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Watch Out For Those Hidden Financial Fees

Steve Pomeranz, Hidden Financial Fees

Once you make the shift from saving to investing, the first order of business is to minimize fees and expenses, in order to get the most return possible. But with interest rates near all-time lows for several years now—and appearing likely to remain that way for many more years to come—some investors are getting antsy… and looking for ways to juice their returns so they earn more than the paltry returns on bank savings, CDs, and bonds. Some are also not so bullish on continued high stock market returns going forward and are concerned that the S&P 500 has little room to rise after its 85% return over the past five years.

The paradox of this “lower expected returns” scenario is that investors are too scared to handle their own money and are willing to turn to professionals, which in itself is a sound strategy.

But, many, in their desperation, are looking for “star investment managers” whom they believe could goose their returns through financial wizardry, out-of-the-box gambles, and other forms of “pixie dust”. As a result, individual investors are increasingly handing their money over to high-fee advisers to overcome low expected future returns.

And many are buying into what some investment managers are telling them, which is to diversify outside of stocks and bonds and other real assets like gold, into so-called “alternatives” and other vehicles, which somehow through the sprinkling of “pixie dust” can produce market-beating returns.   The reality of these alternatives, which has been shown over and over again, is that most of those assets just don’t bring anything remotely close to what they promise despite the high fees charged to you in order for you to get in the game.

But here’s the catch with “star investment managers”: Sure they’re out there—with long-term proven records—people such as Warren Buffett of Berkshire Hathaway and Howard Marks of Oaktree Capital. But finding a sure-fire market-beating money manager is anything but a sure thing. Moreover, as we all know, past investment performance is no guarantee of future returns, so going with a “star” does not automatically guarantee high returns.

There’s another catch with “star investment managers”:  They typically demand higher fees to support their search and research for higher-yielding assets because they often need to dig deep and communicate with specialized experts to uncover hidden, undiscovered, undervalued investment gems.

And while these high-fee advisers or portfolio managers might actually manage assets better, what they put in one pocket with better behavior and performance, they take from the other pocket with high fees. And if they under-perform the market—which statistically is the more likely outcome—you get to experience a double whammy: Your bad returns get further sliced by the high fees you’ve paid, hurting your portfolio more than simple returns from a low-cost index fund.

We also see this in recent data on investment performance. As more active managers fail to perform well, advisory fees are on the rise. So, in their search for higher returns, investors are running scared into the arms of high-fee advisers who gladly slip their hands into your back pocket as they embrace you.

Historical number-crunching of managed portfolios has also proven that high fees can be the most destructive part of any financial plan.

And while no one knows what the future returns of the stock market will be, many think that stocks tend to generate lower future returns when they’re richly valued. So, with the S&P 500 index up 85%, lower returns could be much more likely. Add higher fees to that and they will eat up a bigger portion of this lower return.

Just to clarify, in a world where some of the best funds and advisers cost less than 0.5% a year of managed assets—and much less for index funds—anything above that 0.5% threshold falls into the “high fee” category, in my opinion.

Now that you know high fees are likely only going to drag your returns down, here are the signs to look for on how advisers and managers might sell this high-fee story to you, signs that you should be wary of:

  1. They may try to scare you about how the market’s been up and up, and how the time may now be ripe for the next 2008 right around the corner, when the reality is that the economy does seem to be surely but slowly inching back to normalcy, albeit with a few regular hiccups along the way. So don’t fall into that fear trap.
  1. They tell you that they have proprietary “quant” strategies, with Ph.D.s on their staff that can ferret out undervalued investments, run sophisticated multi-factor models, and deliver outsize returns, essentially spouting mathematically loaded jargon just to impress and intimidate you.
  1. They tell you that you have to diversify into assets outside of stocks and bonds and get into “alternatives” and other assets when the reality is that most of those assets are just high-fee perennial underperformers. By the way, as a side-note, many of the biggest pension plans have been reducing their investment in these quirky, high-priced investments as they have come to realize that the promise of higher returns was not achieved.
  1. They offer you 8, 10, and 12% returns with low risk in an economy where the real low-risk return is only 1.5%.

In short, they use a lot of buzzwords and try to con you into believing they can generate outperformance when they’re really just selling you the hope of higher returns in exchange for the guarantee of higher fees. That’s worth repeating: It’s the hope of higher returns, in exchange for the guarantee of higher fees.

Finally, ask yourself whose best interest is really being served. What do they gain by the sale of these expensive items and, truly, if they are making so much, how much will be left for you when it’s all over?

Thanks to Cullen Roche, author of “Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance,” for some of the research in today’s discussion.