Tuesday, June 27, 2006

Kiyosaki Wrong on Mutual Funds

I like a lot of what Robert Kiyosaki says usually and there are serious problems with a lot of mutual funds, but the basic point in his column on Yahoo's website is plain wrong. He says that if a mutual fund earned 8% a year and charged 2.5% in fees (the first number is plausible as an after inflation return on a long stock mutual fund, the second number is high but not totally implausible) then your after fees return is 5.5% which means that over a 65 year period $1000 would grow to $140,000 if there were no fees but only $30,000 after fees. So far so good. But then he says that this implies that the fund manager makes 80% of the return and you only make 20%. Not true. You make 21% of the potential before fees return but the fund company only makes 10% of the potential return ((2.5*30,000/5.5)/140,000). 69% of the potential return just disappears. So it is just as bad as he said but the mutual fund company isn't benefiting from this. The idea that if you lose someone else must be gaining is a common myth among investors - many people think that if the stock market goes down and investors who own stocks lose someone must have gained. Not true - a few short-sellers do gain, but most of the value just evaporates.

The truth about mutual funds is that actually fees don't matter. Fund companies like Vanguard who have low fees would like you to think this. All that matters is your net return after fees. If the return after fees is better than you can do on your own after taking into account the value of your time you would rather spend on something else then the mutual fund is worth buying and otherwise not. You could just buy an ETF invested in a stock index. If an actively managed mutual or hedge fund returns after fees more than this investment then it is worth buying. I find that in very strong trending markets, passive investing beats active investing. In weaker markets active investment seems to win out even after fees. Last year in the US active funds beat passive funds. But in Australia the opposite was true. In the 1990s, active investing won in Australia and passive investing in the US.

8 comments:

mapgirl said...

Thanks m00m! Those are interesting points. I'm in a few active trading funds, but I am a fan of Vanguard's low-fee passive trading funds. Your post shows me that all I should be reading is the net return after the fees are removed, rather than keeping the fee percentage low. :-)

LAMoneyGuy said...

Very good post. Passive investing became very popular based on a very strong period for stocks over the 80s and 90s. The difficulty for most investors is selecting an active fund/manager who will make an attractive return after fees. Most know little other than past performance when it comes to making their decision. We all know that is a losing way to select investments.

Also, you're right about Kiyosaki's math. It's horrible. By my math the MF makes $14,302. A lot when you consider your ending value is only 30k, but hardly 80% of the return.

mOOm said...

Yes - there are also other considerations with mutual funds - for example if you buy and hold stock you don't pay any tax until you sell (except on dividends). But with actively managed mutual funds they are usually always buying and selling and creating taxable capital gains distributions. And you buy units in a mutual fund on a before tax basis - they don't deduct the deferred tax they owe on capital gains from the price of a unit. Instead you pay the tax on gains you never made when the distributions are paid out to you! Passive funds significantly reduce these issues. So the real basis would be your after fees and tax return. The latter is hard to work out. I also like to look at a mutual funds performance over up to a ten year period if it has been around that long and invest in ones with a consistent track record.

Investorial said...

I always think it's good to stir up the conversation. Jim at BluePrint for Financial Prosperity is taking Kiyosaki's side on this issue. Who's right?

Perhaps a better question is "Is it even about right or wrong?". I like having many perspectives!

jim said...

I didn't take Kiyosaki's side (I merely agreed MF's are foolish) and I didn't actually realize Kiyosaki said the MF fund made the 80% (if you read my take and Bogle's quotes, the "financial system" takes most of the 80% away) because that's flat out wrong.

"The truth about mutual funds is that actually fees don't matter... All that matters is your net return after fees." Then why don't they just take fees off the return instead of fees off the balance?

mOOm said...

This seems to be the most popular topic I've posted on so far... All reported mutual fund returns are always after fees. So there is no problem in comparing the returns of mutual funds with different fee percentages. That's why I say the fees don't really matter. The question is: Are they earning their keep? Sometimes yes and sometimes no.

magpgh said...

Very good points across the board. I think it's amusing that often the pundits out there proposing investors go it alone offer only two basic view points. first everyone in the financial services industry is an enemy of the individual investor. secondly, the individual investor can come up with brilliant investing ideas in "5 minutes a day". They fail to mention that their columns, books, and tv shows, all of which aim to make money, spew this divisive rhetoric precisely to give investors this sense of confidence and to keep them returning to their column, book, or program. Regardless of where the advice comes from, make sure the provider is "earning their keep".

mOOm said...

A point that just came to mind are that the fees you don't want to pay are those mutual fund loads. These fees go back to the broker or if you buy direct the mutal fund keeps them. In Aus I use Commonwealth Securities who refund all the load/application fee on all the funds they sell (they still get a trailing fee). I guess if it is an amazing fund and there is no way to avoid the load... but often there is a way to do so, or get a discount. Again, if you have a financial manager who really deserves the fee... but if you know what fund you want try to avoid it.