The economy may be anemic, but the stock market has been flush.
Over the past year, Standard & Poor's 500-stock index returned
27%, and since the middle of November, it has gone nearly straight
up. I hate to be the one to tell you this, but bull markets aren't
forever. Investors earn their money not in good times but in bad --
when they muster the courage to hang on. The alternative, broadly
called "trading," is bad for your investment health. As Warren
Buffett, the CEO of Berkshire Hathaway, put it, "Much success can
be attributed to inactivity."
Inactivity works in part because no one really knows the best
time to buy or sell. That's because the market is efficient:
Today's prices are the sum of everything known and suspected by
millions of investors about every stock. Tomorrow, the market will
respond to new information, which, by definition, is unknowable
To make educated guesses about the long term, we can glean clues
from history. We know, for example, that a diversified portfolio of
U.S. stocks has returned about 10% annualized, or 7% after
inflation, for nearly a century. We know that what goes up goes
down, and vice versa, and that the overall trend is up. We know
that trading stocks is a bad strategy. Fear and greed impel us to
sell at the wrong times. Trading generates taxes, and taxes,
combined with trading costs, erode long-term returns.
In 2000, Brad Barber and Terrance Odean, professors at the
University of California at Davis, published a groundbreaking study
Journal of Finance
titled, "Trading Is Hazardous to Your Wealth." They received access
to the records of more than 66,000 customers of a large discount
brokerage. They found that people who traded the most averaged
returns that were 30% lower than those of the average customer --
and 36% lower than the stock market itself.
The cost of trading is one facet of investing that you can
control. Those costs apply not just to individual stocks but to
mutual funds. Fund managers are under pressure to trade to justify
their often-exorbitant salaries. Fidelity Large Cap Growth (symbol
), for instance, has annual turnover of 151%, which suggests that
the fund turns over its entire portfolio every eight months. And
the typical fund that invests in large companies with a blend of
growth and value attributes turns over its holdings at a rate of
70%, meaning that the average stock is held less than a year and a
Expense drag. Many investors assume that the main cost in owning
a mutual fund is the expense ratio, which includes the cost of
managing the portfolio; legal, accounting and printing expenses;
and sometimes marketing costs. For U.S. stock funds, that fee
averages 1.19% of a fund's assets annually, according to a new
study covering 1995 through 2006 by researchers Roger Edelen,
Richard Evans and Gregory Kadlec.
Over time, these fees mount up. Consider the Fidelity fund
mentioned above. Its expense ratio, at 0.90%, is below average. But
if you invest $10,000 and the fund returns an annualized 10% over
the next decade, you will pay $1,444 in expenses, or 10.6% of your
profits, according to Fund Analyzer, an online tool provided at
Finra.org. (Finra is the brokerage industry's self-regulatory
But Edelen and his colleagues also found that the costs of
trading the securities in the average stock mutual fund (what they
call "aggregate costs") came to another 1.44%. These costs aren't
transparent. You don't write a check for them each year, and they
don't appear on a line in a fund's prospectus, as the expense ratio
does; they show up only in a fund's diminished return.
And that brings us to the essential question: Can funds generate
returns that overcome those high costs? An expensive BMW performs
better than a low-priced Honda, so shouldn't a high-cost fund
deliver better returns than a low-cost one, even after taking all
expenses into account? With regard to total costs, the Edelen study
confirms what other research has shown on the matter of expense
ratios: The luxury brands turn out to be clunkers. "We found a
strong negative relation," says the study, "between aggregate
trading cost and fund return performance."
It's a rare stock picker who consistently beats the market. So
if nearly every fund manager generates gross returns that are close
to the market averages, then the fund's costs become the single
most powerful determinant of its net returns -- that is, of what
you get to keep in your pocket.
What are these "aggregate trading costs" anyway? They include
brokerage commissions, the bid-ask spread (the difference between
the price at which a stock trades and the actual price you get when
buying or selling), and what Edelen and the others call price
impact. Every time a large fund takes a position in a stock, it
pushes up the stock price. The same is true with selling. When a
fund puts shares on the market, it drives the price down.
It's hard for an individual investor to calculate a fund's
aggregate trading costs, but the turnover rate, a figure that is
reported annually by every fund (and can be found on
Morningstar.com and other services), makes a good proxy. A fund
that rarely buys and sells has low aggregate trading costs. Still,
be aware that the trades of a fund that invests in stocks of small
companies are likely to have a much greater impact on price than
the actions of a fund that focuses on large companies (the
difference between the waves generated by a splash in a kiddie pool
and one in an Olympic pool).
I used Morningstar's screening tool to find high-performing U.S.
stock funds with low expense ratios. Here are some fine actively
managed large- and mid-cap funds:
Yacktman Fund (
), run by its eponymous manager, Donald Yacktman, for the past 21
years, gained 14.0% annualized over the past five years (returns
are through May 31). The S&P 500, by contrast, returned 5.4%
annualized. A longtime favorite of mine, Yacktman has an expense
ratio of 0.76% (low for an actively managed fund), and its turnover
is just 7% (meaning that the fund holds a stock for an average of
Nicholas Fund (
), a mid-cap fund run by founder Albert Nicholas since 1969,
carries an expense ratio of 0.75%, and its annual turnover is 25%.
The fund returned 10.2% annualized over the past five years.
Primecap Odyssey Stock (
), a large-cap fund that's run by one of the nation's best
fund-management firms, returned an annualized 7.1% over the past
five years, with less volatility than the market. Its expense ratio
is 0.66%, and, despite a portfolio of more than 100 stocks, annual
turnover is typically 10% or so.
Or consider two other low-turnover funds that have expense
ratios of 0.8% or less and have whipped the S&P 500 over the
past five years: Mairs & Power Growth (
), a member of the
with turnover of just 2%; and my old favorite, ING Corporate
Leaders Trust (
), which essentially has a fixed portfolio and expenses of only
Buy and hold is the best advice I can give to someone who buys
individual stocks. The same advice applies to fund investors as
well. Find a buy-and-hold manager -- or buy an index fund -- and
hang on for the long term. You won't regret it.
James K. Glassman is executive director of the George W. Bush
Institute, whose latest book on economic policy is titled The 4%