Money Talks

I would like to have a conversation about money with you. If you submit your personal finance and investing questions, I will answer them. It will be much better if you do, because then I’ll know I’m writing about what you want to hear.

Why me?  I am a fully independent, fee-only financial advisor. I am not restricted to any investment product or service, and work exclusively for the benefit of my clients. In fact, as a registered investment advisor, I have a legal fiduciary obligation to act in the best interests of each of my clients. I look at financial issues from the client’s point of view. 

I have a unique and valuable perspective on the financial services industry having worked for a major brokerage firm, a major life insurance company and a small independent brokerage firm. I’ve been in private practice since 1989 as an independent, fee-only registered investment advisor. So, please, submit your questions.

Now, I’d like to talk about something in investing we can actually control, costs.  I met recently with a CPA who complained of lackluster returns in her retirement plan.  She wanted better performance. The first thing I wanted to know was what it cost her to invest in her funds.  

The best place to start is whether or not a mutual fund charges an up-front fee on each new investment, a front-end load or commission. There is no good reason to pay front-end loads in this day and age. My CPA friend got this one right. She knew was only investing in “no-load” mutual funds; funds that do not impose an upfront fee for investing.

But, front-end loads are only the beginning. Mutual funds are run by investment companies who charge a fee to the fund for the advisory and management services they provide.

This fee is called the “expense ratio” because it is expressed as a percentage of the total assets in the fund.  Expense ratios are not standardized and can range from 10 basis points (1⁄10 of one percent), like for Vanguard’s S&P 500 Index fund, to nearly 2.0% per year.

Further adding to the cost, her funds were “actively” managed. Meaning, the fund managers were actively seeking to identify the best stocks to own and the best time to own them.  Their research activities were reflected in the expense ratios of her funds, which ranged from 1.03% to a high of 1.66%. 

While how much you pay for fund management is an issue, what you get for what you pay is even more important. The question is, “Does the fund manager add value?”

The answer to this question is found in a calculation known as R2 (R squared). R2 is a statistical measure that represents the percentage of a fund’s price movements that are explained by movements in the market. In other words, R2 determines how much of the returns generated by a mutual fund are due to the market versus the skill of the manager. The calculation is expressed as a percentage and ranges from zero to 100.

A high R2 means that the market has had more to do with a fund’s performance than the manager’s stock picks. My CPA friend’s mutual funds had R2 calculations that ranged from 94 to 98.

What she didn’t know was that she was paying a premium to her fund managers to get what the markets were essentially offering for free. She would have done better investing in passively managed asset class funds (“index,” for lack of a better term) with substantially lower expense ratios. 

 Quality no-load asset class funds have expense ratios of 0.60% and lower. 

She also didn’t know that she was paying a 0.25% annual 12b-1 fee on each of her funds. 12b-1 fees can be imposed on mutual funds over and above the cost of management’s investment advisory activities to defray marketing and service related expenses. They are usually paid to the brokerage firm that originally sold the fund to the investor.

The irony of the fee in this case was that this CPA did not use the services of a brokerage firm. She purchased his funds directly from the mutual fund company. She needed to know, but didn’t, that she was paying an additional 0.25% per year for services that weren’t even being provided.  Which leads to the conclusion that savvy cost management can enhance returns no matter what the markets do.