“PERFORMANCE COMES and goes, but costs roll on forever,” said Vanguard Group’s founder, the great John Bogle. It’s been just over a year since Jack passed away.
I think he would have approved of Vanguard’s recent announcements that it had reduced fees on 56 funds and eliminated trading commissions to buy and sell stocks and ETFs. The latter followed similar announcements from other major discount brokers. All of this is good news—especially right now.
Why? Vanguard recently forecast that U.S. stocks will average just 3.5% to 5.5% a year over the next 10 years, while U.S. bonds might notch 2% to 3%. Research Affiliates is even more pessimistic, projecting U.S. stock returns that are barely above inflation. Yes, over the past decade, the S&P 500 returned more than 13% a year. But over the prior decade, its return was negative. There’s a decent chance that the 2020s will look more like the 2000s than the 2010s.
If returns are indeed low, investment costs will eat up a larger percentage of our gains—which is why the news on investment costs is good. But maybe it isn’t quite as good as folks imagine. Here are five thoughts on the recent fee-cutting war among Wall Street firms:
1. Commissions are, for many investors, a fairly small cost. Individual investors often pay far more in advisory and other fees, which might total 1% or more of their portfolio’s value. Similarly, beyond commissions, institutional investors can pay hefty sums to trade, including market impact costs—the tendency for their own trading to drive security prices up and down, thus making it more expensive to buy and sell investment positions.
2. Investors also need to be aware of bid-ask spreads, the difference between the higher price at which they can currently purchase a security and the lower price at which they can sell. The difference—which represents the cut taken by Wall Street’s market makers—is typically minimal for liquid securities, but it can be several percentage points for illiquid securities.
3. I view much of the fee-cutting not as proactive, but rather as a response to competitive pressures. For instance, like Vanguard, Dimensional Fund Advisors (DFA) recently reduced its fees. DFA relies heavily on investment advisors to steer their clients to DFA funds. Those advisors are being courted by low-cost index and factor-based ETFs, which is putting pressure on DFA.
4. A good advisor can help investors develop a plan, choose the right asset allocation, invest in appropriate securities and avoid behavioral mistakes. But investors should only compensate advisors a reasonable amount—and they should avoid paying for advisors or services that are unlikely to add value.
Investors might invest on their own or use one of the robo-advisors. The latter offer simple yet smart advice for minimal cost. By contrast, high-cost advisors and funds are likely to have relatively inferior performance, which will be especially problematic if we suffer a low-return environment.
5. The reason index funds have grabbed an ever larger percentage of industry assets is because they effectively allow investors to separate investing from speculating. What counts as speculation? I’m not just talking about day traders and others who buy and sell like crazy. Arguably, active money managers are also speculators, as they try to guess which stocks and bonds will outperform.
In fact, some observers have accused the entire active-management business of being a scam. Don’t want to be scammed? Whether you’re using an advisor or investing on your own, the default choice should be index funds. Remember, any higher-cost investment is more likely to lower your returns than improve them.
Gary Karz is a Chartered Financial Analyst, publisher of InvestorHome.com and author of The Peaceful Investor. He enjoys skiing, hiking, biking and snorkeling. Follow Gary on Twitter @GKarz or email him at firstname.lastname@example.org.