When selecting investments or investment advisors, people get caught up in mutual fund star ratings and performance track records. Cost of investing is only briefly considered, regardless of the sophistication of the investor, until they start to realize they aren’t making much headway. I was reminded of this by a phone call today.
A client’s relative sits on a foundation board, and he’s concerned about the lack of communication and reporting he receives from the company that manages the foundation’s endowment fund. During our conversation I learned they’re being charged 1.25% on the entire balance of the fund each year. This is a HUGE fee for that size of investment. I calculated our management fee using the Asset Advisory Group’s schedule – only .35%. If the endowment grows by 6% per year, over a ten year period the savings would be $2.3 million – which doesn’t even include the fees charged by the mutual funds or sub-managers they use.
This same trap catches people trying to invest on their own. Index annuities are being recommended as a solution for investors afraid of the market – a way to experience stock market gains without the risk. I won’t address all the problems with these investment vehicles (you don’t want to read a 10 page blog) but they’re one of the most expensive investments you can make. The Florida Department of Financial Services describes them as “extremely complex investment products that contain many detrimental features such as hidden penalties, costs, fees, and massive, multi-year surrender charges.” Market value adjustments, administrative ‘spreads’ and internal costs of the mutual funds inside the contract run as high as 25% each year.
When selecting a mutual fund in their 401(k) plan, most investors look at past (especially recent) investment performance to choose. But cost, not an investment’s track record, is a better predictor of whether you will make money in a fund in the future. Morningstar, the company that provides mutual fund scorecards, published a report in August 2010 that concluded the best predictor of a mutual fund’s future results isn’t the genius of the investment manager; it’s the expense burden the fund carries. According to Russel Kinnel, director of mutual fund research at Morningstar, “In every single time period and data point tested, low-cost funds beat high-cost funds.”
If you don’t know what you are paying to invest, find out. Cost is important, and if you ignore it you do so at your own financial risk.