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Opinion: Efficient investing: Spending less can get you more

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Mutual funds and exchange-traded funds are baskets of dozens, hundreds or thousands of stocks and/or bonds. Many investment advisers use these pooled funds in client portfolios.

What many investors don’t know is that the busier a fund manager is, the worse they tend to perform. So, you may be better served by a low-cost index fund that simply tracks the market.

“Active” managers at fund companies buy and sell stocks and bonds, trying to match or beat the performance of the markets. That success is judged against their benchmark index – a large representative sample of their segment of the market, such as large U.S. companies (think S&P 500, Dow Jones Industrial Average and others), small companies (the Russell 2000 Index, for example), bonds (Barclays Indices and many others), and so on.

Every year, S&P reviews U.S. mutual fund performance. The study, called S&P Indices Versus Active, reports just how good professional stock pickers are at outsmarting the markets.

Year after year, the results show that markets are efficient: Stock prices adjust quickly to account for new information, which in this age of instant communication is available to all investors simultaneously.

Each year, some fund managers do beat the market, but it’s not the same managers from year to year. You can’t predict which ones it will be this year, and over the long run, fund managers tend to perform about average, minus their expenses and trading costs.

You can find the expense ratio – your annual cost just to own a fund – in your prospectus.

But fund companies aren’t required to report the managers’ stock trading costs. They only report the turnover ratio. For example, 100% turnover would mean that over the course of the last year, every stock and/or bond was sold and a replacement purchased.

And those trades do cost – commissions, bid-ask spread and market impact costs, in some cases. A 1998 research paper, “The Official Icebergs of Transaction Costs” by Plexus Group Inc., came up with a broad rule of thumb for figuring typical trading expenses: For every 100% of turnover, assume about 1.16% cost.

So, if a mutual fund has 60% turnover, multiply 60 by 1.16% for a 0.696% estimated turnover expense. Consider then, a $1 million portfolio assessed at 0.696% equals $6,960 in estimated trading costs per year.

Now, you might think the trading activity of fund managers would mean better performance despite the costs – after all, they’re the experts, and if they buy or sell a stock, they could tell you why they think it’s a good idea.

However, another study, “Shedding Light on Invisible Costs: Trading Costs and Mutual Fund Performance” by business professors at University of California-Davis, University of Virginia and Virginia Tech in 2013, found higher-turnover funds perform an average of 1.92% worse than lower-turnover funds.

The less trading a fund manager does, the better the performance. Let that sink in.

Why? It’s back to the fact that markets are efficient (the same public information is available to everyone all the time), so any given fund manager can’t consistently outsmart the thousands of other investors who are all making decisions that set the prices of individual stocks and bonds. In other words, a manager can’t consistently predict the movements of the overall markets, or whether any given stock will go up or down, before other traders make the same predictions. So, their expensive trading activity is not productive, and, like a boat anchor, potentially drags down performance as the trading costs evaporate from the funds.

Because of this eye-opening research, many advisers and individual investors have turned to passive index fund portfolios.

Instead of having a manager trying to match or beat their benchmark, an index fund simply mirrors the benchmark index – owning all the same securities that make up the index or a large representative sample. The goal is to track the overall market, not to beat it. The investment costs and turnover tend to be lower, meaning potentially more money stays in the account, working for the client.

There are additional advantages. Lower-turnover investments generate less capital gains taxes. Also, active managers may keep excessive cash handy in a fund so they can hop on “hot” stocks. Cash doesn’t perform well in an investment – known as “cash drag.” Comparatively, index funds need little cash on hand.

Of course, there’s one more piece to the investment cost puzzle: the fees you pay your investment adviser. They’re the gatekeeper and may provide broader financial planning advice, but their fees should be reasonable.

Ask your adviser about your market investment costs and turnover – and look at your investments to see the relationship between lower costs and better performance potential.

Certified financial planner Kenny Gott is president at Piatchek & Associates and author of the book “Bottom Line Financial Planning.” He can be reached at kgott@pfinancial.com.

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