Don’t Pay Fees

Here’s a great article by a legend in investing, Burton Malkiel, on why you shouldn’t be paying fees to an investment advisor:

From 1980 to 2006, the U.S. financial services sector grew from 4.9% to 8.3% of GDP. A substantial share of that increase represented increases in asset-management fees.
Excluding index funds (which make market returns available even to small investors at close to zero expense), fees have risen substantially as a percentage of assets managed. In my judgment, investors have received no benefit from this increase in expense ratios.

The increase in fees could be justified if it reflected increasing returns for investors from active management, or if it improved the efficiency of the market. Neither of these arguments holds. Actively managed funds of publicly traded securities have consistently underperformed index funds—by roughly the differential in fees charged.

Passive portfolios that held all the stocks in a broad-based market index have substantially outperformed the average active manager since 1980. Therefore, the increase in fees represents a deadweight loss for investors.

Of course, when stated as a percentage of assets, these fees do look low—close to 1% of assets. But compare them with returns produced. If overall stock-market returns average, say, 7% a year, fees of 1% point are actually about 14% of stock-market returns. Mutual-fund fees take up well over 50% of dividend distributions.

Even these recalculations may substantially understate the real cost of active investment management. A more reasonable way to assess the benefits of active management is to measure fees as a percentage of the “excess” returns produced by active managers over the returns available from low-cost index funds. Overall, these excess returns are nonexistent.

Why do investors continue to pay such high fees for financial services of such questionable value? Many may incorrectly judge the quality of investment advice by the price charged. Individual and institutional investors may suffer from overconfidence and truly believe that they can select the best investment managers and earn excess returns, despite historical evidence to the contrary.
Outperforming the consensus of hundreds of thousands of professionals at the world’s major financial institutions is next to impossible. It has been for decades. Over long periods, about two-thirds of active managers are outperformed by the benchmark indexes. The one-third that may outperform the passive index in one period are generally not the same as in the next period. But investors can benefit from low-cost index funds and their exchange-traded cousins.

The lesson for investors is very clear: You can’t control what markets can do, but you can control the costs you pay. The less you pay to the purveyors of investment services, the more there will be for you. The quintessential low-cost investment vehicles are index funds, which should comprise the core of every investment portfolio. The high fees charged for active management cannot be justified.