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Investing for The Wealthy

How to Keep Costs Down with Index Funds

02/14/2019

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Reducing costs with index funds has been of paramount importance among investors, according to trends in financial literature and capital.
Indeed, many models indicate that the absolute cheapest way to invest is to absorb low trading costs up-front, to hold shares for as long as possible, and sell them only when necessary.
This requires a rational, nearly robotic approach to investing that is unattainable for the average investor, according to studies.
Nonetheless, index funds are so popular that they warrant examination for any portfolio.

How Index Funds Work, and Why You Should Know

Index funds are passive investment vehicles designed to provide broad exposure to all the securities in a target index. Indexes are conceptual portfolios developed by institutions, financial media companies, ratings agencies and similar organizations, and they are meant to track a specific subset of securities for the purpose of quantifying performance of that group.

Some noteworthy examples include the S&P 500, the Dow Jones Industrial Index, the Russell 2000, the NASDAQ 100, the FTSE 100, and there are also numerous sector and industry-specific indexes.

A multitude of ETFs and mutual funds have been developed to mimic the performance of these indexes, and they are constructed by owning the constituent securities that make up the benchmarks, usually in proportion to market capitalization.

As a result, index funds allow investors to benefit from global capitalistic growth as owners of numerous companies that drive economic production. Rather than treating the stock market like a casino, this approach is ideal for long-term holders who want to dedicate their capital to the largest companies being publicly traded.

Why Are Index Funds So Cheap?

Academics, advisors, and investors have long questioned the value created by active portfolio managers, who are heavily compensated along with their analyst teams for picking winners and losers among securities, especially in the stock market.

Research on the topic delivered several damning results for active management over the long-term, because few managers are actually able to generate superior returns relative to the market overall, something measured by portfolio alpha.

Of the few that deliver superior results, most of them cannot replicate this performance across numerous periods, and even those consistent managers generally charge fees that are sufficiently high to negate their outperformance.

As a result, the investment community began focusing on cost reduction rather than expertise, and a number of solutions began to enter an increasingly competitive and fee-sensitive marketplace. Capital flowed disproportionately to ETFs and passive mutual funds in the 21st century, with passive champions like Vanguard and BlackRock rapidly taking share.

Index funds are by no means expense-free, but their structure and methodology allow them to drastically reduce operating costs. Fund allocation follows guidelines that restrict their investment options, and portfolio composition is strictly dictated by publicly-available third-party indexes. There are very few decisions made by the management team, which reduces the size and expertise of the team. That, in turn, drastically reduces that employee compensation expenses associated with such products.

Moreover, passive funds generally experience substantially lower portfolio turnover, resulting in lower trading costs, fewer taxable events and reduced erosion from bid-ask spreads.

There is also no room for complicated strategies, such as hedging with options or shorting, which can drive significant associated expenses.

Index funds generally reduce expenses through simplicity.

Digging into Numbers Between Active and Index Funds

Each fund must be considered individually, so it is difficult to make generalizations about fund expenses, but trends can be observed by analyzing a survey of popular funds of various types. The asset-weighted average expense ratio charged by actively-managed equity mutual funds was 78 basis points in 2018, whereas their indexed counterparts only charged nine basis points.

This is apparent when looking at noteworthy examples, such as Fidelity’s Contrafund and the American Funds Growth Fund of America, which are well-regarded and well-run vehicles that carry expense ratios between 60 and 70 basis points. Large passive funds such as the Fidelity 500 Investor Index and the Vanguard 500 Index Investor have expense ratios of 0.09% and 0.14%, respectively.

Turnover ratio creates an expense that is challenging to estimate, but analysts indicate that 100% portfolio turnover can add 120 basis points of expenses for shareholders. The above flagship active funds have turnover ratios between 28-34%, but the passive counterparts have turnover ratios of only 3%.

ETFs have been another important tool to reduce expenses and improve investor outcomes. Mutual fund structure requires selling shareholders to redeem their shares for cash at the end of a trading day, at which point they are paid out based on the fund’s net asset value. Each redemption typically triggers the fund to liquidate holdings to produce the required cash, because shares are repurchased by the fund itself rather than another investor.

Each time the fund liquidates its own securities, this creates a potentially taxable event, because capital gains taxes are owed by the fund itself on any realized appreciation in its portfolio. These taxes are ultimately borne by all existing shareholders, as expenses are necessarily passed on to owners.

Exchange traded funds are structured differently, and offer additional efficiency from this standpoint. ETF shares trade on the open market in the same way that stocks do, and ETF share transactions are often functionally identical for retail investors using online brokerage services.

Selling an ETF holding to another investor on the open market does not require the fund itself to sell underlying securities, and there is no associated taxable event impacting the value of all shareholders. Obviously, there could be taxable capital gains for any individual who closes a position, but everyone theoretically has control over the timing and magnitude of these events.

ETFs are excellent vehicles for indexing, and their favorable tax situation provides another avenue for expense reduction.

Hidden Costs You Can’t Afford to Ignore

Investment expense reduction can be an important element of wealth creation, but indexers should still be aware of the real costs they are unlikely to avoid with passive strategies.

Mutual fund shareholders must often pay fees that are not disclosed in the expense ratio, often in the form of transaction fees. There may be loads or commissions paid to advisors or brokers who pair investors with financial institutions. Brokers or the fund itself may also charge a one-time fee to transact business.

Index investors using ETFs are subject to their broker’s trading fees, but there are even expenses incurred for people using Robin Hood or other low or no-cost brokerage platforms. The bid-ask spread refers to the gap between the purchase price paid by a buyer and paid to a seller in capital markets. Anyone purchasing ETF shares on the open market immediately feels asset value erosion equal to the bid-ask spread, so that gap must be overcome to break even.

Highly liquid securities typically have narrow bid-ask spreads, because there is less risk for market makers, and competition among the markets is typically more substantial.

Indexing is not Perfect- Here are the Inevitable Downsides

A brief review of literature and capital flows seems to provide overwhelming endorsement for indexing and passive management, but investors may want to consider their alternatives.

Actively managed funds certainly cost more in terms of tangible administrative and trading expenses, and these produce a measurable and apparent drag on returns. However, indexing necessarily forfeits the benefits provided by active managers in exchange for those lean fee structures.

When markets tumble, for example in the periods following the Dot-com Bubble and the 2008 Financial Crisis, index funds experienced the full brunt of downside market volatility. Investors who were over-exposed to more volatile indexes, such as small cap and tech stocks felt more downside exposure than defensive sectors.

Active managers have the agency to rotate into more customized positions based on market and macroeconomic conditions, which can be especially beneficial during bear markets. High valuations, an “overcooked” economy and worrisome leading indicators might motivate fund rotation to dividends, sectors like healthcare, fixed-income securities, international markets or cash, or active managers might embrace some hedging strategies using short sales or options. Proper rebalancing might also require a level of attention and savvy that escapes the average do-it-yourself investor, whereas active managers can handle that themselves.

If we can assume expertise in practice for active managers, there is a demonstrable opportunity cost for investors who pile into index funds to reduce fee exposure. There is mixed evidence regarding the actual value added in general by active managers in bear markets, but the conceptual model for outperformance remains.

Investors must weigh their options to make the best decision between active and passive management. As is often the case with investing, a measured approach with diversification is likely to produce strong outcomes.

Linden Thomas & Company

One of America’s Top Wealth Managers builds a better Index

At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

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