Investment Fees Are Something, but Not the Only Thing

HUNT VALLEY, Md. ( TheStreet) -- The big talk in the 401(k) world is fee transparency and lower fees. It seems as if everyone has concluded that, "If we can get fees down, the rate of return will improve."

But the cheapest index funds cost 0.1% to 0.4%, and the most expensive active open-end funds cost between 1.2% and 2%. Assuming both have the same annual total return, the most you can increase your return is 1.9%.
Lower fees may mean a better rate of return, but they're only a piece of a much bigger picture.

No doubt 1.9% compounded over 20 years or more is a significant increase, but that is an extreme example; the normal difference is maybe 0.5 to 1%. The lower the additional yield, the lower the long-term impact.

The real issue is that fees are only a piece of a much bigger picture.

Investing is not simple. Index funds and active funds are not always the best answer. The best answer is that sometimes, for some assets, indexes are best, and sometimes, for some assets, active funds are the best. The 401(k) industry and the Department of Labor have been looking for the holy grail of simple investing so the average person can make a good rate return to be able to retire on their 401(k) balance, but the problem is there is no simple investing concept -- and even if an approach works for a time, it will not always work.

Pre-retirees should know 401(k) investing is built on Modern Portfolio Theory, and the most important point here is that MPT is nothing but a theory.

The most important thing I learned in my investing career is that, "Every security, every industry and every market can go to zero." With this in mind, I am always attentive to risk, not volatility. MPT is all about moderating volatility to accommodate a person's psychology to accept wide swings in asset prices. Managing risk requires one to understand an asset and its value. Volatility to a true asset manager merely creates opportunity.

The wealthiest investors today are investing with hedge funds, private equity and venture capital. Many of these investments charge what would seem to be outrageous fees of 2%, plus 20% of profits over net 5%. Even Warren Buffett hired two former hedge fund managers to potentially take over the Berkshire ( BRK.A) portfolio long-term. Why did he not just place the funds in a MPT risk allocation using cheap index funds?

The simplest way I can explain when and how to use an index fund versus an active fund is as follows: Use an index fund when you feel comfortable long term in an asset class you desire to own over a five-year-plus time frame and you don't have the expertise to pick specific securities. If you feel the large-cap multinational U.S. companies are a great long-term value and you intend to buy them, you are probably best suited to buy an S&P 500 index fund. Use an active U.S. managed fund when you are not sure what to own domestically but you like the U.S. long term. Use an actively managed worldwide fund if you want to be invested but are not sure what or where in the world to buy. Use an index fund if you know you want developed-world stocks or solely emerging-market stocks. There is also nothing wrong with buying individual stocks if you have the time and talent to analyze companies.

MPT worked great in a 30-year bull market of stocks and bonds. The "Dogs of the Dow" theory worked for many years until it became too popular. There are many in the advisory community who believe low-cost funds in an MPT allocation model is the way to go, but remember that every investment can go to zero. Make sure you and/or your adviser are well aware of that.

Sometimes you want to pay high fees for real talent and sometimes you want to pay the lowest fee possible for exposure to a great asset class. Fees are only part of the story.

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Andrew Tignanelli, CFP, CPA, is president of Financial Consulate, based in Hunt Valley, Md., and a member of NAPFA, the National Association of Personal Financial Advisors.

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.