Wharton MBAs & Harvard undergrads can't evaluate cheap index funds

[Nords]

Gosh, if these brainiacs can't evaluate the costs & rewards of index funds then what hope is there for us mortal investors?

Two words:  "Better marketing".

Their conclusion: Investors appear to have a poor grasp of the fee issue, failing to minimize fees even when the benefits are presented in a clear and incontrovertible disclosure.  "Most investors don't understand the importance of mutual funds' fees," Madrian notes.  Investors might benefit, she says, if regulators required fund companies to disclose fee information, and its importance, in a brief form providing standards for comparison -- something like the nutrition labels on food containers.  In other words, suggests Madrian, "Come up with something that is shorter, more digestible and more informative."

 

[brewer12345]

UYup. And we are probably never going to see the end of posters here trying to convince us that managed funds are a better choice.

 

[Cut-Throat]

I think it is the main job of the Fund managers to HIDE fees from investors.

I remember when I was working and I got a 401K statement and my number of shares went down with no detail information. I went to our CEO and told him that if OUR software put out a report like this, our clients would HANG us.

We asked the 401K Rep why my shares 'just disappeared' and it took him about half hour and 20,000 words to say 'they took it in fees'.

 

[wabmester]

There was a guy over at the diehards board a while back who basically tried to mirror various indices by simply buying the underlying shares. I don't know how many stocks you'd need to buy before you really had good diversification, but I liked that approach for buy-and-hold investors: 0% annual fees.

 

[saluki9]

Wharton and the other top B schools have little interest in having people invest more with low cost index funds.

Without fully priced active management funds there wouldn't be as many of those $125K + bonus jobs that their grads need.

 

[modlair]

I got my MBA back before index funds were popular enough to be a threat to anyone. Since then the defense presented from managed funds has been two pronged:

1) An array of universal excuses like:

Why does your fund underperform the S&P 500 and why do 80% of funds like yours not equal the S&P 500?

No investor can invest directly into the S&P 500 so you are comparing us to something you can't invest in. Also, we do beat the S&P 500 sometime and if you do careful research you will see that many funds never do. We stack up very well in the Lipper ratings vs other funds of our type. Don't compare apples to oranges.

Which is a nice, sincere bit of phraseology that has the powerful ring of respectable truth and avoids the issue. This is bad. What is worse is they all know it does.

Why does your fund vote its proxies with management over 80% of the time in stocks that declined that year.

We vote our proxies to maximize shareholder value regardless of management's position. This is shown by the 20% of the time we vote against management proposals or nominees on a ballot.

. . . and has nothing to do with how well we are treated by management during company visits.

Prong number 2 nowadays is:

Why shouldn't I buy ETFs devoted to sectors rather than your sector fund that has higher fees?


ETFs are not free. They have not just internal fees but also brokerage commission. And if they pay dividends, you will pay commission to reinvest them. Our sector funds don't charge commissions on reinvestment.

But sometimes with those factors considered, the ETF is still lower cost. Why should I pay your fees?

Well, you have to do what you think is best, and if you think investing your life's savings in some johnny come lately investment concept like ETFs is a superior configruration vs. our tried and true mutual fund products -- hey, there are thrill seekers everywhere.

Fund companies have been dropping fees relentlessly of late. They have no choice and they know it. There are a handful of companies that have managed to retain a reputation and they were always cheap. They have the advantage of being cheap and also having investors with big gains embedded. The tax hit keeps them (and me) paying fees.

 

[bpp]

There was a guy over at the diehards board a while back who basically tried to mirror various indices by simply buying the underlying shares. I don't know how many stocks you'd need to buy before you really had good diversification, but I liked that approach for buy-and-hold investors: 0% annual fees.

I do something like that for some my stocks, and there is a fair amount of extra record-keeping involved. If it weren't for tax issues, I would just buy an ETF instead.

Bpp

 

[Nords]

Fund companies have been dropping fees relentlessly of late.  They have no choice and they know it.  There are a handful of companies that have managed to retain a reputation and they were always cheap.  They have the advantage of being cheap and also having investors with big gains embedded.  The tax hit keeps them (and me) paying fees.

Oh, hogwash.

