Active vs passive investing. What’s an index? Sail your yacht and do nothing. Hit the throttle to maximize performance. The best investment in the World. I can’t sleep at night. Ladders. $1,000 to 1 million, maybe 10 million. The most infamous investment manager quote, “I will make you a multi-millionaire when you retire”.

Welcome to our listener-supported podcast, Money Talk, uncompromised absolute financial truths behind financial perceptions with host, Ed Sutkowski and Chuck LeFebvre. Let’s listen in.

Ed: Hi, I’m Ed.

Chuck: I’m Chuck.

Ed: Today’s topic we’ll be turning to the second stage, the management stage and Chuck’s going to be interested in expressing his views about active versus passive investing.

Chuck: Well, I’m not going to let you be completely passive in this conversation In fact, I think this will be interesting because you and I tend to agree on a lot of things, and we may find ourselves disagreeing a little bit on this. I think it’ll be helpful if we get some definitions on the table to start out. Just to talk about what we mean when we talk about active versus passive investment strategies because you could say, “Well, I bought that apartment building and I’m not doing anything with that. Someone else manages it so I’m a passive investor.” That’s not what I’m talking about when I say passive investment. When I say passive investment, I’m talking about investing in an index or in a market and not engaging in any type of effort to essentially beat the market so to speak. This is typically used when you’re talking about investing in publically traded securities like stocks and bonds.

Ed: Hey, Chuck. What’s an index?

Chuck: There you’d be talking about like a stock index like the S&P 500 stock index or the NASDAQ index or an international index or a bond index.

Ed: How is that compared to actually a mutual fund?

Chuck: Right, mutual funds can be designed in such a way where a fund simply invests in the individual securities that make up part of the index. For instance, the S&P 500 is an index that is comprised of 500 domestic stocks. You can design a mutual fund that simply buys those stocks, and then that mutual fund is at least in theory mirroring the performance of S&P 500 versus creating a mutual fund that invests in, I’m going to pick 20 stocks and I think these are stocks that are going to outperform the market. That second type of fund is your stereotypical active investment approach.

Ed: Why wouldn’t I buy one share of each of the 500 stocks on the index fund?

Chuck: Well, I think that is a perfectly legitimate approach. If you simply buy, now you’re not talking about a mutual fund. Now you’re talking about buying those individual stocks. Let’s say you literally do what you just described. You buy a share of each one so you’re executing 500 trades. You may find that the friction cost in doing that.

Ed: Wait a minute now, the movement now is to eliminate commissions on trades.

Chuck: Well, yes, but there’s still, even on those low-cost platforms, there still going to be some type of friction cost typically a per trade friction cost that’s associated with it. Generally speaking, you’re going to have better success in keeping your expenses associated with investing low. For instance, if you bought a block of a lot of shares of one stock, that will typically result in lower fees than if you bought 100 different stocks and just a couple of-

Ed: Well, say I’m going to buy $100,000 worth of each of the 500 stocks in this index fund.

Chuck: And hold them forever?

Ed: Hold them forever.

Chuck: Right. You’ve got some upfront costs associated with executing those trades which you ought to be able to do at a discounted rate. Then, you have invested in essentially the S&P 500.

Ed: I can just go on my yacht and watch crows fly, do nothing?

Chuck: Right. Now, there are stocks that move in and out of the index. It’s not an everyday occurrence.

Ed: I see.

Chuck: If you really wanted to mirror that index on an indefinite basis, you would also want to mirror those stocks if one drops off or if a new one comes on, you’d want to execute the appropriate trades to mirror that, but maybe you don’t care. Maybe you just decide, “Hey look, I started out with these 500 I’ll just hold these 500 I don’t care if it’s the same as the index forever.”

Ed: I’ve got three choices. An index fund, a mutual fund are actually buying the stock outright.

Chuck: Yes.

Ed: Or a combination.

Chuck: That’s exactly right.

Ed: What’s do you recommend?

Chuck: I think it depends on how much you’re putting in, what your timeframe is, for holding it and a little bit about what exactly it is that you consider to be good performance. Now, here’s just one area where I think you and I both agree that when you’re talking about the performance of an investment, it can kind of come down to one number, which is what is your total return on that investment going to be? but there’s a lot of people out there that are a lot more interested in risk reduction for instance, rather than just hitting the throttle as hard as they can and maximizing the performance. That’s kind of one of the things that– one of the criticisms I would have of people who promote passive investment strategies is that typically though the promoters of those strategies will often disregard the fact that there are reasons why some investors are not looking to match the market or they are looking to beat the market, not necessarily in terms of outright returns on investment, but in terms of being able to have a more stable investment than the market represents. Those people really don’t have a choice. Except to be– provide something other than an investment in the index.

