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When It Comes to Investment Fees, Size Matters By Stephen J. Butler

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Recently, the planets lined up in a way that prompts me to write about the impact of the fees we pay for record keeping and money management. The two questions are: "How much are we paying?" And, "Are we getting our money's worth?"

An acquaintance with a substantial amount of money after selling his company talked about the lousy results his nationally-renowned money managers had achieved. He had chosen as his managers one of the nation's oldest and most revered financial institutions. After lamenting the poor results, he mentioned that he was hopelessly confused about what, exactly, his costs for trading and money management were amounting to.

Across town in the 401(k) arena, a human resources manager with several hundred employees and several million in their retirement plan told me that cost was not an issue in their decision to change plans. What? Still another group of decision makers elected to continue on indefinitely with their major brokerage firm and a plan whose six investment choices had not changed in seven years. Their $15 million in plan assets were being charged fifty percent more than comparable investment types having far better past performance. Yet another 401(k) from a brokerage firm was still using expensive "B shares" with high backend fees when the plan's asset base qualified it for a far less expensive class of the same mutual funds. Finally, a 401(k) offered by an insurance company stated what their asset charges were, but the numbers didn't compute when we looked at actual participant accounts and compared the fund returns with what the insurance company claimed were their fees. Nothing added up and the fees in actual dollars, of course, amounted to more than the percentage amounts claimed.

It's one thing to be subjected to poor stock market performance. It's like bad weather that everybody can talk about but nobody can do anything about. On the other hand, the choices we make about who we have managing our money and what we pay for those services are components we can control. It reminds me of the underlying "fate versus determinism" theme of most good literature. There's good and bad luck; and then there's what we can actively do to determine or influence the outcome.

To gain some perspective, the average salary of mutual fund managers continues to be in the $400,000 per year range, even after the bloodbath of recent months. Years ago, as a guest of the Fidelity Fund organization I spent three days in Boston listening to Peter Lynch and other managers. Peter was the only one with gray hair. Everyone else at the podium seemed to be in their late twenties and early thirties. No offense, but at the time I thought, "What can these young people know about picking stocks and investing money? How much investment intuition can someone five years out of school possibly command?"

John Bogle, the founder of Vanguard, offers some insight in his books on mutual fund investing when he points out that active investment management may offer very little additional value over the results that the market as a whole will generate. Seventy percent of any one stock's performance, on the average, is a function of the performance of the entire market. Then, the style of investing is the next major determinate factor. A value investor will shine during some periods and a growth investment style will be the winner in others. The mutual fund companies recognize this, and they measure a manager's performance (and bonuses) based upon how well he or she manages to beat the benchmark of the specific investment category in which their fund happens to fall. Meanwhile, by the time the total market performance and the investment style have worked over our money, what is left for the manager to do?

Don't get me started on analysts, but Merrill Lynch reportedly has 850 analysts on their payroll. There are only 6,500 publicly held companies, so this means one analyst for every eight companies and this assumes that all are worth analyzing. One way or the other, we, the investing public, are paying for this overkill.

If we want to develop a standard of comparison with which to measure the performance of our advisors, here is something I can recommend. Invest some portion, a round number of ,say $1,000, $10,000 or $100,000 of your money in a variety of stocks at buyandhold.com and don't touch it. Compare its account balance periodically with whatever results your current advisors and/or combination of funds are generating. Over the next five years or so, this will give you at least some picture of what marginal value you are getting for the management fees or annual expense ratios you are paying. It will be a "real live tool" sitting right there in your portfolio rather than some vague reference to "the market" that your mutual fund claims to have beaten for a few quarters. In three to five years, you will know whether or not you are getting what is termed "value added results" in return for what you pay for money management.

Why is a random selection of untouched stocks the standard of comparison? For openers, there are no ongoing management fees and no trading costs. The average mutual fund or money manager triggers annual costs of about 3% which comes right out of your earnings or principal when management fees and trading commissions are added up. Outside of retirement accounts, there are also taxes to be paid on any realized gains during the year from these trades. This can be a huge hit against your principal.

A financial advisor, of course, can be earning his or her money by helping you sift through the allocation decisions you need to make regarding what mix of fund types to choose. They also contribute value by analyzing the tax issues surrounding any money you have that is not inside a tax-deferred retirement plan. We do not want to confuse advisor fees with mutual fund management fees. The water gets muddied when the advisor is being paid by mutual fund commissions, but a good advisor, however they are paid, can be worth their weight in gold if they prompt you to take advantage of investment ideas or constructive changes that you otherwise would have ignored.

In the end, we all need help. The giant Ponzi scheme headquartered in Oakland, California that imploded recently had, as one of its biggest groups of investors, a number of partners from one of the nation's largest law firms headquartered in San Francisco. What a joke. You can imagine the supposedly big guns of "due diligence" that must have been leveled at that mortgage company before those partners bought into the 17% annual returns that were a "sure thing." The point here is that we all need help with investment management, no matter how smart we may think we are. In fact, the smarter we are, the more help we may need. The question is, where do we go and what should we pay?

An extra percentage point of annual cost, when it can be avoided, makes a huge difference over time. On a $10,000 annual investment earning 10% per year, an extra 1% of cost taken from earnings reduces would have been total values by almost $10,000 in ten years, $75,000 in twenty years, and $355,000 in thirty years. It's the stealth bomber that can wreck returns. In just ten years, the missing 1% has added up to one full year's contribution amount. In twenty years, it has chewed up $75,000 of the earnings on the $200,000 you have deposited. If you're spending that kind of money, take some steps to ascertain that the cost-benefit relationship is in your favor. Over time, you may determine that today's cost effective money management resources have turned you into the best candidate for the job.

Vice President Cheney, hired to find the running mate for president Bush, decided in the end that he himself was the best man for the job. With resources like buyandhold.com, you may determine that the best person for your advisory job is yourself. Pay yourself the 3% per year and save a lot of taxes.