Andrew Hallam

Over the past 3 years, I’ve spent thousands of dollars of my own money distributing books to teachers at Singapore American School, on the merits of indexed investing.

 The books were comprised of 15 different titles.  Call it a mission of a driven man, but I’ve been very surprised at the investment fees paid by local Singaporeans and expatriates—which is the only reason I’ve emptied my pockets to distribute free books on inexpensive, common sense investing.

When I first moved to Singapore, I searched for index investing alternatives for my expatriate and Singaporean friends.   I came across an article, ‘Buy Low Cost Index Funds‘,  by Mr. Tan Kin Liam (The Former Chief Executive at NTUC Income) but the indexed options he gave were still surprisingly pricey. 

It’s well known that investors stand the greatest statistical chance of stock market success when they buy index funds.  But a lack of financial education keeps many people buying their far more expensive cousins: actively managed mutual funds, also known as Unit Trusts.  What’s worse, is that many investment companies charge additional wrap fees on top of the excessive fees charged by unit trusts. 

When actively managed funds charge more than 1.5% annually, and then the investment service company takes a further 1.75% annually in advisor’s fees (See the Raymond James Freedom Account)  investors are giving away more than 3% annually.  If the stock market compounds at 9% annually, going forward, then investors are giving away 33% of their profits, when paying 3% in fees.  It shouldn’t be legal, but it is.

If the markets make 6% going forward (a rate of return many people would have been very happy with over the past decade) then investors paying 3% in fees are giving away 50% of their profits to fee-hungry firms.

What does this mean? 

Investors giving away 3% annually in fees are likely to make less than 1/3 of what they deserve over an investment lifetime, as you can see by the example below:

$10,000 at 6% annually =  $102,858.18

$10,000 at 9% annually = $314,094.20

Seemingly small fees make HUGE differences.

How about track records of indexed accounts?

In the U.S., more than 50% of pension funds are indexed.  Of the pension funds that aren’t indexed, nearly 90% have underperformed a combination of stock and bond indexes.

Investing with low cost, diversified indexes is a powerful strategy.  Most unit trusts/mutual funds are expensive.

And you don’t get what you pay for in the investment service industry.

It’s so bad in the U.S. that some companies are doing their best to educate their employees—trying to save them from paying excessive investment fees. Read More

While other people, like Yale University’s endowment fund manager, David Swenson, suggests that the systemic exploitation of individual investors (via unit trust/mutual fund fees) requires U.S. government action.  In his superb book, Unconventional Success: A Fundamental Approach to Personal Investment, he shows the industry for what it is:  a giant fleecing machine. 

If he saw what went on with offshore investment companies like Zurich, he’d rewrite the whole darn thing.  Massive early withdraw penalties with companies like Zurich ensure that you won’t move your money, even after you wise up to the drenching.

How about a comparison?

Over a short period of time, anything can happen with investments.  You might even have a high cost advisor who does well with your account over a short period of five years or so.  But over a lengthier period of time, an actively managed unit trust (mutual fund) account is like a swimmer wearing boots, while dragging a chunk of carpet through the water.  Eventually, the indexes are going to show him who’s boss.

Looking long term, if you had simply split $100 equally into 3 indexes (Canadian stock index, U.S. stock index, Canadian bond index) in 1976, it would be worth more than $3000 today, with no money added. Check it out here:  to see how this balanced portfolio of indexes would have weathered the 1987 market crash, the 2000-2003 crash and the 2008/2009 crash.

For Brits, Australians, New Zealanders and Singaporeans, you could create your own “home country bias”.   For example, instead of a Canadian bias (as with the indexed sample account above) you could have a home country bias with Singaporean, British, Australian or Kiwi indexes.

Historically, returns would have been similar to the Canadian example.

But how do you open an account and get started?

Those based in Singapore can open a brokerage account with DBS Vickers.  Instead of paying 3%+ as an annual investment fee, you could end up paying less than 0.3% while purchasing indexed products called exchange traded funds (ETFs)

The savings go to your bottom line.

In part II of this series, I’ll show you how to construct an account of inexpensive, diversified indexed ETFs through DBS Vickers. 

Donating to charity is great—but donating to the financial service industry is foolish.

… but what exactly are they and how do they differ from what most investors are sold?
 