Ed: You’re really talking about the difference in personality here, ability to bear risks. In other words, let’s assume I have $800,000 to invest. Well, I would, and some people would borrow $200,000, they’ve got an 80/20 ratio and the investment return will be greater. Of course, the downside will be greater too. Really isn’t the measurement here of the personality of the subject investor.

Chuck: It’s the personality of the subject investor and also to a certain extent, their time horizon as well yes.

Ed: Why would anyone ever have a time horizon?

Chuck: Well, I know that in your case, that– I think that it’s a good attitude to have a time horizon that’s essentially indefinite, but there are some people who– and in fact, a lot of people who are looking to invest because they have a– they sort of have some future event that they’re thinking, “well, when that event occurs, then I’m withdrawing this money. I want to make sure that my NASDAQ reaches some sense of stability at that period of time.

Ed: Well, that’s these funds that have ever, when you’re age 65, you should be all in cash.

Chuck: To target-date fund.

Ed: The target-date funds. I mean, I don’t get it, but that’s okay because if you believe in this country, believe in capitalism, believe in what’s going on, you do know that, “Hey, what’s better? What is a better investment than the stock market?”

Chuck: I mean, I think that there’s a better investment I can think of off the top of my head, which is the one you just described, which is investing other people’s money in the stock market by borrowing it. Then you can do better but there are situations where, for instance, someone is managing a fund where they’re living off the income of that fund and they need to have some stability of the income off that fund. That’s a little bit of a different situation than simply investing for growth. I mean, we’re going to have to talk sometime about the risks that are associated in investing in bonds. I think that a lot of times people see that as a safe investment when it is not. I tend to agree with you in the sense that the stock market is really the place to be.

Ed: Yes, and leverage– that’s my favorite 80/20. you’re spending 80% of your time on 20% of your problems, 80% of your time on 20% of your investments. If you keep that ratio of debt-equity going, you’ll have enough theoretically enough dividend income to offset against the interest expense of that $200,000.

Chuck: It should work that way.

Ed: It should.

Chuck: Yes.

Ed: If it doesn’t, are you capable of handling that decline?

Chuck: Right, do you have some other source that you can pay if you have to pay interest on that borrowing? Do you have another source to be able to pay that interest? And if not, do you have additional borrowing capacities so you can borrow in order to pay the interest on that? Of course, some people, the answer to one or both of those questions might be yes. With the only problem being that then they wouldn’t be able to sleep at night. If that was the situation, they would really need to be able to cash flow and the dividends literally pay the service on that loan just in order to feel comfortable. Just in order to not have aneurysm burst or something because they really don’t handle the stress of being in debt as well as other people do.

Ed: Well, Chuck, he’s another question of the ladders. I think of this as a ladder. You maybe you start out with $1,000 and then a year later, two years you’re going to make 10,000 then maybe you go to 50,000. There’s your stair, step it up so you can start absorbing these issues versus you put $1 million in the stock market, you put $100,000, put all of your investments in the stock market. There’s something about learning how this works on you that’s critical in selecting the format.

