How to Convince A Friend Not to Invest in an Active Fidelity Fund by Steve Abramowitz

My good friend Irving was about to open a Roth IRA with a $10,000 lump sum he had squirreled away in a savings account at his local bank. At thirty, he had just been promoted to manager of the production division of Widget Sure Repair, a manufacturer of easy-to-use tools for do-it-yourself homeowners. The promotion came with a large salary increase and my friend felt confident he could afford to make monthly contributions of $250 to the plan.

But I detected a problem—a big problem—with Irving’s retirement formula. You see, his father had gone bankrupt when his men’s clothing store could no longer compete with the online presence of large discount retailers.  Irving became very conservative in his financial affairs, rolling over CDs he purchased at his bank.

Oh No, My Friend Wants to Go Active with Fidelity

After almost a year of cajoling, I was able to convince Irving to start a retirement program and open a Roth. I explained to him the simple logic behind the superior long-term performance of index funds, but he feared he would become too nervous whenever the market nosedived and would probably sell out rather than stay the course. He felt knowing a portfolio manager was at the helm would help him stay calm in bear markets.  He strongly favored Fidelity because it had a branch office a few blocks down the street from his house.

I knew my friend would be throwing away his money unnecessarily and reducing the size of his ultimate nest egg by going active but I was at wit’s end. Then I remembered Irving had been a math major in college and might be swayed if I presented my argument in numbers.

A Rescue by the Numbers

Here is how I made my case to Irving. I briefly described how I conducted a back-of-the-envelope analysis of what it would mean for him to put the Roth into Fidelity’s active funds rather than their index fund alternatives. I could identify four active domestic non-specialty Fidelity funds categorized as large blend (containing both value and growth stocks), whose expense ratios ranged from .46 to .79. To remove any idea that I was up to any hanky-panky, I chose the actively managed fund with the lowest cost, the Diversified Equity Fund.

Next, I selected the less expensive of the two active small cap blend funds at .92, Stock Selector Small Cap. I was frustrated in my search for an active large blend international fund and settled on taking the average expense (.78) of the lone international value fund (International Value, .95), and the cheapest growthier fund (Diversified International, .62). Total Bond costs .45, which struck me as prohibitive for a fixed-income fund.

What were the comparative index funds? Zero-fee Total Market and Zero-fee International funds are obvious choices for our two large blend categories. Several readers have pointed out that these investment vehicles, though available to everyone, are self-evident loss-leaders and by their very nature unrepresentative. I therefore also ran the cost numbers for the passive Total Market (.015) and Total International (.06) offerings. Small Cap and US Bond have the same expense ratio (.025).

I was now ready to calculate the averaged overall cost of the four equally-weighted categories of funds—large blend, foreign large blend, small cap blend and bond, a 75/25 stock/bond allocation. The resulting figures are .65 for the active portfolio and .01 and .03 for the passive zero-fee and total fund portfolios, respectively. But how significant in a practical sense are these seemingly astounding disparities?

A Well-Deserved Latte

I showed Irving how much he could save by investing in passive funds, assuming an average annual market return of 10% across about thirty-five years until retirement. The active approach generated about $1,078,000, whereas passive investing produced about $1,290,000 and $1,283,000, depending on the index funds used, or over $200,000 more either way. Irving was startled at the magnitude of the difference and proceeded to invest in index funds. As a thank you, he treated me to a latte at the local coffee haunt.

Some Notes to Readers. If Irving had insisted on investing in actively managed funds, he would have been better off with Vanguard. PRIMECAP Core and Windsor, two of the low-cost provider’s most popular active funds, have expense ratios of .46 and .42, respectively, considerably lower than the foregoing Fidelity funds. His choice of index funds at Fidelity, though, would not have been entirely unwise. Although Vanguard has over 100 index funds and Fidelity only about 35, their cost is highly competitive with the cost of Vanguard’s similar index funds. The Boston mutual fund behemoth apparently uses them as loss-leaders, confident that aggressive marketing will lure passive fund investors into their inefficient and expensive active funds.