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Are Investors Paying Attention to the Wrong Costs?

If you turn on the television or read the news, you will surely see something regarding high mutual fund fees. Before I discuss the merits (or lack thereof) of this argument, it is first important to understand the two general types of mutual funds.

The first group is the active funds. These are funds where a portfolio manager is actively making decisions on what to invest in, what to avoid, how much cash to hold, etc.

The second group is the passive funds. These are funds that simply track an index or basket of stocks. There is no manager making decisions. The goal is to passively replicate the market (i.e. S&P 500).

The active funds generally have higher fees due to the additional cost of the portfolio manager. The passive funds usually have very low fees because, well, there simply is no manager.

The active funds are the ones that have had a lot of bad publicity because of their significantly higher fees. And it looks like the market has spoken… In 2016 active funds experienced outflows of $340 billion while passive funds took in a record $504 billion.

While I will contend that it is important to pay attention to fund fees, your annual return is most affected by valuation. Let me explain…

Your annual return is simply a function of what you pay for each dollar of earnings. Quite simply, the more you pay the lower the return and the less you pay the higher the return.

The chart below looks at the average annual return of the S&P 500 based upon price paid (CAPE Ratio) since 1881.

As you can see, the higher the price paid (CAPE Ratio), the lower the return. Right now (6/14/17), the S&P 500 has a dangerously high CAPE Ratio of 30. Using the chart above, we can make the following conclusion:

On average, paying $30 for each dollar of earnings yields -0.30% annually over the next 10 years.

In fact, the average CAPE Ratio over the past 130 years is only 17 and there has only been one other time in history that had a higher CAPE Ratio than today – the Dot-Com bubble (year 2000 at its peak). And we know how that ended!

Most passive fund flows have been put into funds that track the S&P 500. However, this passive strategy has a very high valuation (30x) today despite inexpensive management fees. Paying more attention to fund fees rather than its underlying valuation is like missing the forest for the trees.

These are the implicit “costs” that no one is talking about. In conclusion, while it is important to understand and be aware of fund fees, it is more important to pay attention to valuations, the implicit “costs,” because this is where the money truly is made!  

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