Paul Winkler: Welcome, this is “The Investor Coaching Show.” I’m Paul Winkler, talking about money and investing and dispelling some of the myths and misinformation. I was a broker for about a decade, working for the big investment companies and being told go out and sell something, without knowing a whole lot.
The Blind Leading the Blind
I remember going out to this one place and working on their 401(k) plan and they said, which investment options should we put in here? I looked at the wholesaler, the person that works for the company, whose 401(k) platform we were using and going, what do you think?
The guy said, “Well, this one had a good performance.” So we chose a bunch of funds. Now later on, I figured out we just chose a bunch of funds that all had the same investment options in them, the same areas of the market and had no clue.
So often when it comes to investing, we’re actually just the blind leading the blind. I had a financial planning degree when I did that. So it just shows that a lot of the education is not quite up to snuff when it comes down to how investment advisors are actually educated.
Now a question came in about expenses. Now expenses, when it comes to investing, you hear people say that expenses matter. And they do.
We try to keep the expenses down. If we have an expensive investment, and let’s say the expenses are a couple percent higher than they should be, you might end up with like 40% less money over a 20-year period. You may have heard me say that before in other areas.
Just 2% over 20 years makes a big difference, 3% is ridiculous. I mean, it just gets up there as far as how it affects the outcome. You’ll hear commercials by investment companies that say, “Hey, we’re the cheapest thing going.” And what you don’t realize is that they’re the cheapest thing on paper and the visible expenses are very low, but a lot of the invisible expenses are ignored.
Expenses matter, especially the invisible ones.
So recognize there’s a whole lot more to it than what meets the eye. Typically what happens when we’re talking about investing, and if you’re looking through your 401(k), look at the expense ratio and that’s it, that’s the only thing that you focus on.
What are some of the other things? One of the things that we look at when we’re looking at investing is what they charge for the management fee.
Front-end and Back-end Fees
So you can have a front-end load, which is a share that you don’t see much anymore. Instead of having a big upfront fee to get into something, you just had it in an ongoing fee and the commission was paid out of that. What happened is they front-end the commission and you had to keep the money under management for so long and there was a back-end fee if you left early.
Annuities still work like that. They have a lot of high expenses internally because they pay a big upfront commission. Then if you leave early, you get nailed on the backend because they’ve got to recoup the commission that they paid to the advisor, which can be really, really high.
Typically, you’ll see a lower upfront commission if you have a shorter period of time. So mutual funds work that way for a long, long time. Increasingly, we’re not seeing as much of that.
We’re seeing more of a no front-end load, no back-end load and just management fees inside. And that is what’s happening in the investing industry right now.
Some investment management fees are low to the point where they’re trying to figure out some other way to charge more money.
That’s where you see things like ESG investing, so they can charge more because they’re doing something else or religiously conscious investing. You’ll see that and think it’s really good. Well, it’s a good way for the fund company to actually charge more money.
I’ve seen some of these religiously conscious funds with 50, 67, 80, and 100% turnover. That’s buying and selling going on inside. Do these companies become really good or virtuous and then not good or virtuous?
What’s going on here? Are they gambling with your portfolio? Or are they doing something just to show that they’re doing something and they’re able to charge for that? I mean, there’s a lot in there when you get down to it.
So with the management fee, that’s going to be one thing. I’ve just brought up another area of expense, which is the turnover costs. How much buying and selling is going on?
The Belief in Market Inefficiency
Traditionally, fund companies like to buy and sell and trade because they believe that markets are inefficient. In other words, a lot of fund companies out there believe that they can find stocks that are underpriced, sell them when they become overpriced, and then buy the next underpriced thing coming up. That belief system is known as market inefficiency.
What if you had a stock or you thought that this particular company was going to go up in value or the market in general? Let’s just use the market in general, a form of market timing, which would be related to market inefficiency at the stock level.
The whole market is mispriced, instead of just a single stock being mispriced. It’s selling for less than what it’s really worth, so buy it. It’s selling for more than what it’s really worth, so sell it. Buy it before it goes up and sell it before it goes down, in other words.
When you think about this, you have this stock and you think that it’s undervalued and you buy it and then it goes up in value. Now do you sell it now? Do you go to try to find some other company that just happens to be undervalued or a market segment that happens to be undervalued?
Acting on supposed market inefficiency doesn’t always work.
What’s the likelihood that you go and find another thing the same day that has this just absolutely, there’s no doubt about it, is undervalued. What’s the likelihood you’re going to find a market segment the same day that you were able to capitalize on the undervaluation of some other market segment?
Let’s say large U.S. stocks are undervalued and then you go and buy them and then it goes up to proper valuation because something comes out and it jumps up in value and then you sell it.
