Costs Matter, But Behavior Matters More

by A Wealth of Common Sense

“Scale coupled with automation can basically bring costs down to zero.” – Herbert Moore

Two articles grabbed my attention this week that highlight the fact that things continue to improve for individual investors, specifically on the cost front.

The first one came from Larry Swedroe on Seeking Alpha.  Swedroe reviewed a recent academic study on mutual funds that showed how increased index fund investing can actually lead to better active fund investing through lowered costs and higher differentiation in active fund results.

Here are some of his thoughts on this research:

Actively managed funds are more active and charge lower fees when they face more competitive pressure from indexed funds.

The authors concluded that the higher competitive pressure created by the presence of low-cost passive funds in the market leads their active fund rivals to differentiate more.

The bottom line is that active investors are actually benefiting from the success of indexing. The competition is driving down fees. And it is costs, not poor stock selection, that causes active management to be the loser’s game.

With the increasing amount of money flowing into index funds in the past few years some in the industry have voiced concerns about the state of the markets from this shift to a more passive approach by many investors.

The research is telling these people that competition can actually be a good thing for all investors, both active and passive.

The next piece was posted on Medium by Herbert Moore, CEO at WiseBanyan.  He made the case that investment trading and expense ratio costs are on a fast track to being nonexistent.

The advent of ETFs coupled with the competition for investor assets has already meant a fight to the bottom in fund fees and trading commissions in the past few years.

This is Moore on why he feels index fund and ETF fees will continue to fall even further:

As investors continue to be stymied by the performance of active management, they will increasingly shift to passive funds. The continued flow of assets into this area will introduce new competition for those assets in the form of new funds, and fund managers will compete by further lowering fees. Indeed, we have seen fees fall drastically with many exchange-traded fund (ETF) sponsors offering funds with fees of less than 0.10%. The ETF business is hugely scalable, so as assets get bigger and bigger, ETF sponsors will be able to drop their prices further.

Moore cited additional reasons for the race to the bottom including automation, online financial robo-advisors and the fact that fund firms are able to make money in other ways from client assets (for example, securities lending). This means all signs point to future costs of a big fat goose egg for investors:

Ultimately, all this means that the everyday investor will be able to invest for his or her retirement and short-term goals at virtually no cost. Given the recent advances in online financial advisory over the past few years, I’m confident this industry will undergo these changes within the next five years.

I can’t argue with Moore’s conclusion here.

Charles Schwab already offers commission-free trading on over 100 ETFs with expense ratios as low as 4 basis points (0.04%).

I hate to be the Baby Ruth floating in the swimming pool here, but as great as these advances in low costs are for investors, it does present more challenges in other areas.

It will now be much easier for you to cancel out the no-fee advantage through bad behavior by overtrading and market timing mistakes.

In fact, these lower costs could temp long-term investors to become short-term market timers and traders because there won’t be any costs involved, thus lowering the take home returns that these low cost investments provide.

Lest you forget Buffett’s Fourth Law of Motion, which states that ‘returns decrease as motion increases.’

Lower costs do not prevent overconfidence, short-term emotional gut reactions, overexcitement, a herd mentality, loss aversion or any of the other behavioral biases which can hurt investor performance in the long run.

Compounding of long-term returns is one of the pillars of wealth building.

The two factors that can work against the long-term compounding machine are expenses and your behavior.  If competition takes expenses out of the equation that means you only have one thing to worry about (but it’s a big one).

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