[dropcap]I[/dropcap]t’s 2012 – only seven years away from when Ridley Scott’s futuristic cult classic “Blade Runner” takes place. The movie is set in Los Angeles in 2019, and Scott’s vision of the future is surreal, encompassing everything from flying cars to outer space colonies. We now know this is a far cry from what 2019 will actually look like, but there have been some significant changes since the film’s release in 1982. Some are in technology, others are in healthcare. But one change that’s commonly overlooked is the dramatic shift we’ve seen in the investment landscape, particularly in the last few years. What was widely accepted as 1982 industry standard is not the same as today.
Mutual Funds are Investments of the Past
At one point, mutual funds were prudent investments if used appropriately. Some still can be. They offered average investors professional management and an easy way to diversify. But they also have many drawbacks. Most mutual funds are actively managed, meaning the fund seeks to beat its respective benchmark through superior stock selection. This can create significant annual turnover as portfolio managers sell positions in favor of new ones, which in turn can generate taxable gains that are passed on to investors. Moreover, fees on actively managed funds are generally in excess of 1 percent, making them even more costly – not to mention those funds with front and back-end loads (commissions) paid to brokers. All of this means one thing: mutual funds are expensive.
Cost wouldn’t be such an issue if somehow these funds consistently beat returns of their respective benchmarks. Unfortunately this is not the case. Since Standard & Poor’s began tracking fund returns for its SPIVA reports, no 10-year periods exist in which a majority of actively managed funds beat their benchmarks. Yet the “average investor” still uses mutual funds, which is concerning. And according to the 2011 DALBAR QAIB study (a study of investor behavior), the average investor has a 20-year return of just 3.8 percent. This compares to 9.1 percent for the S&P 500! If you’re curious about more recent performance figures, see Carla Fried’s article in Seeking Alpha regarding Morningstar’s Fund Managers of the Year.
But good news: the future is here! The examples above makes a very strong case for indexing as opposed to active management, and it just so happens there’s an easy, low-cost way to do this: Exchange Traded Funds (ETFs). Over the last two decades ETFs have gained a tremendous amount of popularity, and for good reason. These investments typically track broader investment indices such as the S&P 500, Russell 2000, MSCI EAFE, and MSCI Emerging Markets. For this reason turnover is much lower than actively managed mutual funds. This means lower taxes. It also makes for easier management, which translates into lower annual fees for investors. Granted, there are index mutual funds that charge lower fees than their actively managed counterparts, but most still can’t compete with the low cost structure of ETFs. They’re even set up differently than mutual funds – ETFs trade on the secondary market just like stocks. So unlike a mutual fund, the securities that make up the ETF don’t need to be sold in order to raise cash for redemptions. Again, this means greater tax efficiency.
The Broker Model is Dying
Stock brokers were all the rage in the 1980s, and many did well for themselves, as indicated by fancy cars, power lunches, and plenty of champagne. But times have changed. Back then most people didn’t have access to the same information as a broker, and a middleman was necessary to place actual trades. Remember, the Internet as we know it didn’t exist in the early 80s. Nowadays anyone with a computer can get real time market information, tap volumes of research, and place trades from the comfort of their own home. There’s no longer a need for middlemen. That is, of course, unless you need a professional to provide investment advice.
What’s to stop a broker from simply recommending investments paying the highest commission?
But therein lies another problem: conflict of interest. Brokers are paid on commission, meaning they make money selling investments to clients. There’s another word for this: salesman. And you can see why this is problematic. What’s to stop a broker from simply recommending investments paying the highest commission? In fact, in many situations this is exactly what happened, and over time the word “broker” developed a negative connotation. Most now call themselves financial advisors to disguise the fact they’re actually salesmen. There is such a thing as an honest broker, but the conflict of interest remains. They have to get paid somehow, right?
The good news is more and more people are recognizing the inherent flaws with brokers. Like the mutual fund, it is an outdated model. It has given rise to numerous fee-based investment firms that charge clients on assets under management, not commissions. Doing this aligns the client’s interest with the firm’s – both benefit as client assets increase in value. Hence, these firms can provide truly objective and unbiased advice. Always make sure to ask how they’re compensated. And if you end up talking with someone who is paid on commission, RUN.