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I’ll never forget the time I approached a friend’s financial advisor to understand why his returns were so poor. He had been managing my friend’s money for a long time, but I just couldn’t understand such paltry results year after year. So, I had a meeting with him. At that time, I asked him what he benchmarked against. This is when the tap dancing began. He used phrases that he thought I wouldn’t understand like “asset allocation” and “diversification of the portfolio through alternative measures”.
That’s when my probing questions began. I wanted to know if he really understood the models and their indicators. I asked him why he bought a European Gold Fund and American Gold Fund, and if he would explain the difference between the two funds. He quickly confessed that he didn’t know the makeup of the mutual funds. He relied solely on a model from his investment firm to run the portfolio. Needless to say, if you’re paying someone to invest your money, and they can’t explain what they are doing, it’s time to move on.
A Little History
Have you ever wondered why people (like me) benchmark against the Standard & Poor’s 500? The S&P 500 is currently comprised of 505 of the largest companies to represent all industries in the United States. The reason it encompasses 505 companies and not 500, per its name, is because it includes two class shares for five companies. These include Comcast, Discovery Communications, Google, News Corp. and Twenty-First Century Fox as of July 1, 2016.
Since 1928, the S&P500 has returned close to 8%. This is a very good return in comparison to bonds, which have averaged around 5% and in comparison to real estate, which has returned just 0.2% after adjusted for inflation. Many investors turn to mutual funds and hedge funds in hopes of beating the S&P 500. However, they spend little time thinking about the management fees incurred which often times can exceed 1%.
Additionally, Jack Bogle was the first person to set up a market index fund in 1975, the Vanguard 500 Index Fund, based on the research that mutual funds underperform stocks. Instead of trying to beat the market, he set the goal to cut fees and passively mimic the market.
Let’s say that you invest in a mutual fund for $10,000. Before the mutual fund even invests your money, they essentially charge you $100 to manage your money. Now, the mutual fund company really has $9,900 to manage for you. In order for the mutual fund to beat the S&P 500 annual return of 8%, the mutual fund would actually need to make greater than 9.1% just to breakeven with the S&P 500. If the mutual fund continues to charge you 1% each year, over 30 years, your portfolio will be reduced by a minimum of 30%. That is the difference between a $300,000 portfolio and a $200,000 portfolio. As you can see, fees matter.
There is a very well-known financial author and speaker, Dave Ramsey, who I agree with 90% of the time. But, when it comes to investments and more specifically mutual funds, I believe he is dead wrong. He says two specific things in his courses that really irk me. Firstly, he assures his audience that fees don’t matter. Clearly, we can acknowledge that fees do matter because the mutual fund, by default, has a greater hurdle in order to beat the S&P 500. Overall, one’s portfolio can be reduced by these fees if it does not exceed the returns of the S&P 500. And, Dave counters this point by saying that on average, the mutual funds that he invests in return 12%.
Let me explain to you the difference between average and annual returns because there is a HUGE difference. Let’s say you invest $100 into Apple stock. If in the first year, Apple goes up by 50%, great, now you have $150. However, the next year, if Apple drops by 50%, sadly, you are left with $75. Based on an annual rate of return, you would have a 25% loss. But if you follow Dave Ramsey’s reasoning, the average rate of return would be 0%, since Apple went up 50% the first year and down 50% the second year. This Mark Twain quote couldn’t be more fitting: “There are three kinds of lies: lies, damned lies, and statistics.” With that said, be very careful when someone spits rate of return figures at you; they may be sorely inaccurate.
Mutual Funds Fail
Here’s another little secret that the financial industry won’t tell you; most mutual funds fail. The data shows that on average, 75% of actively managed mutual funds underperform the S&P 500 every year. For context, in 2014, 86% of actively managed funds failed to beat the market. In 2015, 66% of the actively managed funds failed to beat the market. So, what does the industry do when a mutual fund underperforms for a couple of years? They quietly close it down as if it never existed. That way they can remain marketable to individual investors in order to convince you to purchase one of their other mutual funds that seem to be beating the market.
In 2015, Chuck Jaffe reported that over the last eight years, only four actively managed mutual funds have beaten the S&P 500. This bears repeating; only four actively mutual funds beat the S&P 500 over eight years. According to the most recent study there are over 9,000 mutual funds so the chances are 0.04% that you would have picked the correct mutual fund to beat the S&P 500 or 99.6% you would have chosen the wrong mutual fund. This is truly remarkable, so as you see, the odds are against an active mutual fund beating the S&P 500.
Buying the S&P 500
Hopefully I have presented a good argument against selecting mutual funds and have convinced you to buy the S&P 500.
Here are the three biggest ETFs that mirror the S&P 500:
- SPY (SPDR S&P 500 ETF)
- IVV (iShares Core S&P 500)
- VOO (Vanguard S&P 500).
Since each of these funds mirror the S&P 500, you may wonder which one to choose. Here are two ways to decide the right ETF for you:
- If you hold a Fidelity or Vanguard account, you can normally buy these funds (IVV for Fidelity and VOO for Vanguard) without paying a brokerage commission.
- If you don’t have a brokerage account with either one of these broker services, you can look at the expense fees for each ETF. According to Morningstar, SPY fees are currently 0.09%, IVV fees are currently 0.07% and VOO fees are currently 0.05%.
I have opened up a Vanguard account in order to invest in VOO based on the low expense fees and the commission-free trades.
I’d love to hear from you. Please share with me why you think I’m right or wrong with the strategy above.