One of the world's better fund companies, Tweedy Browne, actually raised their fees during the last four years when their assets nearly quadrupled.

FundAlarm.com regularly notes fund companies who've raised fees, but I haven't read of any fee reductions with the consumer in mind. The amount of money managed by the fund industry has gone up by orders of magnitude yet those economies of scale haven't kicked in for us retail shareholders!

Yeah, I know Fidelity dropped their fees on their Spartan index funds and dropped the sales charges on their sector funds. I also notice that they did it right after Vanguard & American started eating their lunch... doesn't sound like much of an interest in the little guys.

 

[audreyh1]

Investors might benefit, she says, if regulators required fund companies to disclose fee information, and its importance, in a brief form providing standards for comparison -- something like the nutrition labels on food containers. 

Hah! Most people can't decipher nutrition labels, and most people don't bother to read them anyway......

Audrey

 

[maddythebeagle]

Business school grads ....It takes a bunch of engineers and computer nerds to spread the word I guess....

 

[cute fuzzy bunny]

I haven't read of any fee reductions with the consumer in mind.

Werent we talking about dodge and cox or oakmark funds (I forget which one) that pointed out that they've been regularly dropping their fees on some of their funds over the last ten years? It was either dodbx or oakbx...

You might have it on the "with the consumer in mind" piece though.

 

[HFWR]

Business school grads ....It takes a bunch of engineers and computer nerds to spread the word I guess....

Well, don't have a MBA, but I can attest that a BBA does very little to prepare you for running a bidnnes or managing a portfolio...

 

[ats5g]

Werent we talking about dodge and cox or oakmark funds (I forget which one) that pointed out that they've been regularly dropping their fees on some of their funds over the last ten years? It was either dodbx or oakbx...

You might have it on the "with the consumer in mind" piece though.

CFB,

It was OAKBX:

The expense ratio for OAKBX was over 1%. As of fiscal year ending September 30 of each year.

1996...2.50%
1997...1.50%
1998...1.31%
1999...1.18%
2000...1.24%
2001...0.98%
2002...0.96%
2003...0.93%
2004...0.92%
2005...0.89%

DODBX's expense ratio has been hovering around 0.53-0.60% for years.

- Alec

 

[CCdaCE]

The expense ratio for OAKBX was over 1%. As of fiscal year ending September 30 of each year.

1996...2.50%
1997...1.50%
1998...1.31%
1999...1.18%
2000...1.24%
2001...0.98%
2002...0.96%
2003...0.93%
2004...0.92%
2005...0.89%

DODBX's expense ratio has been hovering around 0.53-0.60% for years.

- Alec

And what have their Assets Under Mgmt. been doing?  2.5% of 100 MILLion is less than .89% of 10 BILLion.  Are they still takin' a big rake?

Not that I care, I don't own the fund.  Just "perverse" curiosity.   I said ASSets.

-CC

 

[ats5g]

And what have their Assets Under Mgmt. been doing? 2.5% of 100 MILLion is less than .89% of 10 BILLion. Are they still takin' a big rake?

Not that I care, I don't own the fund. Just "perverse" curiosity. I said ASSets.

-CC

From the above link:

Well geez, I would hope OAKBX lowered their expense ratio given the massive asset increase.

9/30/1997 33,462,513
9/30/1998 57,745,855
9/30/1999 60,317,591
9/30/2000 54,935,837
9/30/2001 623,356,396
9/30/2002 2,360,587,003
9/30/2003 4,384,649,011
9/30/2004 8,056,557,682
9/30/2005 9,805,219,823

- Alec

 

[cute fuzzy bunny]

Clearly they felt bad about raking in all that money. Or maybe they ran out of places to put it.

Shame too because I liked OAKBX and dropped it because of the >1% fees. When DODBX was doing as well for less than half the cost, and vanguard offered similar performing funds for less than half of DODBX's ER...it did cause a little introspection...

 

[Nords]

Let's see, those numbers would imply that in 1997 they pulled in $501,937.70 and in 2005 they were looking at approx $87,266,456.  (Give or take a few bucks.)

AUM went up by a factor of 293 and compensation rose by a factor of 173.8.

Yeah, I think they're being adequately compensated for their efforts.  I don't think we need to bind the mouths of those kine.

