The Two-Percent Prescription

If you could be highly confident that you could improve your investment returns by almost 2% per year while taking less risk, would you do it? Does it sound too good to be true? Does it sound like a con job? It isn't.

If you could be highly confident that you could improve your investment returns by almost 2% per year while taking less risk, would you do it? Does it sound too good to be true? Does it sound like a con job? It isn’t.

Victims of active managers endure average net returns of about 2% below the appropriate index in every market or market segment in the world. They can be highly confident that active managers will fall short by about that amount. The odds are from 70% to 80% that active managers will fall short of the index during any particular time frame while generating additional risk and enormous tax bills in a futile attempt to beat the index.

Yet active managers somehow convince investors to pay them fees against all the available evidence that they can add value. In mutual funds, such fees and other expenses are disclosed in the fund’s prospectus as expense ratios.

Other expenses often exceed the disclosed fees. Any purchase or sale of a stock by the fund will generate a commission to the broker. In addition, there is a bid-ask spread on every security transaction. The market maker buys at one price and sells at a higher price. Finally, a fund or manager can impact the price of the stock by purchasing or selling shares in excess of the market demand. Unloading a big position can take a long time and drive the price of a stock down in the process.

Such undisclosed expenses are every bit as real as the expense ratios, although they can only be imputed from a fund’s turnover ratio. For accounting purposes, such costs are included in the stock prices that the fund obtains on purchase or sale, reducing net performance. Higher turnover leads to increased costs and reduced performance. There is a strong direct relationship between fund turnover and underperformance.

It shouldn’t surprise you that for investors as a whole, average performance is reduced almost exactly by average costs. Mathematically, this must be the result.

While returns fall, risk rises because the dispersion around the average result is large. For instance, a particular fund might fall 10% or more below the average. Clearly such a fall would be a disastrous result. And the risk is entirely uncompensated. For bearing the risk, our expected return falls 2%!

Of course, a few funds or managers always beat the index. That’s what keeps the suckers coming back. But your chance of picking such funds or managers in advance is only 20% to 30%. Judging by past performance is a brain-dead strategy. If past performance were a useful strategy, we could all use last year’s Morningstar results and end up rich.

Index funds have negligible turnover and rock bottom expense ratios. So, switching from an active to a passive strategy increases your expected return by almost 2%! And passive strategies slash your tax obligations on gains in the process.

The bottom line here is that you have to have a compelling reason to reject index funds as the only rational investment choice. Do the right thing: index. It’s the easiest 2% you will ever earn.

Frank Armstrong, CFP, AIFA

Frank Armstrong III is founder and CEO of Investor Solutions, Inc., an independent, fee-only investment management firm in Coconut Grove, Florida. For the second year in a row, Barron’s has selected the firm as one of the top “100 Best” Independent Financial Advisors in the country. The firm has been named on Bloomberg’s list of Top Wealth Managers and rated a “Five Star” on the Paladin Registry. Frank has more than 35 years of experience in the securities and financial services industry. He contributes to major publications and appears regularly on television and radio. He is the author of the forthcoming book, SINK OR SWIM: Enjoy a Successful Retirement in an Age of Cradle-to-Grave Insecurity and the bestseller, THE INFORMED INVESTOR: A Hype-Free Guide to Constructing a Sound Financial Portfolio.