Chapter 5 – Costs ARE A Big Deal

Chapter 5

Costs ARE a BIG DEAL

Jack Bogle is a giant in the mutual fund industry. He is the founder of the Vanguard Group and the creator of the first universally available S&P 500 index fund. And yet, Mr. Bogle is not too popular with his peers. Why? Because he has spent his life rallying against high fees associated with mutual funds. Mr. Bogle’s message is very simple: Costs Matter. How much?

It’s highly unlikely you stand even a chance of beating the average return with high cost funds over extended periods of time. Unfortunately, this statement is so simple that investors can read right over it with just a nod of their head. But Jeff Acheson, director of retirement planning at Pittsburgh-based Schneider Downs & Co. puts it in perspective, “Hidden fees are a little bit like high blood pressure. You don’t really feel it, and you don’t necessarily see it, but it’ll eventually kill you.”

If you Google mutual fund costs, you will get dozens of articles all saying the same thing— high costs hurt returns. It seems simple enough if you are paying attention, but many investors do not believe it because they can point to a fund with high expenses that is outperforming. What they miss is the fact that no fund can outperform all the time. The extra hurdle of overcoming the costs eventually will take it’s toll.

Jim Peterson, vice president for Schwab’s Center for Investment Research says “You have to care about expenses. It is the most predictable characteristic of explaining future returns of funds. It’s more reliable than past performance. It can’t be said enough: with funds, costs matter.
The Beach Lesson provides a clear example of how costs work against you: http://www.employeefiduciary.com/fees.htm

This is from the Securities and Exchange Commission (SEC) website: As you might expect, fees and expenses vary from fund to fund. A fund with high costs must perform better than a  low-cost fund to generate the same returns for you. Even small differences in fees can translate into large differences in returns over time. For example, if you invested $10,000 in a fund that produced a 10% annual return before expenses and had annual operating expenses of 1.5%, then after 20 years you would have roughly $49,725. But if the fund had expenses of only 0.5%, then you would end up with $60,858. Cost control is the very heart of long-term better-than average returns. It is a fact that causes Mr. Bogle’s peers to squirm. And yet, they cannot dispute it.

Costs, and hence returns, are subject to “the relentless rules of humble arithmetic.” The quote is a favorite of Jack Bogle. It is originally from Louis D. Brandeis in “Other People’s Money,” first published in 1914. People are used to the common idea that you get what you pay for, but in investing it is just the opposite. In the keynote speech at the opening of the 2006 Money Show in Las Vegas, Jack Bogle summed it up this way: “The great irony of investing, then, is not only that you don’t get what you pay for. The reality is quite the opposite: You get precisely what you don’t pay for. So if you pay for nothing, you get everything.” Our goal then is to pay as close to nothing as possible.

In his book, “Common Sense on Mutual Funds,” Mr. Bogle says “Asset allocation is critically important; but cost is critically important, too—All other factors pale into insignificance.” Costs, including tax consequences, take a direct bite out of the returns that go into your pocket. Every penny that goes to costs requires that much more return to break even.

Money Magazine columnist Walter Updegrave in his article, The Single Best Retirement Strategy, has this to say: If I told you there was a risk-free way to boost your retirement savings by 20 percent or more, would you be interested? In fact, what I’m suggesting is the soul of simplicity: Rein in your investment costs. By favoring low-cost funds over high-cost alternatives, you can dramatically increase your chances of having a secure retirement.

A 401(k) of low-fee funds will grow faster than a 401(k) with higher fees. Nest Egg at 65 –

Expenses                      Nest Egg
High
– 1.5%                      $663,600
Moderate- 1.o%              $732,400
Low – 0.5%                      $809.700
Ultra-low -0.25%             $851,800
Note: Assumes a 30-year-old earns $40,000 a year and gets a 3% annual raise.
Sources: T. Rowe Price and MONEY research.”
Walter Updegrave, Money Magazine, 12/17/04

Cost damage is even more dramatic in retirement. Consider a person in retirement who uses a large full-service brokerage. He has accumulated a $1,000,000 nest egg and withdraws $40,000 a year for living expenses. He pays the typical 1.0% in advisory fees plus another 0.5% in additional brokerage/service fees, which is common. But that’s 1.5% of all he owns, which equals $15,000 per year. So every year, on top of the $40,000 he takes out to spend, another $15,000— or 37.5% more—is lost to unnecessarily high expenses. The costs come out every year, even if nothing is withdrawn at all, and even if the investments lose money. Over 30 years four hundred and fifty thousand dollars would be lost to expenses.

