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FEE PYRAMIDING DAMAGES LONG-TERM RETURNS

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       Investor's Insight - September 8, 2006           
          "A Digest of Investment Opinion From the 
             World's Leading Financial Advisers"

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FEE PYRAMIDING DAMAGES LONG-TERM RETURNS
by Scott Burns

Q: We have about $50,000 in Wells Fargo and Janus mutual 
funds. Both are currently in money market accounts. We are 
thinking about moving out of these and putting our money 
into a managed advisory service account with a major mutual 
fund company. The company would manage our money for us 
for a fee of 1.1 percent a year, investing the money in 
mutual funds. The portfolio would be about 60 percent stocks 
and 40 percent bonds.

We don't need this money, but we would like to beat in-
flation or do better with little risk. The rest of our money 
is earning 4.5 percent in a one-year CD. We're attaching the 
investment plan we were sent. -- J.V., Fort Walton, Fla.

A: The problem here is called fee pyramiding, adding a fee 
for the selection of funds to the cost of the funds them-
selves. It may be the only way to provide service to a 
$50,000 account, but the fee is likely to be self-defeating.

Another issue is that the advisory firm is offering an 
insane level of diversification, dividing your $50,000 over 
26 different mutual funds. Each fund has its own expense 
ratio, and your largest investment would be only 9 percent 
of your money. Your smallest would be only 2 percent of 
your money. I guess that makes it look like they're doing 
a lot of work, but it's highly unlikely that you'll get 
much advantage out of having your money spread over so many 
funds.

Diversification is good. But there are limits.

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The bigger issue, however, is fee pyramiding. While 1.1 
percent a year may not seem like much, it can do major 
damage over a long period of time. You can get an idea 
by examining some Morningstar data with me.

Taking the entire universe of "moderate allocation" 
funds -- the ones that typically have a 60/40 stock/bond 
split -- and rank ordering their performance over the 15 
years ending Dec. 31, 2005, I found that funds at the 
25th percentile provided an annualized return of 10.80 
percent. Funds at the 50th percentile provided an annual-
ized return of 9.43 percent. And funds at the 75th per-
centile provided an annualized return of 8.32 percent.


So do the math. The difference between the 25th and 50th 
percentile is a mere 1.37 percent. The difference between 
the 50th and 75th percentile is only 1.11 percent. Com-
pare that to the annual fee for selecting a portfolio of 
funds to create a moderate allocation portfolio -- 1.1 
percent.

In medicine there is a problem called iatrogenic illness 
-- a malady that arises from the treatment given the pa-
tient. That's what we have here. The additional cost 
of selecting the funds, by itself, is likely to drop 
performance significantly. If the future contains a 
period of relatively low returns, the impact will be 
worse. If the future contains a period of relatively high 
returns, the impact won't be as bad.

The medical profession has recognized this problem and 
even has an association, The American Iatrogenic Assoc-
iation, to deal with the issue. Sadly, there is no 
counterpart organization in the financial services in-
dustry.

If you happen to think I'm just another ink-stained 
wretch jealous of the salaries pulled down in financial 
services, then I suggest you ignore me but read a little 
essay by billionaire Warren Buffett. Titled "How to 
Minimize Investment Returns," it starts on Page 
17 of his recently released annual letter to share-
holders.

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Stretch the investing period longer -- like for a 25-
year retirement -- and the difference between the top 
25 percent and the median will likely be still smaller. 
As the investing period lengthens, the burden of the 
fee becomes larger and larger.

Advisers, of course, argue that their adroit select-
ions will offset their fees and more. But they will 
be collecting fees today. You, meanwhile, will wait 
years to see if they deliver the promised value added.

Either way, you'd be better off selecting a single 
balanced fund with a similar asset allocation or, at 
most, selecting a domestic equity fund, an internat-
ional fund and a fixed-income fund.

You can discuss this issue or any other topic in the new 
Investor's Insight forum. Check it out here...

 
Investor's Insight Forum

(Investor's Insight reflects the opinions of experts. It does 
not recommend any specific investments, and no endorsement is 
implied or should be inferred. For more information, contact 
the individual firms cited).

COPYRIGHT 2006 UNIVERSAL PRESS SYNDICATE

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