This is one of the “10 Steps in the Right Direction” that make up The Pasadena Financial Planner‘s personal financial planning and personal investment management process. For a summary of these ten steps, see “Your Family Financial Planning.” To find an in-depth article for each step, just click the Pasadena Financial Planning Services Sitemap link at the top of this page. Also, you can reach us by using the contact form below. Please enjoy reading this article. Thank you!

You can significantly improve your net risk-adjusted investment returns by lowering your investment fees and taxes. Cut your investment expenses and capital gains taxes to the bone!

This very important financial planning step focuses on investors’ net or realized investment returns, after investment costs, fees, and capital gains taxes are taken into account. Net investment returns are those investment returns that individual investors could actually spend on themselves and their families.

Post-Financial Crisis Commentary Concerning:

Investment Strategy and Investment Expenses

NOTE: The best personal financial planning rules endure and shouldn’t vary due to financial crisis or market cycles. The article below was written several years ago and requires no revisions. Given the subsequent credit crisis that we have suffered through, these more recent comments in this colored box were written simply to emphasize the enduring wisdom of the detailed original discussion that follows.

Cutting your investment costs to the bone has been, is, and always will be the single most reliable method for individual investors to increase their long-term net investment returns. The financial crisis did nothing to knock investment cost cutting out of this number one effectiveness position for individual investors. Investment cost cutting is always the first and best lever to use to improve long-term net portfolio returns. If anything, the dot com securities market implosion and the several years subsequent credit crunch crisis gave investors two more opportunities to become aware of the corrosiveness of excessive investment costs.

There is no other investment indicator that is as reliable as lower costs in producing better net investment performance. Unless you make a point of slapping them away, so many little silk and woolen hands will stay in your investment wallet and keep taking “a little bit” here and “a little bit” there in terms of:
1) sales loads to pay brokers and advisors who induce you to buy investments with higher costs;
2) ongoing 12b-1 sales fees that pick your pocket year after year;
3) higher fund management fees to pay for active management activities that inevitably fall short of passive benchmarks — especially as the time period increases;
4) higher portfolio churning and turnover which leads to higher hidden costs;
5) high percent-of-assets advisory fees that compound costs, because advisors try to beat-the-market to justify their fees — inevitably falling short over time on average; and
6) a myriad of other one-time and recurring industry fees that bleed away value related to your taxable retirement asset accounts.

Millions of individual investors have started paying attention to investment costs. This has been demonstrated by massive investment asset shifts from higher cost to lower cost investment vehicles in recent years. When securities market values stagnate, people inevitably begin to look more at reducing their costs to improve their net returns. But, the truth is that they always have been looking for the lowest cost investments — and they always should in the future. There is no credible evidence that professional investors can pick winners that do well enough to overcome their higher costs. Over and over again, the investment research literature has demonstrated the opposite: The less you pay in investment expense, the more you keep!

If you have not already done so, it is time for you to wake up about investment costs. Net investment performance short-term and long-term is a zero sum game across all investors. Long-term the global securities markets tend to reflect the value of the global economic development and growth that underlies the markets. Over the long run, securities markets act as an allocation mechanism to distribute this underlying economic value to debt holders and to enterprise shareholders. Along the way, if you keep giving away some of your ownership share to the industry through higher investment costs, that long-term economic value will just end up somebody else’s pocket. While the financial industry attempts valiantly to minimize and obscure the effects of their unjustified investment costs, the corrosive is always there, damaging your family’s long-term welfare. If you own assets, then you are a profit center for the industry. Get real. There is no “partnership” between the industry and individual investors.

(By the way, the number two investment return improvement lever for individual investors is tax-aware investing, including optimization of long-term capital gains, maximum use of tax-advantaged retirement accounts, and optimal investment “tax location” decisions regarding their asset allocation. See other articles in the Sitemap)

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EACH AND EVERY YEAR, the average individual investor spends about 2% to 3% of their TOTAL investment portfolio ASSETS on excessive investment management fees, unnecessarily high securities trading costs, unjustifiably high investment custody fees, and completely avoidable usually short-term capital gains investment taxes. Where do you think a lot of those multi-billion dollar Wall Street broker bonus payments are coming from? Directly or indirectly from your taxable financial assets and retirement financial assets is the answer. In aggregate, brokers don’t add value. Some clients seem to win on occasion, but most just keep losing, while the brokerage house always takes its cut of the action. (See: “Excessive Investment Costs are a huge problem for individual investors” published on our sister website, The Skilled Investor.)

These wasted investment costs mean that the average individual investor typically gives away between 1/4 and 1/3 of his or her annual investment returns to the securities and financial services industry. In aggregate across all individual investors, these investors will get nothing in return.