OK, now let's go look at the rest of the mutual funds...

 

[justin]

Gosh, if these brainiacs can't evaluate the costs & rewards of index funds then what hope is there for us mortal investors?

Sarcasm, I assume

These students at Harvard and UPenn probably aren't used to selecting goods or services based on cost alone (hence the choice for Harvard and Upenn : ). My guess is these kids grew up in well-to-do households and haven't had much experience dealing with money matters. That's probably a safe generalization for most undergrads in general though.

I wonder if the results would have been different if the study was conducted at a college campus (such as a state school) where the median parental income was much lower, but the students were still smart (though not quite Harvard quality). Somewhere that the kids value hard work and money (Utopia State University ).

Another critique of this study - they focused on college students. People who in general don't have much experience with mutual fund investing. Not many of them have IRA's and 401k's like the rest of us white collar working stiffs. Maybe a study focusing on Harvard or Wharton alumni 5-10 years after beginning work would be a better sample (smart kids who have had the opportunity to earn money and set up 401k's and IRA's).*

I wouldn't expect to get valid results if I conducted a study on pop music or Americal Idol if I went down to the VFW and interviewed a bunch of WW II vets. (no disrespect intended to Jarhead or other vets )


* Based on observing the 401k investing patterns of my 20-something colleagues at work, I don't know if they'd be any savvier on the Mutual Fund Expense study than the Harvard and Upenn students.

 

[bpp]

These students at Harvard and UPenn probably aren't used to selecting goods or services based on cost alone (hence the choice for Harvard and Upenn : ). My guess is these kids grew up in well-to-do households and haven't had much experience dealing with money matters. That's probably a safe generalization for most undergrads in general though.

I wonder if the results would have been different if the study was conducted at a college campus (such as a state school) where the median parental income was much lower, but the students were still smart (though not quite Harvard quality).

I wouldn't be so sure that the median family income at Harvard is higher than at a state school. (The mean income is likely much higher, though.) Most of the kids there are on some kind of assistance. And financial aid packages often include some worky-study component, so kids on assistance work for at least part of their education wherever they go to school.

Another critique of this study - they focused on college students. People who in general don't have much experience with mutual fund investing.

I think that is the real issue. It is not obvious upon uninformed, if gifted, reflection that low costs would outperform (presumptive) skill. That is not true in many other areas of life, and it takes some digesting of data and analysis to see that this happens to be true for mutual funds.

Bpp

 

[d]

research based upon the responses of students is suspect from the beginning.

 

[cute fuzzy bunny]

You could cut off that statement right after the word "of" and it'd still be valid.

 

[doushioukanaa]

UYup.  And we are probably never going to see the end of posters here trying to convince us that managed funds are a better choice.

With any product or service offering, there are always organizations that create systems that deliver the goods at a better value for the money for particular segments of the market.  I do agree with the notion that many if not most managed funds are not a better value for the money than an index fund.  I also agree with the premise that low cost index funds offer a good value for the money to a large segment.

However, if there exists a fund or fund family that has a management system that delivers a good risk/return ratio consistently, sustainably, scalably, at reasonable cost, and with limited manager risk due to a team approach, why should they be ruled out of consideration?

In order to drill down to a specific example, if you had enough to invest in A shares of American Funds' Capital Income Builder to avoid any up front loads (and I realize that is a big "if"), why wouldn't you consider them for a big chunk of your portfolio?  Sorry to sound like a shill for a specific fund but it's actually in my own best interests to keep the fund a secret so that it doesn't get larger faster. 

Capital Income Builder (CAIBX) spits off ~4% in income per year, close to the standard SWR, while the principle goes up well in excess of inflation.   Its annual costs are only .57%.  It has matched the total market over the past 10 years with far less volatility.  It lagged during the entire tech bubble, but went up in 2002 when the total market was down over 20%.  They never change their mandate; they have cracked the code of how to scale the business without sacrificing performance, and now all the other fund families are trying to emulate them. 

I'm paying a premium of .48% over the .09% I could get in an index fund.  I'm getting more income, comparable returns, lower volatility, international exposure, etc.  I think that .48% is well worth it.  Am I foolish to have a good chunk of my portfolio there if I was able to purchase at NAV?  I am open to the arguments and really want to hear why I should switch out into an indexing approach. 

