Why is it so hard to beat the market? Fees, layers and layers of fees. If you work with an investment advisor, they will be charging you an advisory fee (assume 1%). If that advisor believes their best chance of beating the market is through selecting funds, and not individual positions, those funds will be charging you a fee as well (assume 0.73% - the 2017 average i). For example:
Market Return 7.50%
Fund Expense -0.73%
Advisory Fee -1.00%
Net Return 5.77%
To put it simply, you are starting in the hole.
Now apply this to actual market returns. The first column in the table below shows the annual returns for the total US equity market from 2008-2018 (ii). The next column shows the net returns after deducting advisory fees and fund expenses.
Simple math. You are paying 1.77% in fees annually, so your geometric average return is 1.77% less than the market return.
Now assume your advisor does his/her job incredibly well and every fund selected outperforms the market by 2% every year. This would be astronomical performance. To put this into perspective, over the same 10-year period, 85% of funds trying to beat the S&P 1500 failed (iii). They could not produce performance adequate to cover their own fund expenses, let alone the advisory fee. However, even with 2% performance above the market, the client only receives 0.27% of that outperformance after fees and expenses.
Risk and return must go together. To generate market-exceeding returns, you need to take on market-exceeding risk. What if I gave you this option: You could outperform the market by 2% for eight out of ten years, but you underperformed the market by 0.50% in two out of ten years (all before fees). Would you say yes? It’s hard to say no.
It is a reasonable expectation that the funds would achieve their outperformance in bull, or up, markets. Conversely, the funds would experience their underperformance in bear, or down, markets. So, we assume that the funds underperform the market by 0.50% in the only two years with negative annual returns (2008 and 2018).
With just two years of 0.50% underperformance, your 10-year average return is now well below the market (6.99% compared to 7.37%).
What does this mean for the client who employs the advisor for the sole purpose of beating the market? It means the advisor, and the funds themselves, should have a pretty hard time justifying their reason for being. You pay them to outperform the market, which they may do. However, it’s the fees you pay them that keep you from achieving that performance. How ironic.
The future of advising is service-based. Advisors need to be more focused on how they can help solve your financial problems. If they can overcome the insane odds and consistently beat the market over a 20-year, 30-year, or 40-year time horizon, all the power to them. My question to you is this: Was this your financial plan or the advisors?
References:
i: https://www.morningstar.com/blog/2018/05/11/fund-fee-study.html
ii: Benchmarks used: The MSCI US Broad Market Index (2008 – 2013), CRSP US Total Market Index (2014 – 2018)
iii: https://us.spindices.com/documents/spiva/spiva-us-year-end-2018.pdf