What Goes Around Comes Around


By Henry K. (Bud) Hebeler



            I have long warned people to be careful not to select high cost funds because even the average fund takes about 1.5% of the assets each year away from the investor.  In the last few months we’ve learned that those losses are probably understated as a consequence of unreported brokers’ costs that are largely hidden from mutual fund holders.  In other words, the fees paid to brokers for buying and selling securities in the funds are not part of the 1.5%.


            Recently I’ve found two more very disturbing articles.  Here are the key points:


            The first article is “The Way of the Calm Investor” by Jason Zweig, MONEY Magazine, August, 2004.  He first repeats Warren Buffet’s estimate “that the investing public pays about $130 billion a year in brokerage costs, fund management fees and other expenses.”  Then Zweig goes on to say, “Considering that the companies in the S&P 500 generated total operating income of $137.6 billion last year, Buffett’s math has an astounding implication: that we investors are turning most of our rightful share in corporate America’s profits over to the intermediaries who handle our money for us.”


            The second article is “Imbalance is lurking within your S&P 500 index fund” by Gretchen Morgenson which I found in the King County Journal, 6/20/04.  She says, “While many investors think that a broad market index like the S&P reflects an equal weighting of U.S. industries. . . [financial] companies make up 20.4 percent of the index . . . .  double that of industrial company stocks.”  She then follows this with, “. . .the current weight of financial services companies in the S&P is significantly understated because the 80 financial stocks in the index do not include General Electric, General Motors or Ford.  All of these companies have big financial operations that have contributed significantly to their earnings in recent years.


            Then Morgenson goes on to quote Andrew Smithers in her article.   “Financial companies are now generating about 30% of the profits, after taxes, of U.S. companies. . . That proportion has risen from 7 percent in 1982. . . [further,] profit margins at financial companies in the first quarter of 2004 stood at 32.6 percent of all corporate output.


            If the combination of these two articles doesn’t bother you, it should.  The investment firms have so convincingly sold their expensive products that they’ve climbed to the top of the investment ladder themselves at the expense of the investing public.  Wow!


            This prompts the question, “What will happen if the public ever gets wise to this?”  Suppose that investing public stops buying funds with loads and high costs and turns to low cost index funds.  The financial firms will get hit hard.  This in turn will force a major downturn of the stock market which is dominated by financial firms’ earnings.  The downturn will open the door for many other charlatans who will have a ready audience trying to find the best place for their failing portfolios.  It’s not pretty, but it’s got to happen when people stop thinking that they are doing as well as the indexes they see on CNBC instead of looking at their own portfolio performance.  Fortunately, this won’t happen precipitously.  As the industry often says, “We help one investor at a time.”


            It’s not hard to do your own analysis.  Just get out your hand calculator and enter your numbers in the following equation:


Before-tax return % = 100 x (Year end balance minus beginning of year balance minus sum of annual deposits plus sum annual withdrawals) divided by (Beginning of year balance plus ½ x sum of annual deposits minus ½ x sum of annual withdrawals)


            If you think this equation is too tough, give your numbers to a grandchild or baby sitter and ask them to plug the numbers into your calculator.  Technically, the equation above is based on the assumption that your deposits and withdrawals are uniformly distributed throughout the year.  There is a free computer program on www.analyzenow.com that will give a more accurate calculation if your deposits and withdrawals are largely grouped near the end of beginning of the year.


            This applies to only the performance for one year, not a period of several years, and it gives you a before-tax return on investment even if your withdrawals are used to pay taxes.  Some journalists have misstated this and said it gives an after-tax return if you used taxes as a withdrawal.  That’s not true.


            You can use the formula for a single investment, a group of similar investments, or even the total of all of your investments.  I like to compare the total of my stock investments to the index for the total stock market, for example.


            The net result is likely to be a number that’s far less than you imagined.  If you are using brokers, agents, money managers, or media hype that led you to this disaster, make a change so that you give less to the financial industry and more for yourself and your future.  A couple of hours spent on this analysis is likely to add years to the amount of time your money will last in retirement.


            You’ve got to start helping yourself, not the financial firms.  Cutting your own investment cost is much more beneficial for you than the little you will get hurt by the slight reduction in the financial industry’s stock prices caused by your own switch to low cost funds.