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IFA's Quote of the Week - 19 (Michael C. Keenan)

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"Fiduciaries should strongly consider index funds as an alternative to actively managed funds. Index funds incur about 80% less in transaction costs than actively managed funds…long-term returns for actively managed funds trail their respective indexes."

Michael C. Keenan, “The Elephant in the Living Room”, Financial Advisor Magazine, May 2008.

 

 

 

 

The investing spotlight continues to shine brightly on defined contribution retirement plans, threatening to expose hidden costs that investment managers audaciously believed they could foist upon unsuspecting plan sponsors and participants.  

In a flurry of momentous events that have transpired in just a few short weeks, the nearly 50 million American workers who participate in company-sponsored retirement plans, most commonly in the form of 401(k) plans, are poised to get some much-needed clarity on expenses, risks and returns associated with investing their retirement assets.

U.S. Rep. George Miller authored a bill to force disclosure of 401(k) fees and give incentives to companies that offer index funds as a plan option. Meanwhile, The SEC has set forth legislation that would improve the disclosure language regarding fees in the heretofore nebulous fund prospectuses. Not to be left out of the party, the Department of Labor has launched a bill that overlaps Miller’s bill, but one which critics say pales in comparison to Miller’s. Each of the three new regulations thrown on the table seeks to cast light on the hidden costs associated with company-sponsored retirement plans.

Michael Keenan’s article “The Elephant in the Living Room”, found in the May 2008 issue of Financial Advisor magazine, explains the real costs associated with most 401(k) plans—costs that are buried, despite the fact that they cost plenty and suppress returns. Keenan details the known (explicit) costs and hidden (implicit) costs of traditional 401(k) plans, giving plausible explanation as to why many 401(k) plans actually underperform their taxable account brethren.

Mistakenly presumed to carry the lion’s share of 401(k) costs, expense ratios are disclosed to plan sponsors and plan participants. Actively managed funds carry higher expense ratios. Active managers seek to beat the market through stock selection and market timing. They generally charge higher fees than passive managers as compensation for their perceived “skill.” Most often, these fees inflict a significant penalty on net investment returns. In both U.S. and non-U.S. strategies, the average actively managed mutual fund is considerably more expensive than the average passively managed fund.

The charts below reveal the disparity in expense ratios between actively managed funds and passively managed funds. Active managers, on average, charge more than twice the fees of passive managers. This is also true in the international fund universe, although the differences are not as large due to the higher costs of investing in non-U.S. markets.

When it comes to implicit or hidden costs associated with 401(k)’s, Keenan asserts that transaction expenses associated with actively managed funds are roughly equal to their also high expense ratios. Using research from a 2007 report provided by Investment Technology Group, Inc. (ITG) that studied data collected from its clients, which include “the vast majority of large fund managers in the U.S. and Europe”, Keenan determined that if an actively managed fund has 100% annual turnover, it incurs nearly 1% in transaction costs. When this occurs year after year, as is the case with active management, turnover expense is devastating to long-term portfolio growth.

Keenan states, “Index funds incur about 80% less in transaction costs than actively managed funds”. According to that assumption, index funds carry just 0.18% in annual transaction expenses.

The table below shows the turnover ratios of various funds for the one-year period for 2006. As you can see, passively managed index funds have far less annual turnover than actively managed funds. For example, the Dimensional Large Cap Value Fund had 9% annual turnover and the Dimensional Small Cap Value Fund had 27%--a sharp contrast to the Rock Canyon Top Flight Fund with turnover of more than 1600%. If we extrapolate from the ITG data, that fund’s turnover would have generated a whopping 15% in transaction expenses! What were they thinking?

The general excuse given by active fund managers is that they find opportunities to beat their index, and therefore their higher fees and transaction costs are worthwhile. The evidence, however, is to the contrary. The charts below show how rare it is that active beats passive.

Many investors know that excessive turnover triggers unpleasant tax consequences, but it significantly hampers returns for tax-advantaged accounts, as well. Plan participants suffer under the weight of these excessive and unreported fees. 

A movement is under way to clear away the smoke and mirrors associated with retirement investing. There is an acute hunger for clarity and useful information pertaining to the intrinsic relationship between active management and excessive returns, expenses and returns, risk and time, and risk capacity and risk exposure. The proposed solutions, while long overdue, will take time to resolve, implement, and will be met with the usual politicking that will erode precious time. But, investors need answers now. You can obtain a world-class investing lesson at ifa.com. Hundreds of peer-reviewed academic studies, charts, graphs, benchmarking tools, portfolio simulators, calculators and a risk capacity survey will help you learn and invest according to the Science of Investing.

IFA is an expert in providing professional investment education and advice, enabling individuals, 401 (k) plans, institutions and corporations to make sound decisions that can optimize their financial futures. IFA specializes in the passive rebalancing of risk-appropriate, globally diversified index portfolios that are low cost and efficient. To lean more, visit www.ifa.com.