Night of the Living Funds

This is part two in a series on active management. For part one, click here.

A few years ago, a friend asked my advice about an IRA. Her financial advisor had chosen the investments while she was in high school.

When I looked at the statement, I was appalled. The advisor had picked two variable annuities—a long/short fund and market neutral fund—both completely inappropriate for someone with a long time horizon. My back-of-the-envelope math showed these annuities had cost her more than 100% in gains, or about $15,000, compared to a S&P 500 index fund from Vanguard or Fidelity.

How does this kind of thing happen? Simple: the advisor was paid a commission. He received a fee for putting her in products which themselves charged high fees. He had little incentive to do the right thing for his client, and every incentive to choose a product that would earn him a fee.

Unfortunately, that’s why many overpriced products still exist. Commissions-based financial advisors and cheaply designed 401(k) plans routinely put unwitting investors into products that charge outrageous fees. If we didn’t have a system that encourages these products, they simply wouldn’t exist. They would be competed out of existence by superior, cheaper alternatives.

Meb Faber has an excellent post about certain index funds that charge inexplicably high fees. One example, the Rydex S&P 500 Fund C Shares (RYSYX), has an expense ratio of 2.31% and the gall to charge a 1% exit fee on top of that. By comparison, the equivalent fund from Vanguard (VFINX) charges 0.14%. The chart below shows the performance of this fund against the S&P 500 since its inception.

Rydex fund (white line), index (orange line). Data: Bloomberg
From its inception in 2006 until April 2017, the Rydex fund has underperformed its index by a cumulative 51%, and that’s before the 1% exit fee. Imagine what that would do to your retirement fund over time.

As outrageous as these fees are, it gets worse in many active funds. First, take the Sparrow Growth Fund (SGFFX). It’s an equity fund with an expense ratio of 2.45%, a 5.75% front load (entry fee), and a 1.00% back load (exit fee). If you buy this fund, you’re signing up for over 8% in fees even if you only hold it for a year.

There’s also the Saratoga Technology & Communications Portfolio (STPAX). It has an expense ratio of 2.24%, a 5.75% front load, and a 2.00% early withdrawal fee. If an advisor bought this for you, you may not be happy about the 7.99% in fees you’ll pay in the first year. If you want to sell, no worries, just pay an additional 2.00%.

If you were a fan of the technology sector, you could have instead purchased a NASDAQ 100 index fund like QQQ, which charges 0.20% and no load. The below chart shows the performance of these two funds since QQQ’s inception date, and doesn’t even account for the 5.75% front load.

Active fund (white line), index fund (orange line). Data: Bloomberg
This underperformance is not just due to bad stock picking: the active fund would be much more competitive if not for its high expense ratio.

What about those painful front-end load fees? Consider a hypothetical fund that outperforms the S&P 500 by 0.50% every year, but charges a 5% entry fee. The chart below illustrates your dollar underperformance if you invested $100,000 in this hypothetical fund:

If you bought the fund at the end of the year 2000, it would take more than ten years for that 50 basis points per year of outperformance to “catch up” to the 5% fee you paid initially. This also assumes you picked a fund that can consistently outperform after management fees, which is a serious hurdle.

Fighting off the Zombies

Many hyper-priced funds are small, but they still survive. The way some funds stay open is by obtaining investors through unusual means. Maybe a financial advisor gets paid a sales commission or a poorly structured retirement plan offers the fund as a 401(k) option. Maybe someone buys the fund, pays the high entry fee, and feels mentally “invested.” This is the sunk cost fallacy in action.

There are still some excellent active funds with reasonable fees, but many funds remain on the market when they shouldn’t. Fund companies know that high fees are a drag on performance, and it’s easy to see how funds fail to outperform their benchmarks if they charge fees of 1%, 2%, or above. They’re like the living dead; they limp along, dragging down the healthy in the process.