An Easy Way to Boost Returns: Reduce Your Costs
Thursday, March 19, 2015

Every dollar you do not spend on expenses is a dollar you get to keep and grow. It’s basic math and an easy way to boost your returns. Each dollar spent on expenses flows out of your portfolio, never to be seen again. Limiting the outflow of those dollars gives you a larger amount of capital to grow and/or earn income on.

The key to this equation is compounding. I realize many of you are familiar with the concept, but since not everybody is—and since AAII’s mission is to educate investors on how to be better stewards of their portfolios—I’m going to give a brief example: A half of a percentage point (0.5%) reduction in expenses on a $1 million portfolio results in $5,000 in savings. A modest 5% rate of return turns the initial $5,000 into nearly $6,400 over a period of five years.

Sounds pretty good, right? But the initial savings is just the tip of the iceberg. Each year the portfolio increases in value (to keep things simple, I'll treat the portfolio as solely being investing in funds), the benefit from the savings rises as well (assuming you maintain the 0.5% reduction in expenses every year going forward). This because the expense is based on the total amount of your portfolio. As your portfolio grows in value, so do the total dollars paid. The end result is not merely $25,000 in additional wealth (five years of saving $5,000 in expenses), but rather more than $32,000. The compounding of savings is why many encourage investors to focus on reducing costs. There is a direct and significant benefit to keeping costs as low as is logical to do so.

To lower expenses, you have to know what they are. Some costs are very apparent. Every time you buy or sell a stock, your broker immediately charges you a commission. Some expenses are more opaque. Bonds, for example, are often quoted with the commission baked into the price the broker says they can execute the trade at. Others costs require even more awareness on the part of the investor.

Alternative funds, for instance, can be much more expensive than many investors realize. An article this week in Investment News used TFS Market Neutral (TFSMX), and two other “alt” funds to make this point. TFS Market Neutral fund seeks to provide capital gains, while maintaining a low correlation to the S&P 500 and staying less volatile by both investing in and shorting various securities. Our mutual fund guide, which uses data supplied by Morningstar, lists the fund’s expense ratio as 1.89%. The fund’s website, however, lists an expense ratio of 8.40%.

The wide difference reflects the transaction costs incurred by the fund. TFS Market Neutral has a turnover ratio of 669%, which implies a massive amount of buying and selling. In addition, the fund incurs borrowing costs from shorting securities. These costs are not embedded in the management expense ratio of operating the fund, but are costs nonetheless. When Vanguard’s Jack Bogle talks about the full costs of owning mutual funds, he includes the transactions costs into his calculations.

Most funds do not have anywhere near TFS Market Neutral’s transaction costs, but the TFS fund serves as a good example as to why it is important to understand what you are actually paying.

When reviewing your costs, ask yourself what value you are getting for the expenses. It’s perfectly logical to spend more on a fund that gets you a desired allocation or rate of return. It’s also perfectly logical to spend on a service or a newsletter that helps you make better investment decisions. Some investors may even benefit monetarily from paying a financial adviser to help keep them on track.

What you want to cut out are unnecessary costs or investments that can be replaced with a cheaper alternative (e.g., an S&P 500 index fund instead of a large-cap fund that hasn’t outpaced the index by a wide enough margin to justify its higher expenses). By doing so, you not only save money right now, you also will increase your wealth in the years to come.

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AAII Model Portfolio Update

There were two changes to the Model Shadow Stock Portfolio. Standard Motor Products (SMP) was sold and Universal Stainless & Alloy Products Inc. (USAP) was purchased. Omega Protein (OME) was also purchased, but this was done in error due to using old data, and the stock has already been sold. Omega Protein does not pass the screen using end-of-February data. The error will be discussed in greater detail in the Model Portfolio column in the April AAII Journal. There were 11 stocks that passed the screen at the end of February.

Two stocks in the Model Shadow Stock Portfolio, Olympic Steel (ZEUS) and Willis Lease Finance (WLFC), qualified for purchase at the start of March. Qualified stocks are companies held within the Model Shadow Stock Portfolio that currently meet the purchase rules. (They are designated as “qualified” in the notes column of the Model Shadow Stock Portfolio table.)

Kimball International (KBAL) is above the Model Shadow Stock Portfolio’s valuation limit. Stocks are deleted if their price-to-book ratio exceeds 2.4. Kimball International ended February with a price-to-book ratio of 2.55. However, as with Omega Protein, outdated figures that showed Kimball’s price-to-book below the limit were erroneously used for our review, and the stock was not sold.

The Model Fund Portfolio gained 5.2% in February, while the Model Shadow Stock Portfolio, which invests in micro-cap value stocks, gained 5.6% last month.

The Model Shadow Stock Portfolio’s 5.6% increase for the month slightly trailed both of its comparison benchmarks: The Vanguard SmallCap Index (NAESX) gained 5.8% and the DFA US Micro Cap Index fund (DFSCX) gained 6.0% in February. Year to date, the Shadow Stock Portfolio has returned 1.0% while the NAESX has returned 3.5% and the DFSCX has returned 0.8%. Since its inception in 1993, the Model Shadow Stock Portfolio has a compound annual return of 16.8%, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 9.5% annually over the same period.