What are you going to move it to, something else that’s undervalued? Well, what is the likelihood that’s going to happen? Because you look at markets and they move like a school of fish, don’t they? They all kind of move together, so it doesn’t make sense that that would happen, does it?
Missing Out on Returns
Well, how about if you go and move it over to cash and you move it to cash and then all of a sudden a new piece of information comes out, because you see it all the time, news comes out and the market goes up or it goes down.
What happens when that new piece of information comes out and the market jumps and you’re sitting in cash? Well, you missed it. And then you’ve got the trading costs of jumping in and jumping out. Add that all together, and you can see why professional managers struggle to try to match market returns.
It’s not that easy, and that is why 92% of large U.S. stock managers don’t capture the return that the market does on its own.
And I’ve talked about this before, but you take $100,000 in the 1970s and it’s worth 30 million dollars today if diversified across a broad array of assets of large and small and value and growth.
You can go back and look at the tables and do the math and see that most people are not getting those kinds of returns that the market has delivered over the past 50 years. Why?
Because people are back and forth and trading back and forth between different areas of the market and they lack patience. Market’s flat for a while and they get spooked and they jump out and then all of a sudden the market goes down and they go, whoa.
They get really spooked and they sell, and the market goes up and then after it goes up, they buy. And of course, they end up missing out on all those returns.
You can also look at style drift, where a fund has moved from being large value to small value, or it’s been moving from large value over to large blend, which would be more likely, maybe they move into mid-cap stocks or medium size companies and they jump back up to large and they move back around between these different areas.
And that has a cost too, because you’re trading, you’re selling and you’re buying, and that would be an expense. It’s not a visible expense that shows up in the management fee, though. You don’t see that.
Potential Indexing Problems
Now the other thing that happens is this in the way a portfolio’s managed. Let’s say that somebody decides not to engage in this process. They just index the portfolio and keep management fees low.
Doing that equates to overweighting big companies, because an index fund, unless it’s an equal-weighted index fund, will be market cap weighty.
They will weigh toward the bigger companies. Now when you weigh toward the bigger or put more money in the larger companies, you’re weighting toward the area of the market that would have a lower expected return, but you’re overweighting large companies.
Small companies have more potential to grow than large companies.
Now that is why equal-weighted index funds were created, to fix this problem. The idea being that we’re going to have 500 companies and 1/500th of the portfolio, approximately, will be in each one of those companies.
Well, the problem you run into there is that you’ll have relative movements between companies. One company goes down, another company goes up. If you’ve ever seen the heat maps on TV with the stock market, the heat map is showing you what areas of the market are moving up, what areas of the market are moving down.
Now you may see that the market is up on a given day, let’s say. And you’ll see that heat map of all the companies and it’s mostly green. So in other words, most of the stocks have gone up in value.
Then you’ll see that some of them are red. Well, those are the companies that have gone down. Well, if you run an index fund that equal weights, you’re going to have to now sell all the companies that are overweighted are the ones that were green that day and buy the ones that were red.
Two problems arise, you’ve got expenses for selling, then buying, then you have taxes on gains if you have sold the ones that have gone up in value and you can make for a very tax-inefficient portfolio. Now that doesn’t necessarily make the marketing of these funds.
Profitability Exclusions
Now, some people that have looked into this may say, well, the returns have been higher on the equal-weighted. Yes, the returns have been higher sometimes. And if you look at the periods in time where large U.S. stocks did better than small, because that can happen. Actually, the non-equally weighted funds did better.
If you look at the periods of time that are longer where small companies typically outperform large companies, yes, the equally weighted does better. But did it do as well as if you had actually divided the portfolio up between a small cap fund and a large cap fund and not equally weighted them and had not gone through the expense of buying and selling?
When you have an equal-weighted portfolio, everything’s the same. And then all of a sudden they get out of balance. Well, that would be a whole different story, but most people don’t dig that deep.
See how complicated this is. Isn’t this fun? When dealing with value funds, profitability has been shown to help you weed out things that aren’t truly in the asset category and make your portfolio more pure.
Now what happens is that you’ll have some companies, if you’re dealing with a small-cap portfolio, for example, you’ll have profitability exclusions. So you might find that some companies have low profitability, some companies have high profitability, and you can do that with value as well.
There can be companies that appear to be value, but they’re really growth. More likely are companies that appear to be growth, but are actually value. Then all of a sudden now with the profitability, if you go and if you have a fund company that is screening for that, research shows that what’s happening is you’re getting a portfolio that is more pure to the asset categories that you want.
If I want a value fund, by George, I want value stocks in that portfolio, because value in 96% of 20-year periods has a higher return, then I want a fund, if it’s investing in value to be really value. I want a fund that’s investing in small to be really small, of course.
