Fees over the long term can devastate a portfolio

No one wants to be at the bottom of the heap. We want to be above average at everything, including investing.

That's why we spend billions every year, hoping to find a superior investor who will, for a modest fee, invest our modest savings and turn them into an immodest fortune.

Unfortunately there is no connection between what we wish for and what actually happens. When you examine long-term performance data, what you learn is that investment fees that seem reasonable in the short term can be devastating in the long term.

Devastating?

Yes. The longer you invest, the smaller the performance difference between entry into the top 25 percent of performers and entry into the bottom 25 percent of performers. The difference is so small that over 15 years it may amount to less than you pay in fees.

In other words, what you pay in management fees can wreck your investment performance, all by itself. This is why I often refer to professional money management as an iatrogenic illness -- a treatment that is worse than the malady it purports to cure. You can understand this by examining the long-term performance of mutual funds.

The largest single group of funds is what Morningstar calls "large-blend" funds. Basically, they focus on the largest publicly held companies in America. In 2007 there were more than 2,000 large-blend funds in the Morningstar Principia database. Those in the top quartile (the top 25 percent) had returns of 8.45 percent or more. Those in the bottom quartile (the bottom 25 percent) had returns of 4.74 percent or less.

So the difference between being at the top or bottom of the class was at least 3.71 percent.

That's a nice payoff for avoiding the bottom. Better still, 8.45 percent wasn't the best you could do; it was just the threshold for doing still better. Make it into the top 10 percent and your return would have been at least 12.53 percent.

Over a three-year period the difference between the top and bottom quartiles narrows to 2.49 percent. Over five years it shrinks to 2.40 percent. Over 10 years the gap is reduced to 1.97 percent. At 15 years it drops to only 1.47 percent. Now, can you guess what the average net expense ratio of all those funds is?

It's 1.24 percent.

Do the same kind of examination of foreign large-blend funds and you get more dramatic results. There, the spread between the top and bottom quartiles in 2007 was a whopping 5.77 percent. But it fell to only 1.30 percent over the 15-year investing period. The average net expense ratio of this fund group was greater, 1.50 percent.

The comparison is still harsher for intermediate government bond funds, another popular investing category. For 2007 the difference between the top and bottom quartile funds was at least 1.64 percent. For the 15-year period the difference was only 0.51 percent. That's less than half the average net expense ratio for the group, 1.05 percent .

While the trailing return figures will change somewhat from month to month, a pattern emerges whenever this examination is done, whatever mutual fund group is selected. The longer you invest, the smaller the difference between the top quartile and the bottom quartile.

More important, the difference will often be less than the average expense ratio for the fund category.

None of this would matter if the cost of managing a fund had no impact on its long-term performance. But expenses matter. While it is possible for an expensive fund to have superior performance, it is not probable. As I pointed out in a column last year, large-blend funds with expense ratios in the top one-eighth of all such funds had only a 31 percent chance of beating the group median. But 71 percent of the least expensive one-eighth of all large-blend funds beat the group median.

Now imagine what happens when you add the cost of typical "wrap" accounts and other advisory arrangements, where another 1 percent to 1.50 percent in fees is added to select and manage funds. Again, superior performance is possible.

But it isn't probable.

That's why the legacy distribution system -- conventional asset management -- simply doesn't work. If financial advisers were doctors, their fees alone would cause them to violate a primary charge of doctors, "Primum non nocere."

First, do no harm.

© 2008, Universal Press Syndicate