this measure the TSP can’t be beaten.
Written by Mike Miles
For the Federal Times
Publication March 10, 2014