We’re getting more and more comments from readers and we appreciate all of them. Every now and then, we get a comment that inspires us to write a story. We received just such a comment on last week’s article “What’s a Fair Fee to Pay a Fiduciary."
In that article, we included this throwaway line: “it would not be unusual to find a high expense ratio actively managed fund with better investment returns than a low expense ratio actively managed fund.” I call it a “throwaway line” because its relevance lay just on the periphery of the topic. In the end, I’m glad I didn’t throw it away. Here’s why.
A reader, who went out of his way to compliment my writing and to say he’s still a fan, liked everything in the article except that line. He even referred to a statement made by a Morningstar executive saying, “cheaper funds are far more likely to outperform.” I emailed him back thanking him for the comment because it gave me a great idea for a story.
This is the story that came out of it: “A 401(k) Must Read: Mutual Fund Expense Ratio Myth Busted." If you think it’s important to look at a mutual fund’s expense ratio before investing, this article explains when it is and when it isn’t.
A bigger question is: Why do myths like this persist? It’s one thing to see retail investors repeat them. They aren’t supposed to know better. Financial professionals, on the other hand, ought to. Whereas retail investors live their lives in a world far beyond portfolio management, professionals, especially credentialed professionals, too often repeat investing bromides that have about as much credibility as an urban myth.
These investment myths usually derive from a small portion of an academic study. In the marketplace translation, however, all the critical hedging language used by researchers evolves into absolute language. You don’t have to be a trained scientist to know the dangers of absolutism. If you say it rains all the time in Seattle, it only takes a singular moment of dry skies to refute that hypothesis.
On the other hand, if you say it rains most of the time in Seattle, you’re on safer ground. After all, how do you define “most”? Technically, “most” means more than half, so it would have to rain at least 183 days a year for “most” to be correct. (I don’t know how often it rains in Seattle, but it does average 226 cloudy days a year, at least according to KOMOnews.com.)
Scientists more often use the term “significant” rather than a plebian word like “most.” The word “significant” implies some sort of statistical measure as to the relevance of the result in any experiment. There’s always some degree of uncertainty, but as a researcher you want to account for it if not address it to the extent possible.
Think of this as if you’re a candidate running for president and you take a pre-election poll. You’ll feel more comfortable if your lead is greater than the poll’s “margin of error” (the pollster’s definition of statistical uncertainty).
Another popular statistical measure is correlation. It’s something every economist and stock analyst searches for. It’s like the Holy Grail of markets. If you can find a pure correlation between two different factors, you can use the knowledge of one to predict the outcome of the other and, in the process, make loads of money. Correlations could be either positive (i.e., the tendency of both events to occur simultaneously) or negative (i.e., the tendency for one event to occur only if the other does not).
For example, there is a 100 percent positive correlation between “getting wet” and “standing outside in Seattle in an open field without an umbrella when it’s raining.” You can say this another way: There is a 100 percent negative correlation between “staying dry” and “standing outside in Seattle in an open field without an umbrella while it’s raining.” Each of these two examples represents what’s called an “absolute” statement.
The real world seldom offers such absolutes. In the article referenced above, we find the correlation between fees and performance in S&P 500 funds as not quite perfect negative 92 percent for the performance year 2011. This means, while lower fees usually mean better performance, there are some (albeit very rare) cases where a higher fee index funds also has better performance.
Take a look at that last sentence. That’s the statement of a scientist. It’s not the statement of a marketer. A marketers wants a soundbite. The sound doesn’t bite if it contains any qualifications.
And that – for retail investors and financial professionals alike – is what leads us into the netherworld of the alluring, but false, investment rules.