PODCAST EPISODE 166: DO YOU KNOW YOUR FEES AND COSTS?: ILLUSIONS OF INVESTING, PART 4

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Paul 0:00

The cost isn’t that big and their performance is okay. Anyway, it’s valid. It’s not what I would have done. But that’s what’s happening across the mutual fund marketplace in the financial services industry. People are used to doing it the way they’re doing it and they don’t acknowledge those costs. Welcome to your business your Well, we’re your host, Paul Adams and Cory Shepard teach founders and entrepreneurs how to build wealth beyond their business balance sheets.

Cory 0:43

This is how Hello and welcome to your business your wealth. I’m Corey Shepherd, president of sound Financial Group and co host of this wonderful show. With me today is Paul Eagles may soar But honey badgers Don’t get sucked into jet engines Adams. For me, part four of our illusions of investing series now now,

Paul 1:08

Cory, I don’t want to interrupt your role, but you have a GC Do you now see the pleasure of that intro, adding middle names or coming up with new stuff like I am now getting a chance to experience the joy I’m sure you’ve experienced for the last year as I’ve introduced you on every episode, it makes me so happy.

Cory 1:25

Yes. And joy is what it has always been. That’s for sure. And so we’re gonna have to flip coins for who gets introduced to I think going forward because yeah, it is a lot of fun. So if you’re just joining us for this episode, if you’re if you’ve never listened to the podcast before, you’re just coming back, we’re in the middle of a series called illusions of investing. Now that’s just fine that you’re jumping here in the middle. You can listen to this episode and get a lot out of it by itself. But please go back and and start at the beginning because there’s lots of great content here. And it’s a it’s a recap of a series of conversations that Paul and I had back to the very beginning of our relationship when we first met, that led to us joining forces on this mission of bringing evidence and fact based perspectives on investing into the world. And the whole reason that Paul and I are here in this partnership, now years later is that he was able to help me see, through these conversations, some of the things that I had left uncovered or unhandled, for my family and by proxy for many of the clients that I was likely working with. And it quickly became a moral imperative for me to not be doing what I was doing the way I was doing it and start to help get this message out to the world. Paul’s gonna continue to do that for us today.

