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Why the Lowest Fee Does Not Always Equal the Best Investment Option

| April 06, 2017
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I spend a lot of time reading financial articles and blogs.  One theme you can find all over the internet is "low-cost investments."  Google it and see what I mean.  There are hundreds, if not thousands, of articles and blog posts about where to find these mystical low-cost investments and how low cost investing is the greatest thing since sliced bread.  And I understand their appeal.  Who wants to pay more for a product, when they can get the same thing for less somewhere else?  Over the last 5-10 years, our society has become obsessed with finding the best deals on all of our purchases, and investing is no exception.

Overall, I believe the popularity of low costs investments has generally had a positive effect.  The hunt for the lowest cost investments has caused fund companies to lower their costs and/or create new share options that have driven down the overall annual fund expense over the last few years.  As someone who believes in the free-market, I think this competition is healthy.  As someone who also pays for things, a price cut is always welcome!  However, we need to be careful that our preference for low cost isn't slashing out valuable management of our money.

Indexing vs. Active Management Investing

There are many different investment styles in today’s market.  One could even argue that every investor has their own approach.  But generally speaking, you can narrow them into two very different approaches: indexing and active management.  

Indexing

In the indexing strategy, an index mutual fund or Exchange Traded Fund (ETF) tries to replicate the results of a given index: the S&P 500 index for example.  (Remember: the S&P 500 is an index of 500 large companies’ stock and is used as an indicator of the US stock market and how the economy is doing.) There are several index funds and ETFs that do nothing but buy and hold the stocks that S&P 500 represents.  This "passive" style of investing takes very little staff or management since they are just watching the S&P 500 index and buying the same stocks in the index; therefore, the costs are ultra low. And for every index out there, you can bet there are index funds or ETFs to replicate it.

Active Management

A fund that is actively managed tries to outperform a given benchmark; again, let’s use the S&P 500 index as the benchmark.  These funds hire a research and analyst team to look at their current investments and future investments to try and take advantage of an individual company's situation.  This can help them reach higher returns when the market is positive and avoid large potential losses when the market is down.  There are some funds or even fund managers that have a track record of excellence, while some have a record of mediocrity.  Either way, actively managed funds typically have higher costs than an index fund or ETF due to the cost of the management.

Which is better?

The debate of which approach is best has been a hot one for years.

Index funds and passive ETFs are fairly predictable in that they tend to have average returns and perform well in expansions when everything is going up. But they also can follow a recession to rock bottom.  Another risk in owning indexing funds is the reconstitution effect.  This is where the index reevaluates which stocks are part of it, sometimes changing out the stocks of the index.  When this happens, all the index funds sell the old stock (often driving the price down) and buy the new stock (usually pushing the stock price up).  This can cause the index fund returns to be slightly different than the actual index until they finish matching up.

On the other hand, a good managed fund can produce returns higher than a benchmark and/or protect you from the bottom of a recession.  But the part of a managed fund that can make them great, can also be their largest flaw: the human element.  The management may buy in or sell out too early or late and miss a big opportunity.  This is one of the largest risks in investing: market timing.

Which should I own?

In designing portfolios for our clients, I believe that the best-diversified portfolio owns BOTH passive and active investments.  I will often put together a portfolio for our clients that take advantage of both of their positive characteristics.  

For example, certain segments of the equity market (stocks) tend to outperform the market as a whole.  So I like to use an index fund or ETF that targets that segment.  Then, you can blend its strengths with other index funds or ETFs that track different indices for a truly diversified portfolio.  An example of this philosophy could be Asset Class Investing (I hope to write a blog on this in the future).  This low cost, passive approach gives the portfolio a chance to give above-average returns with below-average costs.  On the flip side, I like to use actively managed fixed income (bonds and cash) mutual funds.  In my opinion, the managers of the mutual funds can actively take advantage of interest rate changes, hold cash to help in bond sell-offs, and manipulate the duration of the bonds to produce a portfolio that is stable.

About the Author: Jay Peters is a Para Planner with over five years of experience in the mortgage and financial services industry. His primary responsibility at MSMF is to assist financial advisors in the development of comprehensive financial plans for clients. Jay feels like the best part of MSMF is meeting and working with different people, and thoroughly enjoys the challenge of helping clients provide a comfortable retirement or a legacy. He and his wife, Megan, enjoy distance running, traveling to the Caribbean and attending Cardinals and Blues games. When Jay is out of the office, he can often be found playing baseball or golf, listening to music, and reading.



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