The portfolio has to have returns equaling the withdrawals plus the costs just to break even. That’s an awful lot to ask with a portfolio that isn’t being pumped up with new money. Performance can come and go, but costs are forever. Imagine someone saying invest with me and I’ll take half your retirement nest egg for my fee. An exaggeration? I think you can clearly see that it is not. In the following chart, Mr. Updegrave points out how lower expenses increase the odds of retirement funds lasting your lifetime.

“ODDS OF SAVINGS RUNNING OUT
Expenses                  Odds
high – 1.5%                   31%
moderate – 1.0%         23%
low – 0.5%                    16%
ultra-low – 0.25%         13%
Note: Assumes 7% expected annual return before expenses, initial withdrawal of 4%, which is increased 3% annually for inflation.
Sources: T. Rowe Price and MONEY research.
Walter Updegrave, Money Magazine, 12/17/04

Taxes
Tax costs seem to get even less respect than fund costs. Many investors use the phrase,
don’t let the tail wag the dog” To which, Duncan Richardson, chief equity investment officer at Eaton Vance Management in Boston, adds this caveat: “It’s not like the tax tail is this cute, little puppy dog tail,” he said. “It’s like an alligator’s tail. Ignore it at your peril.

Investors tend to dismiss taxes because they don’t directly see the impact of tax costs in their fund returns. The taxes are paid out of another pocket–the checking account–and somehow the connection isn’t associated with the cost of owning tax-inefficient funds in taxable accounts. The fact is that taxes can reduce returns by as much as twice the fund’s expenses.

Managing tax costs with careful planning can increase returns significantly. According to a study by Joel Dickson and John Shoven, “Taxes and Mutual Funds: An Investor Perspective” in James M. Poterba’s (ed.) “Tax Policy and the Economy” as much as a quarter of a mutual fund investors’ annual returns are consumed by the taxes payable on dividend and capital gains distributions.

And from the Mutual Fund Center, “Mutual Fund Costs,” at MotleyFool.com: “Over time, the compounding effects of an average equity return of 10% being reduced by one-quarter are truly dramatic. Over the course of thirty years, with 10% annual returns, $10,000 will compound to nearly $175,000. At 7.5% returns, it will compound to $87,500—almost exactly half the amount.”

If you want to argue that the tax rates are lower than 25% that’s fine, but it isn’t likely they will remain there. And author Larry Swedroe cites a study by Charles Schwab: Schwab measured the performance of sixty-two equity funds for the period 1963-92. It found that while each dollar invested would have grown to $21.89 in a tax-deferred account, a taxable account would have produced $9.87 for a high-bracket investor. Taxes cut returns by 57.5%.”

The above information demonstrates the need to be aware of how tax-efficient a fund is. Funds create taxes by distributing dividends, interest, and passing along to you capital gains from trading stocks in the fund. Short-term capital gains and interest are taxed at regular income rates. Long-term capital gains and most dividends are currently taxed at 15%. Funds vary in how much taxable income they generate. Funds that return interest or significant dividends and funds that have high turnover are usually considered tax-inefficient. Funds that are not tax-efficient should be held in tax-deferred accounts. There are funds that are naturally very tax-efficient like the total market index and there are funds that are purposely managed to be tax-efficient. These types of funds are best used in taxable accounts.

Here is a list of securities in approximate order of their tax-efficiency (Least tax-efficient at the top.) from the Bogleheads Wiki:
Very Inefficient

High-yield bonds
Real estate/REIT
Any high-turnover active stock fund
Small-cap active fund

Moderately Inefficient
Small-cap or value index (without ETF class)
Large-cap active fund
Bonds (consider municipal bonds or I bonds in taxable)
Value ETF, or index fund with ETF class
Efficient

Small-cap or mid/cap growth/blend ETF, or index fund with ETF class
Small-cap international ETF, or index fund with ETF class
Emerging markets index
Very Efficient

Tax-managed small-cap
Large-cap growth/blend index or total U.S.market index
Large-cap international index
Tax-managed large-cap
Tax-managed international
http://www.bogleheads.org/wiki/index.php/Principles_of_Tax-Efficient_Fund_Placement
http://www.slate.com/id/2139671/

Suffice to say that costs are a corrosive element in investing and the effect is compounded over time. Remember the compounding effect of returns? Well, you get the same compounding with costs, only negative. The larger your assets become and the longer the time, the more costs will take their toll. The more you can trim costs, including the taxes you’ll have to pay, the better your returns will be. In a nut shell, it’s really about investing as efficiently as you can. Don’t waste returns with high costs and taxes.

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