Why Does PSI Maintain a Low Cost Fund Lineup?

While there are hundreds of various investment evaluation methodologies and models available in the marketplace, almost all rely solely on historical performance data.  Some, such as Monte Carlo simulations, attempt to forecast into the future across a multitude of possible future economic conditions to determine “most likely outcomes.”  However, these forecasts rely primarily on historical performance data during similar economic conditions.

This obviously points out the greatest deficiency of these models, as we are constantly reminded: “Past performance is not an indicator of future outcomes.”  This statement is found in the fine print of almost all mutual fund return data.

This historical data, while no guarantee of future performance, is currently the best available quantitative data upon which to base decisions around fund quality.  This is especially true in the short-term, where management teams stay intact, prospectus objectives are being met, and market conditions are similar or more favorable going forward.  As we examine longer and longer time periods, the fund may have undergone many material changes such as manager changes, style changes, cost increases, etc.  This surely makes the data less reliable for forecasting future results.

There is one fund evaluation criteria that does remain fairly static (or improves over time): fund expenses.  Our adage is that you can’t control the market, but you can control the cost of your participation in that market.  The good news for the average investor is that mutual fund expenses have been steadily decreasing over time.  According to the 2018 Investment Company Institute, the average expense ratio for an actively managed equity mutual fund was 1.06% in 2000.  In 2017 that amount had decreased to 0.78%.  When you compare this to “passive” or index investing over the same period, their average decreased from 0.21% to 0.09%.

While both types of investing have enjoyed steady expense-ratio decreases over time, the passive/index strategy has an average expense ratio that is 88% less than actively managed large cap equity funds.  While the net difference of 0.69% (0.78% active -0.09% passive) may not sound like a large variance, it can have a significant negative impact over long time periods.

For example, let’s look at a participant that has a $100,000 account balance and contributes $10,000 per year over 20 years.  Assuming gross returns are equal, this difference creates nearly $50,000 in basic cost increases and when combined with loss of return, a total balance that is almost $85,000 less at the end of that 20 year period.

This is a primary reason why at PSI we employ an evaluation criteria heavily weighted toward the expenses/cost of the potential investment choices.  This is based on two pieces of compelling information:

  1. Over the long term, actively managed Large Cap funds underperformed their index (S&P 500) 92% of the time over a 15 year period. (12/31/2016, Source SPIVA U.S Scorecard). We do not believe this is a coincidence, and that fees are a large factor in this discrepancy.
  2. As mentioned, the expense ratio is the one piece of known information. So all other criteria being equal, not selecting the lowest cost alternative is counterintuitive.

While using passive or index investing is a “no brainer” for Large Cap or Domestic equity, we do feel there are opportunities for more efficient active alternatives in the foreign, small/micro-cap, specialty funds (like socially conscious and precious metals), and fixed income sectors.  The reason for this is that these sectors are generally shorter term investments, or are involved in a more strategic sophisticated personal investment strategy.  Therefore, we will employ some active managed strategies in these sectors.  Expense ratios will still be a large decision making factor for these funds.

401k plans are long term investments.  Over the long term, lower cost index based strategies and 401k investing generally go hand in hand.

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