“The best way to own common stocks is through an index fund”
–Warren Buffett, Berkshire Hathaway shareholder letter, 1996
 
“The most efficient way to diversify a stock portfolio is with a low fee index fund”
–Paul Samuelson, the first American to win a Nobel Prize in Economics 
 
Stock market index funds are similar to actively managed stock market mutual funds because they both hold baskets of stocks.  But an index is different to an actively managed mutual fund because an index is meant to hold a group of (or nearly all) stocks in a given market, while an actively managed mutual fund is meant to trade a group of stocks.  As such, there’s a cost difference that can’t often be overcome.  The fees for the average U.S. mutual fund are 600% higher than the fees for a low cost index fund, when accounting for the expense ratio, 12B1 advertising fees, transaction costs, opportunity costs and sales costs.  It’s a financial albatross that’s virtually impossible to overcome—no matter how great your advisor claims to be.
 
Here are the main differences between index funds and actively managed mutual funds.  For simplicity, I’ll be using Vanguard’s total stock market index, which provides all the exposure to the U.S. market you’ll ever need.  In essence, owning it is like owning slivers of shares in every public company in the U.S.

)f you owned a mutual fund company, and you realized that investors were catching on to the advantages of index funds, what would you do?
 
First, you’d train your sales staff to come up with the greatest stories they could to debunk what the greatest minds in finance have concluded about index funds.  Your staff would have to come across as convincing—and come across as smarter than Economic Nobel Prize winners, and smarter than Warren Buffett, the world’s greatest investor.
 
But, as an owner of an actively managed mutual fund company, if your sales team fails you, you’ll need a back-up plan:  you’ll need to offer your own “in house” index funds.  But as an investor, you’ll want to be careful.  Find out what the index funds cost, and don’t ever buy an index fund with a sales load.  You should never pay an expense ratio of more than 0.3% for a U.S. stock index, or 0.4% for an International stock index either.
 
Vanguard’s total stock market index costs just 0.15% and their International stock index costs just 0.27%. Over time, they have been lowering their fees, while most fund companies have been raising theirs.  Again, there is no fee to get in or out of either of these products—and your investment advisor isn’t likely to recommend them: 
  
“When brokers realize that they won’t be compensated for putting our funds in a plan, they typically hang up on us.”
Vanguard, director of institutional sales.

Roughly 95% of investors are either financially uneducated, or they believe they can find needles in haystacks. 

The financially uneducated ones give their money to financial advisors who typically invest their hard-earned money in actively managed mutual funds.  The investors may be rocket scientists, doctors, lawyers or ingenious academics, but most of those handing their hard-earned money over to a financial advisor tend to be financially naive.

The odds of paying somebody to choose funds that will beat a broad market index over time are miniscule, especially when accounting for the poorer tax efficiency that actively managed funds have over indexes.  Oh, and despite what their advisors tell them, they are paying those advisors—via load fees in, load fees out, trailer fees, soft dollar fees, or all of the above. 

But is it possible to find actively managed funds on your own that will beat the stock market indexes over the long term?  Maybe!

The average investor (buying actively managed funds) will trail a stock market index fund over the long term by roughly 2% to 3% a year, eventually earning a fraction of what they deserve.

Warren Buffett suggests that most individual investors (as well as most institutional investors) should stick to broad stock market index funds to maximize their success.

So is Buffett suggesting that investors can’t beat the stock market?  You might presume so.  But that’s not the case.  In his famous 1984 essay, “The Superinvestors of Graham and Doddsville”  he demonstrates that the market isn’t efficient, short term.  And well-trained, disciplined investors (with the right temperament) can beat the market.  Temperament, he suggests, is the key.  You can be the smartest person in the world, but if you aren’t “wired” to invest money, then no amount of academic learning is really going to help.  If you can control fear and greed, and you understand the fundamentals, then it’s possible:  you might be able to out-invest the market indexes.

It’s understandable then, that if you can’t beat the market yourself, you might want to find someone else who can invest on your behalf.  This is where market-beating mutual funds come in.  Buffett recommends indexes because of the high fees that most fund companies charge—not to mention their poor, after tax performance.  But does that mean that index-beating actively managed funds are impossible to find?  After all, there have to be mutual fund managers from the same genetic/academic vein as the “Superinvestors of Graham and Doddsville”, right?

If you twisted my arm and made me buy a slew of actively managed mutual funds, I know what I’d buy.  And for the most part, they’re fund companies that you haven’t heard of.  The top fund companies aren’t household names.  You generally don’t see them advertising themselves the way a well-known company like Fidelity advertises.  And they tend to pay financial advisors very little, if anything at all, so you won’t find them in most financial advisor-led accounts.

 Can you see the conflict of interest here?  Most advisors want to fill your investment account with funds that compensate themselves first, you second.

