Some Things Don’t Change

Something Borrowed Friday's column discussed how financial advice has evolved dramatically over the past 40 years. That was scarcely the era's only investment revolution. Since 1975, index funds have grown from infancy to leading the mutual fund sales charts, and defined-contribution plans have largely supplanted traditional pension plans. Major changes indeed.

But not all that glitters is gold. The investment world, as with other fields, has its illusions--trends that appear, disappear, and reappear in altered form, giving the impression that they are new inventions, when instead they are merely manifestations of long-standing patterns.

401(k) Fees: The Boogeyman Consumer advocates always have a Big Bad.

"Ray Rigoglioso never understood why other people were so upset about ATM surcharges until he saw two of them on his bank statement. Both were for the same transaction. "I felt it went beyond reason," said Rigoglioso, 29, of Park Slope in Brooklyn. "It's one thing to make money. It's another to gouge people."

So began a 1999 New York Daily News article about a proposal to ban ATM fees in the New York City. Noting that such laws had already been enacted in several U.S. cities, the author wrote that Rigoglioso was among a "flood" of the proposal's supporters, and that the nation was "roiling" over this "great debate."

Where's that great debate now?

The people have moved on; complaining about ATM fees became boring. The replacement enemy is 401(k) costs. I learned Friday morning, courtesy of the building elevator's videocast, that small 401(k)s can have plan costs of 3%-4% per year. This amount, the video noted, could entirely wash away the average 401(k) plan's "net gain of 3.57%."

Well now.

A leading 401(k) database (BrightScope/ICI) computes average total costs for 401(k) plans that have less than $1 million in assets at 1.6%. Stripping away expense ratios for the underlying funds, which are included in that calculation, puts average plan costs at about 0.6% (the smallest 401(k)s have fund expenses of roughly 1%).

Of course, many plans do charge their employees more than the norm. At the 90th percentile for in price, among that same group of small plans, the annual total costs are 2.66%, meaning about 1.66% after fund expenses are removed. That is a lot--but it's still less than half the amount cited in the elevator videocast.

Are 401(k) fees important? Yes. Are they sometimes cripplingly high? Yes. Are they typically anything close to costing what the mass media suggests? Not often.

Happily for investors, while ATM fees have done nothing but rise since the furor subsided, 401(k) costs have been slowly but steadily declining. This particular Big Bad gets better each year, not worse.

ESG Strategies: Who Knows? Some 25 years ago, I was the Morningstar mutual fund analyst in charge of evaluating socially conscious funds. Those funds excluded the stocks of companies that were deemed to be morally unacceptable to the funds' shareholders. The transgressions varied; sometimes they sold alcohol and tobacco, sometimes they had operations in South Africa, and sometimes they had harsh labor practices or they polluted.

Critics warned that the funds would suffer below-average returns because they restricted their investment universe. Supporters countered that businesses that did good works had more-sustainable strategies, which would lead to greater profits in the long run and, thus, higher stock returns. Each side posted studies that "proved" their cause.

But the studies did not. The sample size was too small, making the apparent findings products of noise and of differences in industry exposures. In one time period, the noise and industry effects would cut one way; in another period, they would cut another. The conclusions drawn from the performance comparisons were unstable.

Today, socially conscious funds call themselves environmental, social, and governance, or ESG, but the discussion is unchanged. The business press decries such funds, because they break the MBA rules that corporations should be run solely for share-price maximization, and then searches for evidence to support its prior belief. Those with opposing political views maintain the opposite.

And once again, the arguments for each side are unconvincing. Most ESG funds can purchase most stocks--far, far more than Warren Buffett's self-restricted investment universe (no technology companies, no unprofitable businesses, and so forth). If an ESG fund fails, it's for the same reason any mutual fund fails: It selected the wrong securities (which might be attributable to bad luck, bad judgment, or both). The same in reverse if it succeeds. The debate about the merits of the genre is pointless.

Smart Beta: Been There, Done That On Oct. 22, Morningstar's Russ Kinnel received an email from a company called Index Funds (now that's a straightforward name), informing him of its newly launched Index Funds S&P 500 Equal Weight fund, which carries the ticker INDEX (does exactly what it says on the tin!). This "smart-beta" fund (Morningstar prefers the unloaded term of "strategic beta") offers "the pure version of the S&P 500" by investing equally in each index constituent, rather than by market capitalization. "By definition," writes the company, "this makes it a better-diversified version of the index as it does not over-weight a select few [companies]."

"By definition" seems more than slightly bold. Nevertheless, there's something to be said for the fund. Holding 20 basis points' worth of each stock in the S&P 500, instead of allocating most assets to the largest firms, assures that the fund will tilt toward smaller companies, and will very likely give it a value-style flavor as well (as the companies with the biggest market caps tend to have relatively high price/earnings multiples). The jury is out about the strength of the oft-cited small-company effect, but value stocks do seem to outperform over time. Thus, I would expect this fund to outgain conventional market-index funds.

But innovative? Not really. Once upon a time, there was Dean Witter Equally Weighted S&P 500 Fund. If a dinosaur brokerage firm that sold through Sears branches and was absorbed in a merger nearly 20 years ago launched such a strategy in the 1980s, then the approach is anything but cutting edge.

The Dean Witter fund failed, by the way.

Part of the reason was bad timing. After getting off to a decent start, the fund got buried by the New Era, when the giant growth companies enjoyed historically high returns. The other part was an unsustainable expense ratio that had a front-end load for the A shares and that ran above 1.5% per year for the B shares. Dean Witter made no concession to its standard commission structure when pricing the fund--how could it and still motivate its salesforce?--and that commission structure was unsuited for indexing. An acceptable investment idea with bad pricing.

Index Funds S&P 500 Equal Weight, happily, promises a much lower expense ratio of 30 basis points, with no upfront commission save for what's required to purchase an exchange-traded share. One can debate whether charging 25 basis points more than

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.