Saturday, November 3, 2012

Investing in Wall Street’s Casino: The House’s Take

There is certainly nothing new in comparing Wall Street to a gambling operation, but there is more to be learned about the actual operations and about what our encounters with financial types are actually costing us. John C. Bogle has produced a new book that provides us with some necessary background: The Clash of the Cultures: Investment vs. Speculation

Bogle views stock market speculation as debilitating for investors and the economy as a whole. Unnecessary short-term trading does nothing for the value of the market except to siphon off transaction costs to the financial intermediaries. As in a casino, there are winners and losers, but the house always gets its share.

" need only understand the tautological nature of the markets: Investors, as a group, inevitably earn the gross return of, say, the stock market, but only before the deduction of the costs of financial intermediation are taken into account. If beating the market is a zero-sum game before costs, it is a loser’s game after costs are deducted."

While technology and competition have forced down individual transaction costs, the response has been to encourage more trading in order to keep the dollars flowing in.

"While unit-trading costs have plummeted, trading volumes have soared, and total costs of the financial system continue to rise. Too many innovations have served Wall Street at the expense of its client/investors."

Wall Street has a function to perform in allocating capital to those who need it, and in providing liquidity, but those roles have been overwhelmed by speculation.

"In recent years, annual trading in stocks—necessarily creating, by reason of the transaction costs involved, negative value for traders—averaged some $33 trillion. But capital formation—that is, directing fresh investment capital to its highest and best uses, such as new businesses, new technology, medical breakthroughs, and modern plant and equipment for existing business—averaged some $250 billion. Put another way, speculation represented about 99.2 percent of the activities of our equity market system, with capital formation accounting for 0.8 percent."

Transaction costs can be enormous, and their effect is often unrecognized by most investors who place their money in the hands of mutual funds. This source provides a good summary of the cost structure.

"The expense ratio represents the percentage of the fund's assets that go purely toward the expense of running the fund."

"Currently the typical expense ratio for an actively managed mutual fund is about 1.5%, and that number has been going up lately. With an expense ratio of 1.5%, a mutual fund is cutting itself in on 1.5% of the total money in the fund every year."

The expense ratio has the following components:

"The investment advisory fee or management fee is the money necessary to pay the manager(s) of the mutual fund. On average, this fee is about 0.50% to 1.0% annually of the fund's assets, and is necessary to make sure that the manager of the fund can be very well-dressed at all times and is able to go on good vacations."

  "Administrative costs are the costs of record keeping, mailings, maintaining a customer service line, etc. These are all necessary costs, though they vary in size from fund to fund. The thriftiest funds can keep these costs below 0.20% of fund assets, while the ones who use engraved paper, colorful graphics, and phone answers with highfalutin' accents might fail to keep administrative costs below 0.40% of fund assets."

"Surely the fee that you as a mutual fund investor should be most outraged by is the 12b-1 distribution fee. This fee ranges from 0.25% of a fund's assets all the way up to 1.0% of the fund's assets. This fee is used for marketing, advertising, and distribution services. Yup, that's right. If you're in a fund with a 12b-1 fee, you're paying every year for the fund to run commercials and try to sell itself."

Bogle reminds us that while earnings compound, so do costs. Let’s look at a simple example to see how this works. Say your favorite aunt died when you were young and left you $10,000. You wisely invested it in a well-regarded equity fund and left it there for 40 years so that it would be available to you in your retirement. Say you chose well and your investment earned 7 percent annually over the 40 years. You could then expect to have about $150,000 dollars available. However, you hadn’t reckoned on the fund fees. Say your fund took out the typical 1.5 percent each year; that would mean the actual rate of return was 5.5 percent annually. A return of 5.5 percent over 40 years means you would only have about $85,000. That seemingly small fee took away over 40 percent of your earnings and cost you about $65,000. And remember, 1.5 percent is the typical fee, yours could be higher.

Bogle believes it is absurd to pay these fees, and he thought that many years ago. His recognition that a speculatively traded fund, with its fees, cannot match the market as a whole in the long run, led him to create the index fund. Vogel is most famous for founding the Vanguard 500 Fund. Tying a portfolio to an index that tracks the market as a whole limits the need for transactions and minimizes costs. And it guarantees that you will do as well as the market—at least to the degree that the market is represented by the chosen index.

Our source on fund expense ratios provides this information:

"Meanwhile, in the wonderful world of index funds, the expense ratio is typically around 0.25% and gets as low as 0.18% for the king of all index funds -- the Vanguard 500 Index."

Returning to our example, if one had invested in a fund with an expense ratio of 0.18 percent, and had realized the same 7 percent annual gain, the amount available after 40 years would have been about $140,000 rather than $85,000.

Recent studies have indicated that most people who invest in a 401K are not even aware that there are costs associated with their plan. Estimates indicate that for the average investor, about a third of the potential value of a 401K account is consumed by fees levied by fund managers. There are new regulations forcing plans and managers to be explicit about what fees are in place. Hopefully, this will instill some shame and some competition and drive the fees down. It really does make a big difference.

Finally, Bogle provides us with this perspective:

"Pressed to identify useful financial innovations created during the past quarter century, Paul A. Volker, former Federal Reserve Chairman and recent chairman of President Obama’s Economic Recovery Board, could single out only one: ‘The ATM’."

No comments:

Post a Comment

Lets Talk Books And Politics - Blogged