Well, that is not entirely true. In exchange for paying more to engage in high tax and high cost active investment management strategies, participating investors will be taken on a much wilder investment roller coaster. Unpredictably, active investors may experience more dramatic ups and downs. On average, in addition, they will suffer inferior investment performance due excessive investment costs and unnecessary capital gains tax payments.

The cumulative long-term impact on personal investment portfolios is simply staggering. Across all investors, these excessive costs are a complete waste. In fact, excessive investment expenses are simply an incredible wealth transfer to the securities and financial services industry. The associated and unnecessary capital gains taxes are just a wealth transfer from individuals to the government.

It is difficult to identify another industry that charges so much and promises so much to their customers, and yet ends up delivering so little in terms of added-value to their customers. Until individual investors wake up to the fact that they are paying far more than is necessary for so little in return, they are far more likely to have dramatically diminished investment portfolio assets during their lifetimes.

For more information about the value of reducing your investment expenses and controlling your capital gains taxes, see these articles on “Cost Control and Investment Performance Improvement,” which are published on our sister website, The Skilled Investor.

Human greed, personal investment ignorance, financial advisor compensation incentives, and the securities industry’s beat-the-market sales mantra are far too strong and too well-aligned for investment performance chasing by individual investors ever to end.

Unfortunately, The Pasadena Financial Planner has no expectation that the causes of excessive investment costs and wasted capital gains taxes will ever change. This beat-the-market investment management shell game rubbish will continue as long as individuals believe that they can get better risk-adjusted performance than the other guy does at no real cost to themselves. Naive investors will continue to use superior historical performance as a false indicator of what will happen in the future. They will be continually be disappointed, but only if they ever bother to check their results against the net investment yield of a low cost, low tax passive index investment strategy.

Naive individual investors, often abetted by their financial advisors, will continually pay excessive fees to investment money managers whom they hope will beat the securities markets for them. Yet, investment research studies indicate that there are no reliable ways for individual investors to identify, before the fact, superior active investment managers from within the crowd of mutual fund money managers.

The excessive management fees that are charged across the industry virtually guarantee that individual investors will not be able to hire money managers at a profit. The average mutual fund management expense ratio is about two times higher that the apparent value-added of the average investment fund money manager.

In addition, these excessive management expense ratios still do not include the much higher portfolio trading costs and higher capital gains taxes that go along with an actively managed mutual fund. Furthermore, most high cost actively managed mutual funds are sold through financial advisors who add no value in the selection process. Nevertheless, these investment counselors will still charge you a front-end sales load or a back-end sales load and will also add an annual 12b1 fee on top of the management expense ratio. What a deal!

Particularly during the last two decades of the 20th century, the fees extracted by the financial securities industry have increased substantially on both a total and a percentage of returns basis. What has the value-added been? In aggregate, the value has been negative. Furthermore, as a bonus, unwitting participants in active investment management strategies experienced a much wilder investment ride and took greater investment risks than were necessary.

Total mutual fund expenses and mutual fund management expense ratios have not decreased. To cut your investment fund costs, you have to do it yourself.

If you pay attention to the statements of mutual fund industry trade groups, you may hear claims that mutual fund investment fees have come down (slightly) as a percentage of investor’s assets during the last couple decades. However, what the fund industry fails to explain is that almost all of the new mutual funds that it keeps introducing have higher than average management expense ratios. If the mutual fund industry could get you to pay higher investment expense ratios, it would and it does when it can.

The mutual fund industry does this by launching numerous new mutual funds with high expense ratios. Then, after the fact, the mutual fund industry only promotes new funds and old funds that happened to have done well. The mutual fund industry knows that nothing sells better than the implication that superior past performance, as displayed in performance charts and with 4-star ratings and 5-star ratings, will continue. While this very selective marketing process hints that superior past performance will continue into the future, the legal small print always tells you not to count on it. For more information about the problems associated with immature mutual funds, see this article “Choose Mature Noload Mutual Funds” published on our sister website, Best No Load Mutual Funds.

Even though it is just a chimera, the mutual fund industry is counting on individual investors to extrapolate superior past performance into the future. The mutual fund industry and its supposedly “independent” financial advisors, who only promote mutual funds with sales loads and four stars and five stars, both know that these funds are easier to sell to naive investors. The fee revenues are too good to do anything else instead, such as educate investors not to extrapolate past performance. For more information about selective mutual fund marketing, see this article “How Morningstar Ratings for Mutual Funds Are Used As a Marketing Tool” published on our sister website, The Skilled Investor.

