Are You Paying Too Much For Your Investments? Probably.

Plenty of regular people are sceptical about paying a company to manage their money, and for good reason. But the reason may not be what most people suspect. People often talk of the stock market being like a corporate casino. You buy stocks. The people who sold them make money. You lose money. Finally you cash in your stocks and shake your head without even the benefit of a complementary dinner or live show.

But this sad picture isn't quite right; the stock market--and by extension, the mutual fund market--has been a clear win-win proposition for decades. Probably centuries. It's just that the investment manager wins more than the typical investor. In Canada, investors who buy stock mutual funds pay an average of 2.56% of total money invested to the manager of their fund, which is about 42% of the historical return (6.1%) of the Canadian stock market per year. In other words, if you invest $100,000 in your pension fund and the market returns 6.1%, you pay out $2560 every year to have it managed. That would leave you with $3540 in investment returns*.

Investment managers claim that they are justified in charging such high rates, since they can pick the best stocks and beat the market. Researchers (at Morningstar, for one recent example) have been quite critical of this position for some time, and it looks like the fund managers are finally starting to learn.  Jason Zweig at the Wall Street Journal reports that fund managers seem to be giving up on the proposition that they can beat the market at all (See also here. But ignore the absurd headline.) Instead, these savvy managers are buying passive index funds which are simply a large group of stocks that move in line with the stock market as a whole. Now if even your money manager has given up on the idea that they can beat the market, why should you pay them 2.56% of your investments?

There is really no reason that I can conceive. You would save yourself a lot of money by instead buying a Vanguard Canadian stock index fund for a fee of 0.05% of your investment. At approximately 50x cheaper than the average mutual fund, you can save about $2500 per year in investment costs if you invest $100,000. Or you could buy an American stock index fund for 0.15%. If you don't like Vanguard as a company for some reason, i-shares sells a similar American index fund for 0.11% of your investment. There are a host of stock market index funds and bond funds sold all over the world that have much more reasonable fees than what the typical Canadian has been sold on paying.

Of course, investing is risky business and stock index funds are not guaranteed to outperform all mutual funds. But the traditional mutual fund is at a distinct disadvantage relative to passively managed index funds. And if you happen to have money already set aside in a traditional high-cost mutual-fund, there may be tax implications of transferring that to an index fund, so don't go cashing out everything without doing your homework. Financial advisors (not me) can be quite useful in sorting through the legal details in that regard.

So good luck out there, in these turbulent times. I hope we investors can save a bit more on unnecessary fees and get a few more bucks in our pockets. Maybe we'll even run into each other at the poker tables some time. Be kind.



*Fear not, perceptive reader. Your Sceptical Economist realizes that the managers' calculated fees of $2560 are not more than your expected returns of $3540. If stock returns were exactly 6.1% every year, you, the investor would indeed get about $1000 more than the manager. But a variety of factors make this a better shake for the manager, including investor decision errors, and the compounding effects of variable return rates. 

*Photo source: http://www.freeimages.com/photo/money-down-the-drain-1537821

A Dangerous Time to Invest? / The Sky is Falling!!!

The Silliness

“Yes! The stock market is down another 2.5% points! 11.8 points for the year,” I said joyfully. My colleague, Bill, is accustomed to hearing such strange things from me early in the day, but he had a puzzled look on his face that begged for an explanation of my mirth.

“Oh, right. That’s a good thing, because I invest in Canadian stocks.” As he continued to stare at me, I first asked myself whether I had slipped into speaking Esperanto, but quickly remembered that most people think that stock crashes are bad events that ought to cause investors grief. Also, I don’t speak Esperanto.

“Stocks are on sale!” This seemed to be mildly more sensible and it was definitely English this time. So I continued on.

If you are an investor who plans to be buying stocks into the future, you should prefer the price of those stocks to be low right now. The only time that it is important for stock prices to be high is before you sell. This year is an unlucky time to be selling stocks and retiring. But if that is so, it should be a good time for buying. To see how that works, suppose that you managed to save $10,000 this year. Good for you. Historical returns of the Toronto Stock exchange are 6.1%, before inflation, so if the future matches the past, then your $10,000 could grow to $18078 by 2026.

“But isn’t it risky to buy when the market is falling?” one may ask. This question needs to be unpacked. We don’t know that the market is falling. We know that the market has fallen. Is it going to continue to fall this year? Possibly. But it is far riskier to buy after the market has been rising. Market rises are what ultimately result in crashes when the bubbles burst. This current downturn has followed a period of market growth going back to 2008. That crash followed a period of people over-investing in US houses and related products. Before that, the crash of 2003 was the result of people getting too excited about the internet boom, which became a bubble that ultimately burst. People feel secure after they see a period of increasing stock prices, when that’s precisely the wrong time.

In fact, one of the best predictors we have of future stock market price is Robert Shiller’s cyclically adjusted price to earnings ratio (CAPE). The intuition behind it is that we should examine the average earnings of stocks over the previous 10 years. Divide that by the current average price in the stock market. Historically speaking, people buying American stocks will pay 16.65 times the yearly earnings for a stock on the main index (S&P500). So if the CAPE is much above 16.65, stocks are said to be expensive and we should expect a slower or negative growth of stock prices. If they are less than 16.65, cheap. Stocks should grow faster than average. But if the CAPE is exactly 16.65, we expect stocks values to grow at their average rate, around 9.5% per year.

Source: http://www.multpl.com/shiller-pe/

In the US, Schiller’s CAPE was found to account for about 40% of the 10-year future stock market returns. So we can predict to some extent how valuable our investment will be, in ten years. On the other hand, it explains very little of the return this year. The message is clear. In the short-term, the markets can do just about anything. But in the long-run, buying the stocks of companies with high earnings—or buying the stock market when it is cheap—has been a winning move. Also, crucially important: there are no guarantees. The casino bets that each night it will make money on slot machines, but sometimes the customer gets lucky and the casino has a bad day.

So just how cheap are stocks right now?

That depends where you are buying. American stocks are relatively expensive right now. At the time of writing, the American stock market** had a CAPE value of 24.42, perhaps overvalued by 50%. So a prediction based on the CAPE would suggest American stock prices probably won’t increase much over the next 10 years.

What about the Canadian market?

The Canadian market hasn’t been studied nearly as much as the American. Still, we do have some basic statistics. According to the Wall Street Journal, Canada’s historical CAPE average is 19.4 as of last year. As of late January, the Canadian CAPE was 16.9. This would suggest that the Canadian market is a bargain—undervalued by perhaps 15%, which is about the value of the fall of the Canadian market from its high in 2015. Average returns of the Canadian Toronto Stock Exchange between 1979 and 2016 were 6.1%, before inflation (original calculations based on this). So if the past is a useful guide, we should have higher than historical returns.

Yeah, but isn’t it risky to invest in the stock market now? Well, it might be. You already asked that question. There tends to be an advantage to using historical data and economic theory to make decisions. It might be true that this time is different. Maybe the economy is going to grow at a much slower rate than the past 200 years. Maybe we are seeing the beginning of a new era. But consider that the optimists said the same thing during the tech bubble of the late 1990’s with undue optimism. Allen Greenspan and Ben Bernanke said the same thing during the American housing bubble: “This time is different.” We were supposed to be entering an era of stability and continuously improving economic indicators. But it wasn’t really so. During upswings it can be easy to get on the bandwagon and proclaim that all is well and there is nothing to worry about. But the same tendency obtains during depressed economic times. And with the benefit of hindsight we can see that those periods of difficulty give way, eventually, to better times.