The Model Fund Portfolio’s 5.2% increase in February compared to a 5.8% increase for the Vanguard Total Stock Market Index fund. Since its inception in June of 2003, the Model Fund Portfolio has a compound annual return of 9.4%, slightly underperforming the Vanguard Total Stock Market Index fund over the same time period, which returned 9.6%.

The Week Ahead

Fewer than 10 members of the S&P 500 will report earnings next week. They are Carnival (CCL) and McCormick & Company (MKC) on Tuesday; PVH (PVH), Paychex (PAYX) and Red Hat (RHT) on Wednesday; and Accenture Plc (ACN), ConAgra Foods (CAG) and GameStop (GME) on Thursday.

The week’s first economic report of note will be February existing home sales, released on Monday. Tuesday will feature the February Consumer Price Index (CPI), February new home sales and the March PMI manufacturing index flash. February durable goods orders will be released on Wednesday. Friday will feature the second revision to fourth-quarter GDP and the University of Michigan’s final March consumer confidence survey.

Several Federal Reserve officials will make public appearances, as is typical following a Federal Open Market Committee (FOMC) meeting. Cleveland president Loretta Mester, Vice Chair Stanley Fischer and San Francisco president John Williams will speak on Monday; St. Louis president James Bullard will speak on Tuesday; Chicago president Charles Evans will speak on Wednesday; St. Louis president James Bullard and Atlanta president Dennis Lockhart will speak on Thursday; and Fischer will speak again on Friday.

The Treasury Department will auction $26 billion of two-year notes on Tuesday, $35 billion of five-year notes and $13 billion of floating-two year notes on Wednesday and $29 billion of seven-year notes on Thursday.

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AAII Sentiment Survey

Optimism fell to a two-year low according to the latest AAII Sentiment Survey, a sign that individual investors have become more cautious about the short-term outlook for stocks. Pessimism rose to a five-week high, while neutral sentiment remained above 40% for a second consecutive week.

Bullish sentiment, expectations that stock prices will rise over the next six months, fell 4.4 percentage points to 27.2%. This week’s reading is tied with April 17, 2014, for the lowest level of optimism since April 2013. The drop puts bullish sentiment below its historical average of 39.0% on consecutive weeks for the first time since June 19 through August 7, 2014.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, declined by 1.6 percentage points to 41.4%. Neutral sentiment remains above its historical average of 30.5% for the 11th consecutive week. This is the longest such streak since a 32-week stretch of above-average readings between January 9 and August 14, 2014.

Bearish sentiment, expectations that stock prices will fall over the next six months, jumped 6.1 percentage points to 31.5%. This is a six-week high. It is also the first time pessimism is above its historical average of 30.5% since February 5, 2015.

Bullish sentiment is in the midst of a five-week, 19.8-percentage-point plunge. The drop has now put optimism at an unusually low level (more than one standard deviation below its historical average). At the same time, bearish sentiment has risen by a cumulative 13.6 percentage points.

Neutral sentiment remains at an unusually high level (more than one standard deviation above its historical average). Historically, both unusually low levels of bullish sentiment and unusually high levels of neutral sentiment have been correlated with better-than-average market performance over the following six- and 12-month periods.  (See Analyzing the AAII Sentiment Survey Without Hindsight in the June 2014 AAII Journal for more information.) There is no guarantee history will repeat in the future, however.

The change in sentiment has occurred as the S&P 500 index has experienced an increase in volatility, though the index ended yesterday essentially unchanged from its February 19, 2014, close. In addition to the recent price fluctuations, prevailing valuations, disappointing earnings or guidance from certain companies, geopolitical events, the pace of economic growth and worries that an even larger decline in stock prices could occur are weighing on AAII members’ short-term market outlook. Keeping some AAII members encouraged is the ongoing bull market, sustained economic expansion, earnings growth and still-accommodating monetary policy.

This week’s special question asked AAII members what indicators they use to determine whether the stock market’s valuation is reasonable, too high or too low. More than half (55%) of respondents said they rely on the price-earnings (P/E) ratio. Many of these members said they specifically look at Robert Shiller’s cyclically adjusted price-earnings (CAPE) ratio. Various technical analysis measures are used by about 15% of respondents. A nearly equal number said they look at other indicators, such as economic data, interest rates and monetary policy. Some members said that they consider more than one indicator when assessing the market’s valuation.

This week’s Sentiment Survey results:

Bullish: 27.2%, down 4.4 points
Neutral: 41.4%, down 1.6 points
Bearish: 31.5%, up 6.1 points

Historical averages:

Bullish: 39.0%
Neutral: 30.5%
Bearish: 30.5%
Take the Sentiment Survey.

Local Chapter Meetings
AAII Local Chapter Meetings offer you a variety of presentations from expert speakers who will give you their view on the world of investing. A bonus of attending a Chapter Meeting near you is the opportunity to meet other AAII members who share your interest and enthusiasm for investing. You can even share the Chapter experience with your family and friends by inviting them to attend Chapter Meetings with you!