Note that the mutual fund industry will not dispute the fact that the total amount of fees that they collect has risen many times over. Invested assets have increased many times over due to investor savings and new investments and to investment asset growth and appreciation. When you charge people a percentage of their appreciating assets, then total industry fees have to go up in proportion, as well.

Percent of asset fees are a revenue and profit gravy train for the financial services industry. However, you might want to stop and ask why the industry deserves a percentage of your assets each and every year. They are YOUR assets, are they not? Why just give them away without getting incremental value in return?

Mutual fund management expense ratios have only come down because some investors have shifted their assets into low cost noload mutual funds.

If you looked more carefully at the numbers, you would find that mutual industry claims of reduced management expense ratio percentages are based on aggregate data across all types of mutual funds. These aggregate data combine both: a) the much higher costs of actively managed mutual funds with sales loads and b) the much lower costs of no load index mutual funds. The primary reason why the average mutual fund expense ratio has come down in the past, albeit only slightly, is that a substantial minority of all individual investors has gotten smarter about excessive investment costs.

More cost-conscious individual investors and certain of their more helpful financial advisors and some more cost conscious institutional investors have been redirecting increasing proportions of investment assets under their control into lower cost funds. These transfers of assets into lower cost no load mutual funds pulls down the overall management expense ratio percentage for all mutual funds.

Furthermore, returns on low cost, no load index mutual funds have been better on average than actively managed funds. Therefore, these noload mutual fund assets have appreciated more rapidly. Low cost no load mutual fund assets will also tend to be greater, because an investor’s full dollar gets invested into a noload mutual fund. Sales loads siphon away about a nickel of each dollar at the outset to pay the financial adviser through a sales load. These sales loads diminish the total amount of actively managed investment fund assets compared to noload mutual funds.

Therefore, the actions of some investors to seek lower costs have held down the growth of management expense ratio percentages and other costs. The mutual fund industry did not cause the average mutual fund investment expense ratio to come down (ever so slightly). They have been trying to push up your costs – and their revenues and profits in the process.

If you start taking investment cost cutting much more seriously, you will not be alone. The industry will not do it for you. You have to lower your investment costs yourself.

Management expense ratios and trading costs are also excessive for exchange-traded funds (ETFs).

Concerning exchange-traded funds (EFTs), you may hear the argument that ETF management expense ratios are lower than mutual fund management expenses. This is another false industry comparison. Due to the structure of ETFs, virtually all exchange-traded funds are passive index funds. Unfortunately, newer exchange traded funds that have been introduced to the securities markets increasingly have carried higher management fees and have tracked narrower and more esoteric indexes. This ETF Balkanization defeats the important goal of achieving a broadly diversified portfolio economically.

As a quick summary, here is why almost all ETFs are passively managed index funds. Since the composition of an ETF’s portfolios is known daily, an actively managed exchange-traded fund’s strategy would be exposed and would be gamed by other market participants. That is why it took until 2008 for just a few somewhat actively managed exchange-traded funds came to the market. On the contrary, actively managed mutual fund portfolios are not known to other market participants in real-time. Therefore, actively managed mutual funds can pursue their investment strategies without other professional traders knowing their strategy and trading against them.

Since ETFs are almost all passively managed index funds, then their management expense ratios and all other expenses should be compared with very low cost passive index alternatives – both mutual funds and ETFs. When you look at the management expense ratios of most ETFs you find that there almost always is a much lower cost index mutual fund or ETF that you could purchase instead.

Furthermore, since ETFs are traded on securities exchanges much more easily than mutual funds, the daily volume of ETF trading has exploded, when compared to total assets that are invested in ETFs. Mutual funds, which get priced once daily, are traded excessively by some performance chasing investors, but the amount of these trades is no where near the volume for ETFs. Furthermore, due to the mutual fund trading scandals early in this century, restrictions have been placed on short-term mutual fund trading, which occurs at the expense of longer-term mutual fund investors.

If you do not buy and hold very low cost, broadly diversified ETFs, you can easily drive up your costs through excessive brokerage fees.

ETF brokerage fees are far more likely to sink investors’ returns, than investors’ clever trading bets are to increase their exchange-traded fund returns. If you decide to invest in ETFs, you should understand the real danger of excessive exchange-traded fund trading. Only a small portion of ETFs are very low cost and are broadly diversified. The rest of these ETFs are just high priced index funds that focus on narrower and narrower securities market segments.

The more you trade ETFs, the worse you are likely to do. Remember that exchange traded funds are a brokerage industry response to the mutual fund industry. ETFs have allowed securities brokers to capture some investor assets that otherwise would have be invested in traditional mutual funds.