Chuck: Well, yes, and I think that for many people, now hopefully over time we might be able to dissuade people of this need. For many people, having that self-awareness in order to approach mentally the investment activity with a real strategy in mind, such or a plan that they’re going to be able to stick to you. Many people are looking for outside help in order to do that. When they’re looking for outside help, they’re talking to somebody who is a broker at a warehouse or an investment advisor of some type. Then they’re going to get into this conversation with whoever that person is about this topic of passive investing versus active investing. I want to be able to arm them with the ins and outs of what’s being told there. There’s a lot of those investment advisors out there who will do a lot more than simply say, “Hey, look, I’m going to sit down with you and teach you some basics about how to map out your strategy so that you’re entering in the market in a way that you can live with and executing a plan that you can stick with.” Instead there’s a story about, “Hey, I’m going to be able to pick investments for you that are going to knock the ball out of the park and so look at this projection I’m giving you now that, shows that I can give you 12% rate of return indefinitely for the next 20 years, and then you’re going to be retiring as a multimillionaire.” That story is simply false. I don’t know if there’s any gentle way of saying it, but a person who tells you that story may believe it themselves, but they’re not telling you the truth. They just simply can’t make a promise like that in the fine print on those illustrations will always say that. There’s research out there, lots of research actually out there that analyzes the approach of people who try to pick individual investments and compares it against, well, just how does the index behave. That research suggests that individual investors, frequently in fact, usually will underperform the index. Meaning you’re better off just buying an S&P 500 index fund or if you can afford it buying all of the stocks that are in the S&P 500 and just holding those versus trying to pick and choose which stocks to buy. That is often marketed as the so-called passive investment approach and there’s certainly an element of additional honesty to recognizing the fact that the activity of trying to pick individual stocks is often a losing game and yet, I also have a lot of personal concern out of the fact that a lot of the people who talk about that passive approach are also not being entirely honest about the research that they’re citing. When you really talk about your all-in experience, working with an investment advisor and engaging in this passive investment approach, what that really means in terms of the real performance because here’s the bottom line, and unless you actually do go out and buy all 500 of those 500 stocks in the S&P 500, you’re either putting your money in a mutual fund or you’re giving your money to some kind of an asset manager who is charging a fee to do that for you. Even though those fees tend to be fairly low, you are in fact going to experience a total return that is less than the return of the index itself. Quite often, these investment advisors, they’ll steer you towards an index fund, they’ll put you in an index fund, and say, “Well, we’re going to save you all these fees, because you’re going to be investing in the index instead of paying high fees to some investment advisor,” and yet they’ll still turn around and charge you 1% per year on the amount that they’re “managing.”

Ed: Well, I want to address that issue because it’s very troublesome to me. Specifically, a lot of folks I’ve known and work with will say, “Well, this investment advisor is my friend,” and by the way, there’s a lot of merit in having a good close relationship, this is relationship with investment advisor that satisfies those needs, those psychological needs. We’ve been talking about concerns and fears and invariably gets into your family and your dog and your car and/or your girlfriend or whatever. There’s some value that’s created there. The issue I see though is quite different. That is what is the cost of the investment advice and what is the cost of the psychological or qualitative value you’re receiving and why are they tied together and why is the percentage versus a breakout for the investment advice and an hourly charge for the qualitative value?

Chuck: Well, no, that’s exactly my concern too. When you’re talking about someone who’s engaged in passive approaches, you simply have to. You just inevitably conclude that most of what you’re paying for is really not investment advice. There’s no investment activity going on, other than coming up with a plan at the beginning of the relationship and then initiating that plan. But going forward, what investment advice are we talking about? It’s really all psychological advice on that in that situation. Why are the fees based on– First of all, I have a big problem with what’s really the industry standard here, which is charging a fee based on the percentage of assets that are “under management.” I think that’s a big issue. Second of all, if you’re going to charge that way, why are those fees so high? Why is the standard 1% on the first million dollars of assets that are under management? It seems like that is very hard to justify in. Of course, we’ve seen plenty of situations where these investment advisors are charging 1%, even on much larger funds than that, where they’re pushing that rate, even when they’re talking about people who have 10, 15, $20 million dollars under-investment, and they’re still talking about fees that are up to, sometimes even over that 1% mark.

Ed: I’ve never understood that because you’re investing the portfolio for the first million the same way you’re investing for the next 9 million or use 100,000 and a million dollars or 10,000 or 100,000, but the point is, they’re the same stocks. Why should you get a percentage on the value when it’s the same investment portfolio, A and B. You’ll find that that spread is unanimous across all the clients, the same mix. You will press the button, and I’ve got some positive to say about the investment advisors in just a second but my point is when you have a sufficient number, the cost of the marginal cost adding a new client is insignificant versus the return that you’re securing.

Chuck: Right. I do think that there is obviously someone who’s providing the service and I think a lot of people need the service even if the only service being provided is really what I would call handholding making sure because– Let’s back up a step. One of the things that really erodes the investment performance that most people experience is not the selection of poor investments but basic psychology that people tend to get really excited about investing in the market when the market is doing well. They go in on a high and then when the market is doing poorly, they get scared and they pull out. You see this happen over and over and over again, where people will, and you’re supposed to buy low and sell high. The psychology that drives people in and out of the market, drives them to do the exact opposite of that. It takes someone with either a great deal of discipline, a great deal of knowledge, or someone holding their hand who’s forcing them to behave in what is going to be a counter emotional way, in order for them to invest in a way where they’re not pulling out at the worst possible time and then going back in at the worst possible time to go back in. Ideally, everyone would have the same intuition as, Warren Buffett said, “When everyone else gets scared, I get greedy and when everyone else gets greedy, I get scared.” Not everybody can operate contrary to the crowd.

