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A few years back, I approached a friend’s financial advisor to understand why the his returns were so poor. He had been managing my friend’s money for a long time. I just couldn’t understand such paltry results year after year when looking through the financial statements. 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, so 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. Instead, he relied solely on a financial 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 may be 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, including Comcast, Discovery Communications, Google, News Corp. and Twenty-First Century Fox as of July 1, 2016.
One of the most remarkable things about the S&P 500 is that since 1928, it has compound annual growth rate (CAGR) of 8% average after inflation. 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 believe they can beat 8% and, like many investors, turn to mutual funds and hedge funds in hopes of beating the S&P 500. But the management fees incurred can often times can exceed 1%.
Let’s first look closely at mutual funds. 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 means the difference between a $300,000 portfolio and a $200,000 portfolio. As you can see, fees matter.
There are financial pundits out there who claim 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.
On top of that, they counter this point by saying that on average, mutual funds typically return 12%.
Average vs. Annual Returns
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 their faulty 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.” So, be very careful when someone spits rate of return figures at you. They may be sorely inaccurate.
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.
Only 4 Mutual Funds
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 4 active mutual funds beat the S&P 500 over 8 consecutive 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
So you may be thinking, who buys the S&P 500?
Well have you ever heard of Warren Buffett? He’s the mega-rich investor that runs Berkshire Hathaway. He said regarding when he passes away,
“My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”
Exchange Traded Funds (ETFs)
How can you buy the S&P 500? There are exchange traded funds (ETF) that can mimic 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 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 recently opened up a Vanguard account in order to invest in VOO with commission-free trades and low expense fees.
While I may never beat the market, I won’t lose to the market either.