With a few notable exceptions, most mutual fund companies try to push up their fees by implying that their actively managed funds will beat the market. In aggregate this claim is false, and the more you spend the less you are likely to get. In the same vein, brokers selling ETFs may point to lower ETF management expense ratios and the supposed superior tax efficiency of ETFs.

However, most ETFs still have excessive expense ratios and carry the heavy added burden of brokerage trading fees. Excessive trading can easily negate any supposed ETF tax advantages. ETFs only make sense as an alternative to mutual funds, if you buy only very low cost, broadly diversified ETFs from a discount broker, and then you hold them for the long-term without trading

To obtain better net investment returns, individual investors must carefully control both visible investment management fees and more hidden investment trading costs and associated capital gains taxes.

At the same time that investment management fees and costs were rising dramatically, industry deregulation, market innovation, and increased competition provided many new and useful low cost investment fund mechanisms for investors to manage their assets in a far more cost-efficient and tax-efficient manner. Just because most other individual investors and their financial advisors seem not to have a clue about optimal investment strategies does not mean that you need to be clueless, as well. You do not have to play this game. You will not be alone, if you decide to stop listening to the siren song of superior returns and then cut your costs to the bone so that you actually have a better chance of really obtaining superior returns.

Adopting investment strategies based on scientific finance is the first part of investment cost and investment tax reduction. Low cost, passive index fund investment strategies are inherently more cost-efficient and far less risky. This is not surprising, because a fundamental goal of investment research has been to discover those strategies which maximize personal economic welfare on a risk-adjusted returns basis. It is time to pay attention to this research and to stop listening to the securities industry’s siren songs about superior investment returns.

Individuals can adopt very low cost passive index investment strategies and avoid the charade of paying much more to get inferior investment results. Furthermore, when you stop playing this game, you also stop exposing yourself to many unnecessary and uncompensated investment risks along the way. In addition, you save a lot of your valuable time. For more information about why passive investment strategies are advantageous, see this article “Passive individual investors are “free riders” who benefit from the higher costs of active traders” published on our sister website, The Skilled Investor.

The conflicts of interest between individual investors and the financial services industry continually threaten the investment portfolios of individuals and their families.

Focusing on investment cost reduction can also draw your attention to the potentially very negative personal financial impacts of biased and sub-optimal advice. The financial services industry offers products and services for investors to buy at prices that include the market value of the investment securities plus the costs and profits related to the sale and transaction. Often the true cost of the industry’s markup is obscured or hidden.

Investors need to understand that their interactions with the financial markets through these industry intermediaries are a “zero-sum game.” In and of itself, the securities industry does not create any value for you. Of course, the markets serve extremely valuable price setting and capital allocation functions within the global economy. Nevertheless, the competition between professional investors largely drives and achieves these important capital allocations functions.

Before investment costs and capital gains taxes are considered, at best, the securities markets are a “zero sum” game from the point-of-view of the interests of individual investors.

I say “at best,” because the demonstrated naivete and mistakes in personal investment management of millions of individual investors, makes it likely that their involvement in the securities markets is already a slightly “negative sum” game even before they pay such high investment fees and costs. However, when excessive “retail investor” costs and taxes are considered, then a significant portion of investors’ potential returns are simply swept away by the financial securities industry.

Particularly with the abnormally high market returns of equities-based securities during the last two decades of the 20th century, many investors became very lax about managing their investment costs and capital gains tax realization. Double digit returns made costs seem like “just few percent” and not very important. Following the dot-com stock market crash and the deflating of the equity securities asset bubble, many investors need to make cost cutting and investment tax reduction a much higher priority.

The most effective strategy you have to improve your investment returns is to cut you investment costs and investment taxes down to the bare minimum. Once you commit to this mission across your lifetime, you may discover another financial miracle. When you refuse to pay more than the bare minimum needed to buy very broadly diversified investment funds, then financial advisors who add no value will figure out that you are not an easy mark and move on. Then, you might actually have a better chance of finding a financial advisor who will provide advice that is actually in your best interests!

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See: Financial Planning Consultants in Pasadena California >>>

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Larry Russell, Managing Director

MBA – Stanford University, MA – Brandeis University, and BS – M.I.T.

Lawrence Russell and Company Pasadena, California 91103

(626) 399-9579

A California Registered Investment Adviser — Certificate 133101

KNOWLEDGE — OBJECTIVITY — HONESTY — DILIGENCE — SATISFACTION

A truly independent financial planner and fee only investment advisor

(Concerning my compensation, I perform services solely on a fixed fee or hourly fee for services basis, and only under a contract that would be agreed upon with you. You do not have to pay any form of asset fee. Furthermore, to avoid any conflict-of-interest, I do not accept compensation or commissions of any kind from the industry.)

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