Paul 2:42

Paul, take us away. If you’re just joining us now we’re going to get into illusion number four today the cost of investing. But prior to this, what have we covered? Well, we’ve talked a little bit about stock picking why stock picking doesn’t work. Why track record investing doesn’t work. Why market timing doesn’t work. Now, when I say they don’t work, I don’t mean that they never work. I mean that they don’t work for you. And why they don’t work for you is there’s no way to consistently or predictably get returns in excess of the market using any of those strategies. And today, we’re going to cover down on the cost of investing. That’s so often when we invest, we don’t think about the underlying cost and impact. Now, what is the cost of investing? These are fees incurred by investors to buy sell and own stocks or mutual funds. And the illusion is, well, if I don’t see it, it’s not really going to hurt me that bad. But there are underlying impacts to cost in your investment portfolio, that you may not be aware of anything from your 401k to the Roth IRA that you opened just in time before you filed your taxes. So with that, let’s just look first at what happens when we search this on Google. If you Google in quotes, real cost of mutual funds, you will find the top article is an article from Forbes. Now, it may seem kind of funny to you that the latest article that ranks at the top of the Google search is an article written back in 2011. But one of the first things to notice is if you flip through Forbes, Inc, entrepreneur, Money Magazine, Smart Money Magazine, any of these, it’s astounding how many of the full page color ads are actually from mutual fund companies. In fact, you go to the website, for any of these Google results, no tremendous amount of the advertising and the banners on the right left top center pop ups are from where they’re from financial institutions offering to manage your money. As a result, these financial publications don’t have a lot of interest in consistently sharing with you how expensive all these platforms are. It’s as if Car magazine continued to write articles about how a particular luxury brand had just been screwing up every car that came off the line and had all these incidental repairs and things that you shouldn’t have to worry about. Well, that would cut off that entire luxury brand from advertising in Car and Driver. So you’ll notice that they don’t do things very often any magazine that attacks or does a significant disservice to those who would advertise with them. So if you get a chance to look at this article, I’m going to give you a glimpse of it, we just kind of took the top of the article the bottom and and fit it on a slide. But you can google the real cost of owning mutual funds and you’ll actually find this article as the top result. Now, what they did in the article, which I thought boiled it down, so simply, is they took the expense ratio, which is the thing that most people are familiar with, in this particular case, they came up with an average expense of point 9%. So point I have 1% for a set of actively managed equity based mutual funds, but then they disclose some other costs. Some we’re going to share with you more about here in a minute. But there’s a cost called transaction cost. transaction cost is the trading of the underlying stocks inside of a portfolio. Now, for years, and by the way, I’m not the only one who had this experience. For years, I always assumed that the mutual fund company paid for all their research and for all of their trading and everything out of that asset management fee is disclosed in this case a little less than 1% point nine zero. Now, that is not the case at all. Our returns for a mutual fund are paid to us at the net proceeds of every trade. So these asset managers are trading stocks inside the fund. And every time they do that, we get the net proceeds of that trade but out of that trading, there’s brokerage commissions and fees that have to be paid sometimes to an associated entity with the mutual funds and sometimes to an outside party. But the thing to consider is that there’s just a huge chunk of cost. That’s not disclosed on average, as a result of this study, it was 1.44%. So we have a point nine disclosed cost, then an additional 1.44% of transaction costs. Let me give you one more look inside transaction costs would be if that asset manager had to sell $10 million of say, Microsoft, but after the trading is done, they net less than 10 million for the sake of this conversation. I’m just going to say they net $909,995,000. Well, that’s all that’s reported the mutual fund but that extra chunk of money that had to go to the trading costs is a real cost is just not reporting the asset management fee. In fact, this is such a prevalent misbelief Even in the advisor community, I had a gentleman I spoke to who had been in the industry for 30 plus years. And I shared that with him. And he said, You know, I’m fine with all the stuff you do, and I appreciate some of the training you do for our advisors, etc. But at the end of the day, I think are just fear mongering, that stuff isn’t true. That’s there isn’t really all that extra costs in the mutual funds. And I said,

I don’t want to be disagreeable, but you’re flatly wrong. I said, What do you mean, I’m flatly wrong? I even after watching your presentation, because we had done a group setting presentation, I went to unnamed mutual fund company to talk to somebody on the phone and said, Is there any additional trading costs? And they said, No. I said, What you need to do is ask for a few managers up and they will give you the right answer is I just don’t believe it. So I said well, which is your favorite one of their mutual funds. And he told me, I said you have a prospectus there? He said yes. Now I’m sometimes known as the ctrl f King, meaning hit Ctrl F or Command F if you’re a Mac user, and quickly find stuff in a PDF document or a webpage. So I quickly pulled up that perspective on my end via PDF, he and I are chatting by phone. And I said just turn to page I think it was 14. So you see right there, it says trading costs are not reflected in the expense ratio. And it gave him pause and he said, Okay, I’m gonna, I’m gonna call them and and he did. And he went asked for the managers like I had mentioned, he should, and sure enough, they didn’t report it inside the mutual fund the way he vehemently believed for over three decades. And here’s the thing, when he was done with that, he has millions and millions of millions of dollars under management, this mutual fund company, was he able to pivot and change his ways immediately. The cost isn’t that big in their performances, Okay, anyway, it’s valid. It’s not what I would have done, but that’s what’s happening across the mutual fund marketplace in the financial services industry. People are using Doing it the way they’re doing it and they don’t acknowledge those costs. Now there’s one last cost that’s reflected here on this slide and in that article, and that is something called cash drag. You see, most mutual funds are purchased, not with any kind of rigor, but they’re sold by the investment advisory community, bought by clients who oftentimes do not have the best behavior when markets are volatile. Because of that other investor behavior and when you invest in one of these mutual funds, picture yourself like locking arms with a whole bunch of people your left or right that you’re depending on them also, because you’re in a mutual fund with them. All of you, and your closest hundred and 50,000 friends have plopped your money into a mutual fund together and you’re counting on their behavior. Well, what kind of bad behavior would hurt your returns? Well, the first off is they know these people are more likely to have higher redemptions because they know they’re going to have redemptions when markets are volatile. They keep a lot of money in cash. And it produces an additional drag on return in this study of about point eight 3%.

