For years, the conventional goal of investing has been to beat the market. If you can get in on the ground floor of the next Google or Apple, your retirement years will be white sands and pina coladas. There are three problems with that - one obvious, one not so obvious, and one nearly invisible.
1. The obvious problem: Actually finding the next Google or Apple. Over the last 10 years, 60% of mutual funds that invest in large U.S. companies - like the companies listed on the S&P 500 - failed to outperform the actual S&P 500. You read that right: 60% of the fund managers who tried to buy only the best companies in the S&P 500 would have been better off just buying all of them.
2. The not-so-obvious problem: The S&P itself might have a bad year compared to investments in smaller companies, international companies, government bonds, etc. So not only do you have to pick the right funds, you have to pick the right combination of funds. You have to diversify.
3. The nearly invisible problem: Fees. The money that mutual fund companies and retirement administrators take out in fees costs you more than you would guess - nearly 1% to nearly 1% of the entire value of your portfolio every year. What's worse than the fees themselves is the fact that the money is no longer compounding in your account. A $10 annual account fee would cost you $300 over 30 years of retirement savings, but it will cost you more than twice that amount by the time you account for the lost earning potential of the money you spent on fees.
Robert Hiltonsmith, a policy analyst who has written and talked about the hidden expenses in 401(k) and other retirement plans for news outlets left, right and center, said in a recent "Fresh Air" interview that many retirement accounts lose as much as 30% of their value to fees. And the fees are hard to find because they're mostly buried in lower asset prices than in a line item marked "fees."
A solution that addresses all three problems is hard to come by because full-service brokerages (Merrill Lynch, Morgan Stanley), online brokerages (E*TRADE, Ameritrade) and mutual fund companies (American Funds, Dreyfus) are oriented more toward maximizing their fees than your returns. And the plans with low-fee options don't offer much guidance on which low-fee options make the most sense for your retirement accounts.
FutureAdvisor, a web-based investment app that launched in 2010, has taken a fundamental, techy, and completely transparent (no advertising, no sponsors) approach to those problems. Co-founder Bo Lu and I discussed FutureAdvisor over a series of emails, which I lightly edited below.
FutureAdvisor uses an investment model called Modern Portfolio Theory. What is that?
We've all heard the phrase "don't put all your eggs in one basket." Modern Portfolio Theory is really just this axiom applied to investing. It's the name given to the mathematical model that helps financial advisors get you the best returns for a given amount of risk you're willing to take by diversifying your money across different types of investments.
Your model recommends buying index funds, which are mutual funds and exchange-traded funds (ETFs) that track certain market indexes. Isn't using a model like that just a defeatist admission that you're not even trying to beat the market?
Decades of academic research have shown that very few people beat the market, and the losses accumulated by investors attempting to do so are staggering. It's statistically better to match the market than to even try to beat it, as most people lose when they try and they lose by a lot.
FutureAdvisor will recommend seling higher-fee funds and replacing them with lower-fee funds. What are those fees actually for?
Mutual funds and ETFs charge fees to pay for operating expenses and to pay their managers (who make a lot of money). These fees, taken from your retirement savings, is what pays for the buildings and annual bonuses. We too understand that it takes money to run a mutual fund or ETF, but imagine if you were paying 10 times what your neighbor paid for identical auto insurance. That happens every day in mutual funds.
Why does a mutual fund that tracks, say, the S&P 500 have higher expenses than ETFs that track the same index?
This is common, but not always true. It's a good practice to always check. Vanguard and Schwab are two examples of ETF firms known for their low fees. As to the why, it's pretty arcane, and probably not something everyone wants to spend dinner parties chatting with friends about. It has to do with the fact that you buy ETFs from other investors (just like stocks), and that you buy mutual funds from the fund companies themselves, so the mutual fund companies have to do more work everyday as shares change hands. Thus, they incur costs interacting with you, the retail investor, that ETF firms do not since they only deal with large banks. If you want to get more details you can look up ETF creation baskets... but only if you're dorky like me.
Why has the mutual fund industry not made a bigger push to match the lower expenses of ETFs?
They have. Vanguard is a great example of a mutual fund company that has many mutual funds that are equal in expense, and even sometimes less expensive, than most ETF counterparts.
FutureAdvisor's model recommends investment mostly in broad markets - domestic, international, emerging markets, and bonds, but the only individual sector you recommend is real estate. Why not healthcare, IT, etc.?
Great question. Research shows that Real Estate Investment Trusts (REITs) bring unique value to a portfolio. because it has relatively low correlation with stocks and bonds in general, and yet it has high returns like stocks. REITs are more an "asset class" than a sector, and has unique traits, because it lets retail investors (that's us) own a slice of corporate real estate nationwide, or worldwide. For example, it's good protection against unexpected inflation because rents tend to go up quickly in reaction to inflation.
FutureAdvisor doesn't have ads and doesn't accept fees to recommend individual ETFs or mutual funds. How do you make money?
FutureAdvisor makes money because some of our customers choose to use our premium service to directly manage their portfolios; we charge a low monthly fee for that. Premium gets you the full power of the software, in that your portfolio is diligently watched over and rebalanced, and made more tax-efficient. We always notify you ahead of portfolio changes and give you chance to veto, of course. Our customers will always be able to get specific personalized recommendations for free.
Your business model is basically looking at my stuff and telling me how far off it is from a model portfolio, which is pretty straightforward. How will you differentiate the next five startups that do the same thing?
There's a lot more to our vision of bringing turnkey financial management to everyday American households than just the long-term investment piece that's available today. You can expect us to expand in the future both in terms of the financial goals we help households with, and the breadth of financial instruments we help advise on.
Have you gotten much flack from investment advisors? Don't they hate you?
This is the most interesting thing - many advisors actually love us. Advisor Bill Schultheis wrote about us on his blog. The best financial advisors, like Bill, went into the business to help people. It's just an unfortunate side effect that because managing a household's portfolio by hand is so time-consuming, it's only cost-effective to do this for the wealthiest households. But advisors welcome the innovative and cost-effective ways that companies like us are pioneering to help less-affluent households get high quality financial management.
Are you working on apps for iPad, Android or Windows 8?
We are - I have no comments on when they'll be ready, but it's definitely on the roadmap.