Every 18 months or so, Burton Malkiel writes an article on investment costs for the Wall Street Journal.  He’s done it again with May 29th’s You’re Paying Too Much for Investment Help.  You have to hand it to the guy – he really stays on point.  Actually, so much so that he makes the exact same point every time.  Malkiel believes that investment management fees are too high and that all investors everywhere would be better off if invested directly in index funds.

With Malkiel’s argument, we find ourselves in that somewhat awkward position of agreeing whole-heartedly with his main point (fees are too high) while disagreeing strongly with his conclusion (everyone should invest in index funds).  Let’s first look at the cost argument and then come back to indexing.

The lower your fees, the more you keep; that much is obvious.  The predominant model in our industry today is to layer advisory fees on top of mutual fund fees.  We see this structure as not only generating excessive costs, but also leading to one-size-fits-all solutions.  Malkiel correctly notes that costs for actively managed mutual funds have risen considerably in the last couple of decades; this even though the market price for fund management should’ve become more efficient as new competitors entered the space.  Let’s be clear: we are surprised by how much many investors are paying for standardized advice.  We agree with Vanguard founder Jack Bogle’s comment in the PBS Frontline documentary, The Retirement Gamble:   investors should strive to keep their costs to under 1% of assets annually.

But we disagree with both Malkiel and Bogle that the solution is index funds.  That’s not to say we don’t see a point to index investing.  In fact, we utilize some index exchange traded funds in our client portfolios.  We take exception that index funds are the only smart, reasonably-priced investment option.   There are several reasons why indexing might not serve investors well.

The Good, The Bad, and The Ugly.  Index funds contain exactly what is in the index, no more and no less.  The most widely known bond index is the Barclay’s U.S. Aggregate Bond Index.  As of this writing, 43% of the fund was invested in U.S. Treasury and Agency bonds, which yield practically nothing.  At the same time, the index has a weighted average maturity of almost 7 years.  We believe that interest rates will continue to rise, and that Treasury bonds in particular remain very overvalued, and we’re investing accordingly.  With an index fund, you simply have no latitude to take that kind of corrective action.

Go Your Own Way.  Some investors have it all: they have the skill, the time, and the discipline to go it alone successfully.  Those investors may simply not need a professional manager.  Many people, even if they have the skill and the time, don’t have the discipline or temperament to stay invested – to work the strategic investment plan – when markets become volatile.  We know of many investors who pulled their money out and have yet to get back in.  Market timing is impossible to get right consistently.  Staying invested is sometimes emotionally difficult, but it is aided by the discipline of rebalancing.  Some small portion of every fee dollar we earn is directly attributable to keeping investors on plan and engaged, through thick and thin.

Performance + Structure.  Investors’ financial needs are unique, and their portfolios should be as well.  We absolutely agree that benchmarking our performance to index is an appropriate way to measure relative value.  But, portfolio structure is just as important.  By structure we mean the way in which assets are combined to meet the unique future financial needs of each investor.   For instance, investing in the S&P 500 index fund would currently give you a dividend yield of 1.67%.  That amount of income may be totally insufficient for an investor’s withdrawal needs – especially in this low interest rate environment.

A Helping Hand.  Because we focus our attention on investment management, we often refer clients to knowledgeable and trusted professionals in related fields (e.g., tax and estate planning) as those needs arise.  But there are many, many other circumstances where we can offer recommendations relating to financial decisions outside portfolio management.

So, no, directly investing in index funds doesn’t always make sense for everyone.  But, keeping costs reasonable is a universal goal.  We look forward  to reading Mr. Malkiel’s next Wall Street Journal article saying the same thing.