Now, that’s not counting the tax cost, if this is a investment that’s outside of a retirement plan, which could be another 1% because of the way that they turn over the mutual fund in an attempt, well, why do they turn over the mutual fund so much, they’re attempting to outperform the market. And a little bit like somebody’s running with a parachute on the harder you run while wearing the parachute, the higher the resistance gets, we know, the more they trade, the more they increase trading costs. And in this case, that trading cost is 1.44. But the taxability of it can drag the returns by an extra percent. So if you had that mutual fund that you looked at and had point 9% expense ratio, you might be paying 3.17% all in, and if it’s in a non qualified account, it might be 400 percent of cost a year. Now if what you’re hoping to get as an 8% rate of return year over year, that’s a lot of drag to have to overcome. Now reminds me of a story of these two guys that are kind of from the backwoods. They had grown up and, and never really had much in the way of education. And these two cousins, who lived in the country, lived together, had a pickup truck and one of them went to community college, and he took a class on marketing. And he said up, I have got the idea, Cletus, what we’re going to do is we are going to buy a bunch of tomatoes and we are going to head to the farmers market and they say, oh, my goodness, what are we going to do there? He says, well, we’re going to buy a bunch of these tomatoes for $1 each, we’re going to drive over farmer’s market sell them for $2 each. That sounds like pretty good idea. So they load up their pickup truck with a flat of tomatoes covering the bottom of the pickup truck, go to the farmers market, sold them all This is what are we going to do next week and he says, learn in my marketing class, what we’re going to do is we’re gonna load up a truckload with twice as many aces. We’re just gonna sell them for $1 50 he’s well, how are we gonna make any money if we’re only charging 50 cents before we’re charging $2 they sold just vices. We’re going to make it up on volume. So Cletus says, All right, we’ll do it. Sure enough, twice as many tomatoes went to farmers markets sold them all. Cletus thinks his cousin’s genius. Now. He says what are we going to do next weekend. He says we’re going to get twice as many again sell them for $1 25. Cletus is you sure he says Yep, we’re going to do it and it’s going to work because we’ve dropped the price again. So sure enough, they go sold all the tomatoes. Then next weekend, goes to Cletus and says here’s what we’re going to do. We’re going to buy another double amount of tomatoes. And this time we are going to sell them like crazy because we’re going to sell them for 90 cents each. Cletus says How in the world? Are we gonna make money if we sell them for less than what we paid for him? And he says, keep in mind, I’ve been taking this marketing class, we’re just gonna make it up on volume. Now that we know that you can’t make it up on volume when you’re losing money with each transaction. And yet, that tends to be what happens when active managers find themselves behind the eight ball as it relates to returns is they’re attempting to trade more to outperform the market a little bit like Cletus and his cousin trying to sell tomatoes. Now, when we come back, after this short commercial break, we’re going to talk a little bit about the bid, ask spread. Now try to pronounce that very clearly. It’s the bid, ask spread. This is not an explicit episode of your business, your wealth. When we come back, I’m gonna explain to you what that means and how it can drag on your returns. Hey everybody, I had to interrupt our show for just a moment to share with you something new. We’ve designed a new white paper that we think is going to add new value in the way that you think about money. It’s three the biggest mistakes we see people make and six ways to fix them. Now for some of you, you might not want the white paper you might be ready to have a conversation with us. And that is okay, you can email us at info at SFGW calm that’s info at SF GW comm find us on the web at your business, your wealth calm. And anytime on any of our social media platforms, send us a message and we can get you this white paper. But in the meanwhile, if you want to just skip over the white paper, have a philosophy conversation with us. We’re happy to do that with you. Just let us know, philosophy conversation, the subject line. And if you want this white paper, just put white paper in there. And we’ll immediately get out to you this white paper on the three biggest mistakes that we see people make and the six things that you can do to fix them. And now, back to our show

