High Fees and Low Cost ETFs

If you are a serious investor and don't know who Jason Zweig is, you should.  His book, Your Money and Your Brain, is a must read.  Very well written, it will make every investor better.

Recently he has examined a use of ETFs, When Cheap Funds Cost Too Much,  that overrides one of their  biggest benefits:  low expenses.  As Zweig points out, some advisors use ETF strategists--thereby adding a 3rd layer of fees to the investment process.  There is the advisors's fee, the strategist's fee, and the expenses of the ETF itself.  He points out this can drive costs to between 1% and 3% of portfolio assets.  Included may be a transactions cost incurred when ETF funds are traded.

A broader issue Zweig discusses is that strategists frequently provide performance results that are not real client performance results - they are back-tested results.

All of this can be avoided, and is, by numerous advisors.  I, like some other advisors, for example, index the market, avoid the "middle man" strategist, and use mostly commission-free ETFs.  Performance, in line with the objective,  is going to be close to the benchmark.  For example, here is performance for a typical client (note that it is up-to-date and can be seen by the client anytime she wishes by going online!):

Source:Schwab

CLICK TO ENLARGE
As you can see, performance since inception of the account is within .20% (average cost of ETFs) of the benchmark.  Note that the benchmark is explicitly listed in the footnote.  Each client has a specific benchmark reflective of their risk tolerance.

My fee is .4% to set up the account, manage it on an ongoing basis, and rebalance as necessary - all mystery eliminated voila'. Total cost, all in, is .6%.  If she did it herself, it would be .2%.  As a matter of emphasis, the layers pointed out by Zweig results in the usual opaqueness in fees and costs that Wall Street is adept at creating.

Quote on Indexed Investing

One of the 3 or 4 books I recommend to those serious about learning investing is Your Money and Your Brain by Jason Zweig.  This is a book that will change the way you look at investing.  It is the single best intro to leading-edge research on the field of "neroeconomics" which carries out experimental research to understand how financial decisions are made.  It came to mind after reading the quote by Jason Zweig presented below.  I sheepishly discovered that I had not listed the book in my bookstore (link to the right) but have since added it.

I came across the quote when reading a piece entitled "How to Manage Your Investment Anxiety" by MarketRiders, an online portfolio management service.  The service is well worth considering for DIY investors and offers excellent free educational materials.

This is what Jason Zweig said about indexed investing:

Indexing enables you to say seven magic words: “I don’t know, and I don’t care.”
Will value stocks do better than growth stocks? I don’t know, and I don’t care – my index fund owns both. Will health care stocks be the best bet for the next 20 years? I don’t know, and I don’t care – my index fund owns them. What’s the next Microsoft? I don’t know, and I don’t care – as soon as it’s big enough to own, my index fund will have it, and I’ll go along for the ride.
Indexing enables me to say, “I don’t know, and I don’t care,” liberating me from the feeling that I need to forecast what the market is about to do. That gives me more time and mental energy for the important things in life, like playing with my kids and working in my garden.

MarketRiders goes on to point out that you can control the allocation of assets but not how the overall market will perform or how individual sectors will perform.  Focusing on what can be controlled frees up the investor from anxiety over what can't be controlled.

Well worth thinking about as we navigate today's volatile markets.

The Proteus Effect and Saving

If you are interested in behavioral economics or the psychology of investor behavior, read Jason Zweig.  His book Your Money & Your Brain is the classic in this field.

In a thought-provoking article, "Want to Retire Wealthier? Start by Scanning Your Photo,"  in Tuesday's Wall Street Journal, he described the research being done using, of all things, avatars.  He reports that research being done at Stanford University enables people to see themselves at retirement age via their avatar. This, in turn, gets them to save more. The use of avatars has worked in the area of increasing confidence by giving people an attractive avatar in virtual reality space. The research suggests it can help people save.

Now DIY Investor is admittedly low tech. He doesn't deal with avatars and such. He doesn't even have, as far as he knows, an avatar. In his low-tech style, he merely reminds clients that one day they will wake up and it will be their 65th birthday and whether they have choices depends on their saving behavior today. It's hard to tell how effective this is.

Who knows? Maybe avatars are the key to getting people to focus on the long term. As the article points out, research by the Center for Retirement Research at Boston College finds that over 50% of Americans are not in a position to maintain their lifestyle in retirement.

Interestingly, some people already have the talent to think longer term without putting on the headset and going into virtual reality space.  Warren Buffett, for example, thinks about the value of spending on a haircut today compared to investing the money for 30 years. Most advisors dwell on the spending that takes place at life's big events and wonder whether people give them sufficient weight. DIY Investor tends to think, as well, that not understanding the basic concept of compound interest plays an important role in people spending significant amounts on weddings, funerals, and the first two years of college.

Mr. Zweig points out that one difficulty is that people don't know what they will want 30 or 40 years from now, and this is a hindrance to saving. DIY Investor suggests that perhaps a better way to think about it is in terms of what you don't want. This is a good place for a little Zen. DIY Investor doesn't want to work part-time for Walmart.

One of the psychologists, Dan Goldstein,  working at Stanford suggests putting employee's "age-morphed" photo on benefits section of company website. Great! Now we'll be even more depressed in down markets with statements showing how we'll look at 65. Admittedly, this isn't as big a deal for DIY Investor as it might be for some of his readers.

Winners and Losers

Suppose you bought two stocks in 2007: Fannie Mae and Apple. Fannie Mae had a near monopoly on packaging mortgages to sell into the bottomless pit of demand for mortgage-backed securities. It was bumping along at $60ish/share. Apple had started the year at $85 and ended at $94. It had a reputation for coming out with "cool" products and being totally in tune with design. It did have the lingering questions of Steve Job's health.

We know the outcome. Today you need to tack on .ob to get a quote on Fannie Mae. It is trading as a penny stock around $.30/share. Apple, on the other hand, has gone on a moon shot in a very difficult market environment and is close to $250/share.

A big winner and a big loser. How would you have played it if you would have bought them? Everyone knows the dictum, first offered by a voice from the past: Edwin LeFevre- "Let your winners run and cut your losses quickly."

We have an indication of how the average investors handle winners and losers. Along with other evidence, Jason Zweig in "Your Money & Your Brain" reports that

"A look at more than 97,000 trades found that individual investors cashed in on 51% more of their gains than their losses - even though they could have raised their average annual returns by 3.4 percentage points (and cut their tax bills) if they had held on to the winners and dumped the losers."

Psychological Basis

Why do investors act exactly backwards and hold on to losers but grab profits too quickly? There's a psychological basis. Sell a loser, and the awkward possibility exists that it could immediately turn around - the mistake is compounded. In fact, anyone with any market experience knows the evil "Mr. Market" is lurking behind the bush just waiting for us to hit the sell button. Psychologically, taking action and it being wrong is more devastating than committing an error by not taking action. This is where the brain is playing tricks. So we hold on to the loser. The same effect takes place for our winners but in reverse. Taking a profit is a reward- a "pat on the back" as Zweig puts it. And we all like "pats on the back!" Especially when "Mr. Market" isn't being pleasant.

All of this is pretty much known by students of the market. What may not be appreciated quite as much is that the same behavior is likely at play when it comes to firing a poorly performing advisor. The same psychological factors are likely in play as clients hang on too long with poorly performing advisors and actively managed mutual funds for that matter. The possibility of making two bonehead moves is a restraining influence. And so both are held on to too long. At least that's my take. What's yours?