Knowing your priorities in life is crucial, especially when it comes to investment goals. Often asking the “how” and “when” of the investment equation helps you get started on the right path. Many come across mutual funds as one way to start investing in a highly diversified manner with a skilled money manager serving as a cherry on top for their financial knowledge. However, a mutual fund manager charges you hefty fees for their service. Moreover, a typical mutual fund manager wears different hats, which means their time is spent doing things that have little to do with investing as they go out and network to market their funds and make presentations to sell their funds in order to attract more clients to invest with them. The point is simple: you pay a mutual fund manager for doing stuff that does not completely align with your own investment interests. Plus there is an abundance of studies that show that the so-called “skilled mutual fund managers” are no better at beating the market than a monkey picking stocks at random (don’t believe me, go to FT.com for the full story)! So why not put some of that money spent on mutual fund’s fees back into your pocket? By going with a robo-advisor and staying passive in your investment style, you tend to do much better than by investing with a mutual fund.
Most mutual funds strive to beat the market by using an active strategy. There are many variants of this strategy and depending on the fund manager’s particular investment view, this could involve being bullish on a few undervalued stocks, shorting stocks, employing options strategy to hedge downward risks of a portfolio or a combination of all. Whatever form the active strategy may take, it comes with high transaction costs, which lowers net returns for the investor. NY Times reported on a study that S&P Dow Jones Indices conducted focusing on the period between March 2009 (start of the bull market) to March 2014. The study aimed to identify mutual funds that had the best returns over each successive 12 month period starting from March 2009. There were a total of 2,862 actively managed domestic stock mutual funds included in the study, and only two funds were able to stay in the top quarter consistently for 5 years. Statistically speaking, it’s quite negligible! If managers compete on skill, then you can bet each one of them is almost equally skilled. Thus, over-performance in investments then becomes a question of luck rather skill.
If luck is what it comes down to, one would rather try luck by investing with a robo-advisor. The lower you pay in fees, the better your chances of achieving above average returns over the long run are. A mutual fund has many layers of fees. A few fee categories are as follows:
- Expense ratio related to the marketing, distribution, and ongoing management costs of the fund. Typically is around 0.90% per year according to Morningstar
- Transaction costs are very challenging to quantify accurately as there are multiple facets to it but can generally be estimated around 1.44% (on top of a mutual fund expense ratio)
- Cash drag is the cost associated with cash not being invested. If stocks perform poorly, cash drag tends to go up. Conversely, if stocks perform well, this cost tends to go down. Mutual funds need to have some of the invested capital available for liquidity and redemptions. Consequently, a portion of an investor’s capital is kept in cash. It hurts the buy-and-hold investors the most as they subsidize other investor’s liquidity concerns without redeeming their shares in a mutual fund themselves. Robo advisors don’t have such issues as they are meant to cater each individual’s investment needs. According to a Forbes article, cash drag is approximately 0.83% per year for large cap stock mutual funds invested over a 10 year horizon.
- Tax costs can be significant if you invest in a taxable account. A mutual fund investor has to pay capital gains taxes on stock holdings that the fund owns, even if the investor did not benefit from the appreciation in stock price at the time he bought into the fund. This is referred to as “embedded gains” in a mutual fund and can range from 1% to 1.2% per year (Forbes). With a robo advisor, you are responsible to pay taxes on only your individual capital gains.
The discussion above entails but a few costs one may encounter with a mutual fund. There are many hidden costs that can reduce your net return. Since beating the market is almost like a fallacy in today’s age of passive index ETFs, an investor needs to be cost conscious at all times and use technology to achieve optimal portfolios.
Wealth management sure is being shaped by the robos!