The Lowest Cost Portfolio Doesn’t Guarantee Future Success

David Fabian

There is a litany of evidence about the benefits of cost cutting on long-term portfolio results.  This mantra has been echoed by large institutional portfolios such as pensions and endowments all the way down to main street investors.Basket Egg Investment Portfolio Concept

The theme generally follows the line of removing high fee managers and making your portfolio as passive as possible.

The logic entails that reducing transaction costs and overall management fees will ultimately add to your net returns over long time frames.

Private equity and hedge fund managers are usually the first on the chopping block because they tend to charge the highest fees linked to performance measurements.

Next comes actively managed mutual funds and insurance products, which often include sales and redemption costs on top of ongoing management fees.  Lastly, you can whittle down all the quasi-active or smart beta indexes to the absolute lowest cost exchange-traded funds.

Cheaper is better.  Cheaper is efficient.

But, is it better under every single circumstance or just in the abstract?

returnWhat is lost in translation or perspective in this conquest is what is known as the behavior gap.  There is a significant breach between a benchmark return and a true investor return that can’t be completely explained away by fees.  Often the biggest driver of this difference is simply behavioral choices driven by embedded pressures to outperform or protect capital.

Not every investor is cut out to buy and hold for decade after decade.  They have a hard time separating their emotions from the hysteria of the media or other sources of influence.

There are also some investors that are simply adhering to a strategy or comfortable with a process that can’t be replicated with an ETF charging 0.03% annually.

I am all in favor of removing high-fee investments that are fundamentally similar or structurally inferior to an index fund.  However, at some point you are going to have to pay someone to steer the ship or do so yourself.  The replacement of expensive investment products can only be successful if you map out an alternate path with cheaper tools that you stick with through thick and thin.

There also must be some consideration as to when you decide to make this switch.  Those who converted to ETFs or index funds and have ridden the market higher over the last half decade are going to be more comfortable understanding their opportunities and risks.  They likely have a favorable cost basis established and have grown accustomed to what works and what doesn’t.

A pension fund that is firing 30% of its portfolio exposure in hedge funds right now has a much different risk symmetry.  They more than likely know the basic asset allocation of what they want to own.  However, they must figure out how to own it, when to buy it, and at what points would those parameters change.

The bull market could go on for another 10 years or we could have witnessed the peak this year.  No one knows with any certainty.bear vs bull

The Bottom Line

My advice is to treat your investment portfolio the same as you would any other decision in your life.  You evaluate the cost of a strategy, advisor, or fund versus how much value it created for your personal situation.

Some investors may be paying a little bit more in one area (such as advisory fees), but the benefits are such that they would ultimately have much worse performance on their own.

There is usually a happy medium between implementing a low-cost portfolio and paying a little bit to make sure its properly looked after and serviced to your goals.

Until next time,

David Fabian

David Fabian is a Managing Partner at FMD Capital Management, a fee-only registered investment advisory firm specializing in exchange-traded funds. He has years of experience constructing actively managed growth and income portfolios using ETFs. David regularly contributes his views on wealth management in his company blog, podcasts, and special reports. 

 

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