 

[free4now]

Congress should require that your financial statements include an accounting of how much fees/costs/loads/etc you pay. Reading through a prospectus to seek out all the possible fees that might apply to you is difficult, but when your brokerage statement shows that 2% of your egg was lost to fees, many people will have a "hmm" moment.

 

[brewer12345]

With any product or service offering, there are always organizations that create systems that deliver the goods at a better value for the money for particular segments of the market.  I do agree with the notion that many if not most managed funds are not a better value for the money than an index fund.  I also agree with the premise that low cost index funds offer a good value for the money to a large segment.

However, if there exists a fund or fund family that has a management system that delivers a good risk/return ratio consistently, sustainably, scalably, at reasonable cost, and with limited manager risk due to a team approach, why should they be ruled out of consideration?

In order to drill down to a specific example, if you had enough to invest in A shares of American Funds' Capital Income Builder to avoid any up front loads (and I realize that is a big "if"), why wouldn't you consider them for a big chunk of your portfolio?  Sorry to sound like a shill for a specific fund but it's actually in my own best interests to keep the fund a secret so that it doesn't get larger faster. 

Capital Income Builder (CAIBX) spits off ~4% in income per year, close to the standard SWR, while the principle goes up well in excess of inflation.   Its annual costs are only .57%.  It has matched the total market over the past 10 years with far less volatility.  It lagged during the entire tech bubble, but went up in 2002 when the total market was down over 20%.  They never change their mandate; they have cracked the code of how to scale the business without sacrificing performance, and now all the other fund families are trying to emulate them. 

I'm paying a premium of .48% over the .09% I could get in an index fund.  I'm getting more income, comparable returns, lower volatility, international exposure, etc.  I think that .48% is well worth it.  Am I foolish to have a good chunk of my portfolio there if I was able to purchase at NAV?  I am open to the arguments and really want to hear why I should switch out into an indexing approach. 

I guess the real problem is that you have no guarantee whatsoever that the historical performance, style, management, etc. of a managed fund will continue to persist. What if the management team at the fund you own turns over and the new crowd isn't as good? What happens if asset bloat finally weighs down the fund? What happens if the American Funds management company changes hands to new ownership that has different ideas about how to run the business? Most or all of these considerations do not apply to index funds/ETFs, plus they are ahead from day 1 on expenses, turnover and tax efficiency.

Having said that, I've no doubt that some managers can consistently beat the market/deliver aplha. Its just that it tends not to persist for various reasons. Add in the cluelessness of most retail investors, and you have an ugly situation where the investors can't pick the best managers and the best managers tend to go elsewhere over time even when the retail schmoe does manage to stumble into a good fund. After all, hedge funds pay far better than mutual funds, so anyone with skill and ambition has had to at least think about hopping the fence.

 

[doushioukanaa]

I guess the real problem is that you have no guarantee whatsoever that the historical performance, style, management, etc. of a managed fund will continue to persist.  What if the management team at the fund you own turns over and the new crowd isn't as good?  What happens if asset bloat finally weighs down the fund?  What happens if the American Funds management company changes hands to new ownership that has different ideas about how to run the business?  Most or all of these considerations do not apply to index funds/ETFs, plus they are ahead from day 1 on expenses, turnover and tax efficiency.

Having said that, I've no doubt that some managers can consistently beat the market/deliver aplha.  Its just that it tends not to persist for various reasons.  Add in the cluelessness of most retail investors, and you have an ugly situation where the investors can't pick the best managers and the best managers tend to go elsewhere over time even when the retail schmoe does manage to stumble into a good fund.  After all, hedge funds pay far better than mutual funds, so anyone with skill and ambition has had to at least think about hopping the fence.

All really good points.

I guess my inside information about the fund by knowing one of the fund managers is the X Factor that gives me the confidence that key staff retention is good and that their team approach is for real. This obviates the risk of a star manager departing and impacting the fund.  The acquisition risk is something I hadn't thought of.  I could lose out on some big tax deferred gains if I lose confidence and need to trade into an index fund.

Now, everybody, ignore what I said and don't buy CAIBX -- I don't want to expedite their path to bloat!  ;-)