An out-of-town visitor was being shown the wonders of the New York financial district.  When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor.  He said, “Look, those are the bankers’ and brokers’ yachts.”

“Where are the customers’ yachts?” asked the naïve visitor.

Fred Schwed, Where Are the Customers’ Yachts?


If you’ve never read an investment book before, chances are you’ve never heard of index funds.  No, your financial advisor won’t likely discuss them.  Index funds are flies in caviar dishes for most financial advisors.  From their perspective, selling them to clients makes little sense.  If they sell index funds, they make less money for themselves.  If they sell actively managed mutual funds, advisors make more.  It really is that simple.

Most expats, however, should be interested in funding their own retirement, not somebody else’s.

The term index refers to a collection of something.  Think of a collection of key words at the back of a book, representing the book’s content.

An index fund is much the same: a collection of stocks representing the content in a given market.

For example, a total Australian stock market index is a collection of stocks compiled to represent the entire Australian market.  If a single index fund consisted of every Australian stock, for example, and nobody traded those index fund shares back and forth (thus avoiding transaction costs), then the profits for investors in the index fund would perfectly match the return of the Australian stock market before fees.  Stated another way, investors in a total Australian stock market index would earn roughly the same return as the average Australian stock.


Global Investors Bleed by the Same Sword


Now toss a professional fund manager into the mix—somebody trained to choose the very best stocks for the given fund.  Unfortunately, the fund’s performance will likely lag the stock market index.  Most active funds do.  Regardless of the country you choose, actively managed mutual funds sing the same sad song.

Professionally managed money represents nearly all of the money invested in a given market. Consequently, the average money manager’s return will equal the return of the market—before fees.  Add costs, and we’re trying to run up that downward-heading escalator.

Consider the UK market.  According to a study published by the Oxford University Press, “Mutual Fund Fees around the World,” the average actively managed fund in Great Britain costs 2.28 percent each year, including sales costs.2 Regardless of the market, the average 53 professionally managed fund will underperform the market’s index in equal proportion to the fees charged.

Ron Sandler, former chief executive for Lloyds of London, reported a study for The Economist, suggesting that the average actively managed unit trust in Great Britain underperformed the British market index by 2.5 percent each year. It’s no coincidence that the average UK unit trust (mutual fund) cost British investors nearly 2.5 percent per year. 

In Canada, Standard & Poor’s reported that 97.5 percent of actively managed Canadian stock market funds underperformed the Canadian stock market index from 2005 to 2010, thanks largely to the funds’ high management expenses.

In South Africa, nearly 90 percent of actively managed unit trusts underperformed the South African stock index, as measured by the Satrix 40 exchange-traded fund (ETF) during the fi ve years ending 2010.

In Australia, according to the Standard & Poor’s Indices versus Active (SPIVA) funds scorecard, 72 percent of actively managed funds underperformed their indexed benchmarks over the three-year period ending 2012.

As for American expatriates, beating a portfolio of index funds with actively managed funds (especially after taxes) is about as likely as growing a third eye.


American Expatriates Run Naked


Unlike most global expats, Americans can’t legally shelter their money in a country that doesn’t charge capital gains taxes.  And actively managed mutual funds attract high levels of tax.  There are two forms of American capital gains taxes.  One is called short-term ; the other, long-term. Short-term capital gains are taxed at the investor’s ordinary income tax rate.  Such taxes are triggered when a profi table investment in a non-taxdeferred account is sold within one year.

I can hear what you’re thinking: “I don’t sell my mutual funds on an annual basis, so I wouldn’t incur such costs when my funds make money.” Unfortunately, if you’re an American expat invested in actively managed mutual funds, you sell without realizing it.  Fund managers do it for you by constantly trading stocks within their respective funds.  In a non-tax-sheltered account, it’s a heavy tax to pay.

Stanford University economists Joel Dickson and John Shoven examined a sample of 62 actively managed mutual funds with long-term track records.  Before taxes, $1,000 invested in those funds between 1962 and 1992 would have grown to $21,890.  After capital gains and dividend taxes, however, that same $1,000 would have grown to just $9,870 in a high-income earner’s taxable account.7 American expats, as I’ll explain in a later chapter, must invest the majority of their money in taxable accounts.

Because index fund holdings don’t get actively traded, they trigger minimal capital gains taxes until investors are ready to sell.  And even then, they’re taxed at the far more lenient long-term capital gains tax rate.

In a 2009 New York Times article, “The Index Funds Win Again,” Mark Hulbert reported that Mark Kritzman, president and chief executive of Windham Capital Management of Boston, had conducted a 20-year study on after-tax performances of index funds and actively managed funds.  He found that, before fees and taxes, an actively managed fund would have to beat an index fund by 4.3 percent a year just to match the performance of the index fund.  8 Flying parrots will serve you breakfast before a portfolio of actively managed funds beats a portfolio of index funds (before fees) by 4.3 percent over an investment lifetime.

Researchers Richard A. Ferri and Alex C. Benke reported in their 2013 research paper, “A Case for Index Fund Portfolios,” that the slim number of portfolios that beat index funds before taxes between 2003 and 2012 did so with an annual advantage ranging between only 0.29 percent and 0.54 percent per year.  And that’s before taxes.


Excerpt from The Global Expatriate’s Guide To Investing – From Millionaire Teacher to Millionaire Expat

Andrew Hallam is the author of The Global Expatriate’s Guide To Investing. It’s available on Amazon USA and Amazon UK.

First Published in Wealth and Finance International Magazine – November 2014

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