Over the next few months, I will be building a personal finance curriculum for high school students at an elite international school in Singapore. Most of my students’ parents are successful executives from Canada and the United States who yearn to see their children excel financially.
This success is by no means guaranteed. A Chinese proverb says wealth doesn’t last more than three generations: There’s a generation that builds wealth, a generation that maintains wealth, and a generation that squanders it.
Many of my students represent their families’ third generation of wealth. Part of my job is to ensure that my students learn the tools to build financial wealth, while avoiding the problems common among privileged kids.
Like most teachers, I design a course by working backward. I start by asking, “What do students truly need to learn?” Once I’ve identified the necessary skills, I construct a final exam to test those skills, then build lessons to ensure students can pass the test.
Let’s see how you would do on a few of the key questions I have in mind for the final exam.
Question: When selecting mutual funds, is it better to seek funds with low costs or ones with the best track records?
Answer: Choosing funds with low costs gives you a higher chance of success than picking funds with strong track records.
Most investors get this question wrong. They think that funds with the best returns in recent years are the ones that have the best chance of future success.
The evidence doesn’t bear that out. The fund-ranking company, Morningstar, rates mutual funds based on a five-star system – four or five stars for a fund with a great track record, and one to three stars for funds with less impressive histories. Roughly 95 per cent of mutual fund assets flow into Morningstar’s four- and five-star funds. But high performance in the mutual fund world is rarely sustainable and many of these funds go on to underperform the average.
Investors are better advised to seek funds with the lowest fees. Cheapness is a far stronger predictor of future performance than history – something even Morningstar admits. In a recent study, it found that using low management expense ratios as a way to pick funds was more effective than using high star rankings.
“If there’s anything in the world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds,” says Russel Kinnel, the study’s author.
Question: On average, do mutual funds selected by financial advisers for their clients outperform mutual funds selected by do-it-yourself investors?
Answer: No. Experienced advisers may be able to add value to an investor’s financial plan by helping with advice on asset allocation, goal-setting, and taxable advice. On average, though, the mutual funds that advisers select for people underperform the results of funds selected by do-it-yourself investors. A Harvard Business school study found that funds sold to investors via brokers between 1996 and 2002 lagged behind funds selected by individual investors.
Are individual investors smarter than most brokers? Not necessarily. But many brokers select funds based on how well they’ll be compensated by the fund company. And those funds are often accompanied by higher costs, which hurt investment returns.
Question: Based on a recent study by Morningstar, what country has the world’s highest mutual fund costs?
Answer: Canada. In fact, this country was the only one of 22 nations in the Morningstar report to get an “F” on fees and expenses.
According to analysts John Rekenthaler and Benjamin Alpert, Canada had the highest management expense ratios for equity funds, the second-highest for bond funds, and was tied for the highest, with Italy, for money-market funds.
The median expense ratio for equity funds was 2.31 per cent, more than twice as high as the 0.94 per cent in the low-cost United States, Morningstar said. The median fee for fixed-income and money-market funds is more than 70-per-cent higher than in the U.S.
Paying an extra percentage point or so every year might look innocuous, but over an investment lifetime, it can decimate a portfolio’s potential.
If a 19-year-old invested $1,200 a year, making 9 per cent a year for 45 years, she would have $631,030 at age 64.
But if she was paying an extra percentage point a year, reducing her annual return to 8 per cent annually, she would have only $463,807.
Investment costs matter. If you understand that, you’re well on your way to getting an A on life’s personal finance exam.
Andrew Hallam is a Canadian who teaches English and personal finance at Singapore American School. He is the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School. This is the second in a series of columns based on his book.
Special to The Globe and Mail