Great fund companies don’t tend to pay advisors generously (if at all), and they have some other things in common:

1.  They often shut their funds to new investors when they become too big.  Large fund assets make it hard to beat the market, so great fund companies shut their doors to new investors when their large funds balloon.  Companies like Fidelity and American Funds don’t bother doing this.  Assets under management mean money for the mother-ship, after all.  So if a particular fund attracts plenty of investors, it becomes a cash cow for the company, so why close their doors?

2.  They tend to charge low fees, and they have low taxable turnover.  In many cases, you must buy great mutual funds directly from the fund company, not through an advisor.  They keep fees low by keeping out the middleman, and they don’t “trade” a lot.  High trading volume means lower taxable efficiency.  For an actively managed fund to perform as well as an index fund after taxes, most have to beat the index by about 1% a year, just to break even.  And that’s really tough to do.

3.  They also tend to mandate that their managers invest large portions of their own net worth in their funds.  This also ensures that the managers are eating their own cooking.  They’ll want their money to do well, and they’ll want to do well after taxes.

4.  They are honest with their reporting.  On their websites, it’s always very easy to see what their fees are and what their returns have been relative to the stock market index.  They don’t just give you pieces of the truth; they give you the whole truth.  For every time period comparison (ie. How have they done over 1 year, 3 years, 5 years, 10 years, 15 years etc) they compare their funds’ results directly with the S&P 500 index—if it’s a large cap U.S. fund.  If it’s a small cap fund, they compare their performance to a small cap index.  It’s very admirable reporting.  Here’s an example: 

5.  Their funds have been around a long time.

So….which do I think the top mutual fund companies in the U.S. are?

In no particular order, here are a handful of companies deserving applause.  And they have all beaten the stock market indexes over the long term.  Funny though.  You may not have heard of them:

1.  Tweedy Browne

2.  Longleaf Partners

3.  Dodge and Cox

4.  Sequoia funds

5.  Royce Funds

There might be brilliant fund managers out there who can beat the market.  And this list of five fund companies may have a few of them in their midst. 

And if you’re going to venture off onto the road rarely taken (with these fund companies that are rarely, if ever, pushed by advisors) invest in them for the long run.  Most investors (and most advisors) jump around.  When their fund hasn’t done well lately, they switch to a fund that has.  I’m sorry if you think your advisor can do this and stay ahead of the curve—he or she can’t.

Stick with a great fund for the long haul and you’ll do far better.  And if anything, do the opposite of what most financial advisors would do:  buy mutual fund shares (in the above companies) after they have had a terrible year, relative to their peers.  Because they’ll likely come roaring back if they follow disciplined investment approaches.  And I believe that the above funds do.

If you want to know if your investment advisor is truly a fool, listen for these words:

“We’re going to get you out of this fund because it hasn’t done well lately.  And we’ll get you into this other one because it has.”

It doesn’t matter what those funds are.  A poor recent performance alone is a terrible reason to leave a mutual fund.  If your advisor lacks the sophistication to say something so silly—run from that advisor, and don’t look back.

Then buy and hold broad market indexes–or funds like the companies listed above.  Studies have shown that investors who trade more often (whether they’re mutual funds or individual stocks) perform far worse than investors who buy and hold.

Human instincts tempt most people to sell low and then buy high.  Buying yesterday’s recent winners is always a bad idea because they often turn into tomorrow’s losers.  And jumping around, instead of buying and holding, can have significant tax consequences as well.

But another word of caution:

Do you remember what I said about how an actively managed mutual fund (in a taxable account) will have to beat its counterpart index by roughly 1% a year, just to break even with the performance of the index?

One of the above companies, Tweedy Browne, actually shows its pre-tax and post-tax performance comparison with the S&P 500 index.

Since 1993, its value fund has amazingly beaten the S&P 500 before taxes.  As you can see below, it has produced an annual return of 8.53% before taxes, versus 7.59% for the S&P 500 index.  But that’s before taxes.  Tweedy Browne is fabulous enough (I love honest companies) to show its annual return after taxes and distributions.  Compared to the index (which is more tax efficient than an actively managed fund) the comparison doesn’t look as stellar for this fund now, as you can see below.

 But Tweedy Browne is still a fabulous actively managed fund company.  And if you twisted my arm and made me buy some actively managed funds, this would definitely be one of them.

That said, tread lightly into this good night.  Finding outperforming actively managed funds ahead of time can be a tough thing to do—as the past isn’t always a prologue to the future.  You’ll be relying on long odds, and if you want to beat a comparable index after taxes, your funds will have to beat the market by more than 1% a year.

Impossible?  Nope.  You might be able to do it.  It’s just not a wager I’d be willing to bet.