Engineering Matters
Well, there are fund companies that charge for doing that. The question is, do their efforts actually pay for themselves? And I would argue, yeah, the research shows that they do. But they charge more, so an investor would not be attracted to that fund looking at two funds side by side.
They would buy the cheaper one because it should get greater returns. And then, lo and behold, doing that could actually leave a person with much lower returns in the cheaper fund, because it did not screen for something that is an obvious problem in engineering of the portfolio.
Engineering matters. If you had one bridge that was engineered and then put together and another bridge engineered by people who didn’t know what they were doing and then put together, one bridge would collapse and the other one would stand just fine. From an outsider looking in, they may have both looked good.
We can’t know what’s really going on just from looking at the outside.
There’s a lot more going on than just management fees. So I’m going to walk through some more things, because this is a request from a friend.
I’ll walk you through a lot of things that I think you really need to know as an investor when it comes to how to keep expenses down. What should be going on underneath the hood if somebody really knows what to look for as an investor, because it matters. It matters a huge amount, as I’ve talked about.
A lot of people think the management fee is the only expense when it comes to investing, but perish the thought. It’s only the tip of the iceberg.
So let’s say we’re dealing with a small-cap portfolio, small company stocks, and a lot of times you don’t see this in investment portfolios because it’s arcane. Most people don’t know. They don’t follow small caps.
How many times have you heard a report on what’s going on in Wall Street about the Russell 2000 or the S&P 600, which are small-cap indexes?
How many times have you actually heard about the EAFE small index, that area of the market, international small companies. You just don’t.
Expenses and Expected Benefits
Small company stocks have a higher expected returns over 20-year periods. Why is it that we don’t see those in 401(k) plans? Well, a lot of times the visible management fees are higher in that particular market segment.
Because people buy things based on management fees and pretty much that’s it, that’s all they look at, they may actually avoid that because the management fees are higher. Until that area of the market goes up more than everything else, and they go, heck with it, I’ll pay the higher management fee, and then of course the horse is out of the barn.
It’s already up and then you go buy it, then it goes down, you go, I knew I should avoid that management fee. Come to the wrong conclusion, right? No, nobody ever does that.
So we have, number one, profitability exclusions that you might see employed. Downward momentum, you’ll have stocks that are in a downward momentum or an upward momentum. I don’t want to buy something that is in a downward momentum.
So what does that mean?
Well, objects in motion tend to stay in motion.
So what happens is you always have money flowing in and out of mutual funds. You have money flowing into the market because people are making deposits. You have money flowing out because people are taking withdrawals for their retirement money and trying to live off of it. And if you have money flowing in, what do you buy?
Well, the research has shown that you can actually look for companies with an upward momentum because objects in motion tend to stay in motion. Now, trading based on this to try to get higher returns does not work, the research shows.
The expense of doing it outweighs the expected benefit. So don’t look at this and go, hey, I’m going to go find MoMo funds. That’s what we call them, momentum.
Momentum Funds
So what we look at is the momentum, but it can be good if we’re just trying to shave expenses off here and there. I find these attractive as far as choosing funds that are actually aware and making use of this information.
Because if I have two stocks, and I don’t care which of these two stocks, now this works really well when you believe in market efficiency, by the way. In other words, I don’t believe that there are mispricings in the stock market.
I’ve got money flowing in and this is a small-cap fund and I need to buy some small company stocks. So I’ve got a universe of 2,400 stocks out there and I’ve got some money flowing in. I’m not going to spread whatever amount of money that flowed in that day between 2,400 companies. I may buy 10, let’s say, with the money that’s flowed in.
Well, when I buy those 10, I’ve got to choose which 10. Do I choose something that happens to have had recent downward performance? Well, what we know, which is still an anomaly. It’s still something that academics are questioning, this momentum effect.
Where does it come from? Nobody really knows. And maybe it’s just that people get excited about something and they keep bidding up the price and maybe it’s just the emotions of investors or whatever.
By using momentum when buying, investors can buy something that happens to be in an upward momentum and benefit from that.
Like I said, it’s not something you can benefit from trading on.
So it’s still part of the market efficiency belief system that there aren’t mispricings. Because people might say it sounds like market inefficiency. It’s actually still efficient because the expense of trying to capitalize in it outweighs. It’s just a little shaving off of expenses here and there.
Now, another thing that you can look at has to do with a problem that you run into with index funds, actually indirectly. This is another reason that you don’t hear me talking about some of the big index fund companies. Even though the expenses are low, the visible expenses, it’s another reason that I don’t really get into using those, unless I’ve got a 401(k) and no other choices.
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