all Right right before break, I promised we would talk about the bid ask spread. So in the market, there is the bid price for any individual stock. And that’s what somebody says that they are willing to sell it for. And then there’s the ask price, which is what somebody is saying they’re willing to pay for a stock, and there’s always a little spread between those. Now that bid ask spread plus the mutual fund expenses, make buying a mutual fund a little pricier than what we’d normally think taking us back to that Forbes article we referenced? Well, let’s say what somebody is going to do is sell a stock for $49 and 50 cents, that’s the price of the stock. Now, for the sake of this example, we’re amplifying a little bit what the cost is of the market maker. But there is a market maker. And this exists on every Stock Exchange, where there is somebody that provides liquidity in the market and facilitates the transaction that results in brokerage costs or just the difference. Between the bid and the ask, and that bid ask spread. If the purchase price is $50. Then we only netted if our portfolio was selling the stock for 4950 we technically sold it for $50. But the market maker made that 50 cents. Now, this is relatively small when you’re trading in highly liquid highly traded companies, such as those in the standards and Poor’s 500 index. But where it gets more difficult and more important to not have the stocks trade too much is when you assess it, especially in international markets. And in small cap stocks. I’ve talked about on the show before how small cap stocks have a premium, they get a little bit extra return in exchange for the little bit of extra volatility they are. But there’s also a bigger market maker spread in each of those transactions because it’s a relatively less liquid market than say us large cap stocks. So that’s the way that those transaction costs stack up inside an investment, we don’t see it in the expense ratio where it shows up is just drag on return. Now, I’m going to be showing a graph here for those of you that are listening. But let me just I’ll summarize this graph we’re looking at, and that is that the higher the trading, done in any mutual fund, the higher what they call their turnover ratio. If you have 100% turnover ratio, that means effectively, they’ve done as many trades to trade in volume, the same as the entire value of the mutual fund. So the higher the turnover, the less likely it is they are going to win or outperform the index that they’re being compared to. So if you have an average turnover of 17% or less, you put yourself in the position that you’re more likely to outperform, then those high turnover ratio investments like 100% plus in turnover. In fact, it’s nearly twice as likely over long periods of time that those higher turnover funds are going to be able to outperform the index that they’re being compared to. And let’s say one of the things that you’ve bought into or accept is I’d rather just be in totally no load mutual funds. I’m not worried about any of that. I do no load mutual funds, because I don’t want any sales charge or asset management fees. But in and of itself, going no load isn’t enough. We’re going to go back and reference one more quote from Charlie Ellis from our last episode, where we watched him talk about the inability for individuals to beat those who are at the highest trading volumes in the market. But when he talked about Nola mutual funds, he said the key question is under the new rules of the game, how much better must the active manager be? Rest to recover the cost of their active management. The answer is daunting. Meaning that forget the charge on the mutual fund the asset management fee, that if the mutual fund manager the active manager is attempting to trade their way to success, it’s actually less likely they can even outperform the cost that they created by doing all of the trading in an attempt to outperform the market.

What we want to watch is and what you can take away from this episode, I don’t go to google search on the mutual funds you currently have. Look at their turnover ratios. And you can find those turnover ratios are higher, you’re probably having some of this what I might refer to as parasitic drag on your investments, making it harder for them to outperform the market and certainly harder for them, to put you in the position to be at definite financial independence to fund your work optional lifestyle. So glad you could join us today. Join us next time for illusion number five, where we’re going to deal with the idea that coaching and having an actual advisor can make a difference. Because people feel like they may just be able to go it alone or abdicate it to somebody else. And what we want to do is make sure that you understand the value of you being the driver’s seat around your money, and being in a position that you’re thinking about it enough to actually have the amount of output that you will need to live a good life for the rest of your life. And as always, we hope this episode has been a contribution to you being able to design and build your good life.

Unknown Speaker 21:52

This is how legends are made.

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