June 24, 2020

“In Investing, You Get What You Don’t Pay For”

That was the title of a keynote address given by Vanguard founder John Bogle in February 2005.  For Bogle, a prominent evangelist of low-cost investing, the premise, simply stated, was that investment expenses directly erode investor returns.

Investor Returns = Market Returns – Expenses

Market returns are going to be what they are going to be.  We do not control them (although investors have control over the extent and type of market risk they are exposed to).  We do have control over expenses.  Unfortunately, many investors find it difficult to believe that investing is uniquely different from most everything else that is consistent with the saying “you get what you pay for”.

Following are three characteristics that help explain why investors seem open to the idea that expensive investments are better.

  • Exclusivity
  • Complexity
  • Guru veneration

A recent Wall Street Journal article by Jason Zweig, “Invest with the Upper Crust and Sometimes You Just Get Crumbs” highlights this issue.  While the article focuses on one particular type of investment expense, performance fees, it also reflects on a larger issue.  The issue of how the investment industry presses on the exclusivity button to sell wealthy investors on expensive, illiquid, and likely to underperform investment products.  Following is a quote from Anthony Scaramucci, the founder and co-managing partner of SkyBridge Capital, in response to why it makes sense for investors to pay premium prices for access to their fund-of-funds[1] investments.

“This is like an Hermès Birkin bag [which retails for thousands of dollars]. You’re invested with some of the most successful money managers in the world, and you’re paying additional fees for that. You could invest elsewhere for much lower costs, the same way you could get hundreds of pocketbooks at Walmart for the cost of one Hermès Birkin bag.”

The implication here is that investors get “better” investments if they pay more for them.  Unfortunately for Mr. Scaramucci, the evidence suggests otherwise.

According to Hedge Fund Research, Inc. (HFR), the HFRI Fund of Funds Composite Index, during the period from 1996 through 2019, returned an annualized 4.84% per year.  Over the same time period, the plain-vanilla Vanguard Balanced Index Fund (VBIAX)[2], with a very Walmart-like expense ratio of 0.07%, returned an annualized 7.85% per year.  To put that into dollar terms, if an investor invested $1 million in the Vanguard fund at the beginning of 1996, the portfolio value would have reached over $6 million.  And in the hedge fund-of-funds asset?  Roughly half that amount, just over $3 million.

Chart 1: Vanguard Balanced Index fund vs HFRI FOF Index


Source: Kwanti and HFRI

Ultimately, investors must answer the following question for themselves.  For what purpose are you investing?  To make an impression at cocktail parties or to grow your wealth so you can build a better life for yourself and others?  If it is the former, hedge funds, fund-of-funds and other complex, expensive products might make sense for you.  If it is the latter, don’t fall for the sales pitch.  Stick with the fundamentals; low-cost, tax-efficient, globally diversified portfolios.

[1] Funds of funds are a basket of hedge funds with an added layer of management fees

[2] The fund targets an allocation of 60% U.S. equities and 40% U.S. bonds