Ed: Yes. So, there’s a value. There’s a qualitative value.

Chuck: There’s value in what they’re performing and there are genuine expenses associated with delivering that value. Some of those expenses are based on simply having– if you’re an investment advisor, and you’re going to bring a new client in, even if the client says, “Look, I don’t want to talk to you more than once a year. I want minimal contact. I don’t need your newsletter, or whatever,” regardless of that feedback from the client, this investment advisor is going to have to perform a certain amount of service for that client, whether it’s appreciated or not, whether it’s wanted or not, there’s a certain amount of effort and that means overhead in order to provide that service to that client. That’s a set amount of labor and expense that is going to be incurred by any investment advisor, regardless of the size of the account. It’s just a warm body is there and that involves a certain amount of expense.

Ed: Yes. I think I read a recent publication that was a wealth advisor newsletter, and the first point was, make sure you establish a personal relationship with your clients, which suggests to me that it should be, make sure you get the best possible formats for your clients. The pitches you’ve got to dwell a little bit on fear and greed and the government.

Chuck: Right. Well, you and I, we spend a lot more of our time, essentially engaged in the unlicensed practice of psychology, so it’s not really too surprising that investment advisors are doing that too. It’s a major part of their job but that is different than, I read the same article and I know that the pitch there was no. You’re really trying to get the client to think of you as not a professional contact but as a friend, and that’s tipping over to a world that instead of just being good service then becomes disingenuous, the ideas, regardless of whether you’re providing good advice, or taking care of them, or whatever, that they’re going to stick with you because now they feel some emotional connection to the advisor that prevents them from making objective decisions about the relationship.

Ed: It’s hard to change lawyers, accountants, and insurance people, investment advisors, car dealers, you default to the truth, you default to this relationship. Having said that, I want to set the record straight here about my views. They may be shared by you about these various platforms. I’m speaking of the big three that I know of Schwab, Fidelity and Vanguard. Now, as much as we’ve talked about, so to speak, looking behind the services being provided the disclaimers, I own no shares of Charles Schwab. However, Schwab has been a custodian of my listed security accounts for pretty much as long as I can remember. The bottom line is their platform, and maybe this is the same for Fidelity and Vanguard, but I haven’t looked at it, that says default to the truth. Maybe those are better but I’m going to have a hard time changing. I doubt that ever will. I can go to that platform and I can see all kinds of numbers, dividends, other reports and comparative analyses my account versus someone else, A and B margin interest. If an individual has enough securities with Schwab, the margin rate is competitive, and that margin interest can be offset against the dividend income. The net I receive is simply the appreciation plus a little more dividend’s appreciation and evaluative portfolio. What I’m saying is, for me, there’s a terrific value of using Schwab again from a quantitative point of view and then from a qualitative point of view, I can talk to the broker and say, “Charlie, I’m thinking of doing X, Y & Z, what’s wrong with that? Think about it and call me in a couple of days.” I have someone to bounce that off of so there is a qualitative value and the net to me on an economic basis is zero and extra make money when you combine all those resources.

Chuck: Well, I think that you would probably find that most of the platforms they’ll all be available or have brokers associated with them. You’ve developed a professional contact with someone who matches your personality, and that works well for you. That certainly isn’t unique to the Schwab platform to have someone who’s capable of giving that type of advice. I do think that the Schwab platform, the online experience seems to put a lot of good information at your fingertips very readily if you need that. I have noticed now Schwab isn’t the only one here, but there’s definitely a small number, like, for instance, TD Ameritrade, I’ve got some assets there. There’s also a very competitive margin rate there. I’ve seen in instances where you talk about some of the retail brokerage firms. I’ve gotten quotes in conjunction with work for clients from some of these other firms like Merrill Lynch, and Raymond James, and so on. It’s actually astonishing how high you just don’t want to engage in any kind of margin borrowing from some of these platforms because it’s almost like a credit card type interest rate. It’s usurious. If margin borrowing is any kind of a priority at all, there’s probably a pretty small universe of platforms that are going to do that in a way where they’re really trying at all to accommodate the margin accounts. It’s clear that some of the big retail houses they must simply not have any interest in making that business available for their clients or they just see it as something that only someone under distress is going to ask for and so they’re just hitting them with really high-interest rates.

