Opinion and Investing Column

SKARBECK: Alternative investments not worth their high costs

March 23, 2013

Ken Skarbeck“You get what you pay for” is an expression that suggests if you pay a cheap price for a good or service, you are likely to receive something of poor quality. Stated conversely, if you want the best, expect to pay a high cost. This advice applies in most consumer decisions—except for investing.

When it comes to choosing the products or services offered by the investment industry, the evidence suggests that when investors pay less, they often get more.

Last year, an index fund that tracked the stock market returned 16 percent and charged fees of about 0.17 percent. In contrast, 65 percent of equity mutual funds underperformed the market, while charging fees nearly 10 times that of an index fund.

These results confirm the oft-quoted statistic that, over a 10-year period, 60 percent of actively managed mutual funds underperform the stock market—higher fees subtract from net return.

Now let’s really ramp up the cost structure with hedge funds, where the standard cost to investors is a 2-percent annual fee and 20 percent of the profits.

In 2012, 88 percent of hedge funds drastically underperformed the market with an average return of 6.4 percent, well below the market’s 16-percent return. That followed an average loss of -5.3 percent for hedge funds in 2011.

Thus for the past two years, hedge-fund investors earned nothing versus the 17.5-percent return earned on a low-cost portfolio of 60-percent stocks and 40-percent bonds.

That miserable showing from an asset class crammed into institutional portfolios across the country has led to high drama in South Carolina. Treasurer Curtis Loftis has expressed dismay that, over the past five years, the state’s public pension plan has paid $1.2 billion in fees and earned a measly 1.3 percent annual return. With 56 percent of South Carolina’s pension plan invested in high-cost alternative investments, Loftis complains “the complexity of our portfolio is uncharted in public pension plans.”

The South Carolina Retirement System Investment Commission recently issued a public censure against Loftis for “engaging in false, misleading and deceitful rhetoric” in his communications with the media regarding the state’s pension portfolio.

Meanwhile, neighboring Georgia, whose $54 billion pension plan is twice the size, incurred one-tenth the fees paid by South Carolina and earned 3 percent annually with a portfolio of stocks and bonds. Less is more for investors.

Yet, despite all the evidence, a Deutsche Bank survey found that 67 percent of pension plans will increase their allocation to hedge funds and alternative investments.

Other high-cost investment products are avidly marketed to investors. Structured products are complex investments created by Wall Street firms, thus come with high expense. The wildly popular annuities offered by insurance companies attract investors with their pitch of safety and “guarantees,” but also harbor expensive unseen costs and limited liquidity.

Investment costs serve as an implicit tax on returns and investors should seek to minimize their impact. The “less is more” approach to costs—combined with a rational, long-term investment strategy—will lead to a larger net worth over time.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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