Ed: Well, yes, the point is, if you want a friend, as we said before, get a dog. The mission of that we’re trying to accomplish here is advising you telling you what to look at, and what are the risks and rewards and what’s the cost in dollars of this activity. Again, I don’t own shares of Schwab, but I’ve been around them for a long time, and I can dial up information whenever I want to. Now that Schwab started the no commissions, it’s filtered down through Fidelity and E-Trade and whatever. The next area and challenge me on this one is the percentage being charged by the investment advisor.

Chuck: Oh no, that is exactly– I think it’s really critical for people to understand that the investment industry is one where– this might almost be unique to the investment industry in the sense that the more you pay for a service, the less of that service you are actually receiving. By that, I mean that when you pay a percentage fee, it seems like all these people or it’s the industry standard to charge a percentage fee for providing investment advisory services or it’s built in to the performance of mutual funds if you’re purchasing shares of a mutual fund, and that’s a percentage of the assets that are invested. Whatever that fee is, it is a direct drag on performance. It’s just no escaping the math that’s involved in the fact that whatever the raw performance of those underlying investments is, let’s say it’s 10%. If you’re charged 1%, well, that 10% just became 9%. A different advisor who charges a lower fee but invests in exactly the same thing is going to give you a higher performance. There is a very strong correlation, in fact, one of the best things you can do if you are, for instance, in the mutual fund universe is the easiest place to see this in practice, you can go to Morningstar. For a pretty small fee, you can get on their platform, you can read all their research reports and do screenings and that thing. You can see for yourself just by going there and going through a few screens and you will see a direct correlation between low fee and high performance. There is absolutely no benefit at all to paying a high fee to anyone no matter what their story is, it is simply going to cause the performance of your investment to be lowered by whatever that fee is.

Ed: Chuck, in terms of a wrap-up. We will have an episode about Private Equity Investing, which is a whole different animal. Today’s discussion is limited to typically the New York Stock Exchange Companies with index funds, mutual funds, and freestanding securities. We’re not going to be run over by too many investment advisors.

Chuck: Or maybe a couple.

Ed: Maybe a couple, but the point is the market will dictate these results, and it’s moving toward the diminishing cost of investment services, more passive investing, more stock market-focused, and that, I think, is a good thing. Your comments?

Chuck: No, I agree completely. I think that people need to arm themselves with knowledge about the way fees are charged. First of all, in today’s discussion, we’ve just been assuming that people are aware of the fact that this model of paying a broker a commission to execute a trade is a definitely it’s diminishing part of the industry these days. You could still go. Walk into the office, pick your investment firm, Edward Jones, Merrill Lynch, Raymond James, any of them. You can say I want to buy 500 shares of X, Y, Z stock, and they will charge you a relatively high retail commission to execute that trade on your behalf. They’ll be happy to do that, or you can go to a discount brokerage platform like Schwab and execute that same trade for pennies on the dollar versus what it would cost to do at one of those retail brokerage houses, but typically what has happened in this industry is that most of those storefront, most of those people who are going to be face to face with you providing you investment advice are operating now on what they call a fee-for-service model, even though they call it fee-for-service. It’s really fee-for-assets. They’re not going to charge you an hourly fee or a per-service fee. What they’re going to charge is a percentage of the assets under management. That makes it very easy to compare the fees of one person versus another person. The problem is that the entire industry seems to have adopted a fairly lofty fee schedule for themselves.

Ed: That’s an amazing response. That is the world. Chuck, we’ll be featuring on one of the following podcasts. I’ll call it The Hidden Fees, Cost, and Expenses, and we’ll be using as a model, an IRA and a real-life example that we’ve gone through and determining the actual fees, costs and expenses associated with a major firm in respect to an IRA including the nature of the assets purchased and how people can go wrong without knowing they’re going wrong. That’s for another day.

Chuck: The spoiler on that is that it’s just as we’ve represented here, which is that the fee is a direct drag on the performance of the investments and almost dollar for dollar.

Ed: Yes, but when we go through those details, the result is, to understate it, is shocking. It was shocking to me and yet the individual didn’t change.

Chuck: Right.

Ed: Next topic. We’ll see you next time

Thank you for listening to Money Talk. Please join us again and do check out our previous Money Talk topics.