Morningstar Advisor - April/May 2013 - (Page 25)

In Practice Investing’s No-Brainers Have Costs By Jeffrey Ptak Every investing decision comes with a potentially pricey trade-off. In managing portfolios for financial advisors, we talk often about ways in which we try to maximize the risk/return quotient for their clients. We diversify across a multitude of asset classes; we actively seek out lower-cost investments; and we try to hold the line on trading by sticking to our long-term investing discipline. Experience has shown that these practices alone can help to push the risk/ reward line higher. But we also try to be realists about the trade-offs we’re making. In diversifying, we forgo the opportunity to dive headlong into mispriced areas. In sticking to lower-cost fare, we might deny clients access to talented active managers who nonetheless cost more. In not transacting, we arguably subject clients to short-term volatility and drawdowns that rattle them. Nothing is free. Yet, investors frequently hear claims to the contrary. They’re told that they can trade for free or that they can get beta, liquidity, or even some extra income for nothing. In truth, as we will explain, these are trade-offs masquerading as no-brainers. Free Trading We’ve written of the insidious effect that 12b-1 fees have on fund expenses. They socialize the cost of distribution by keeping management fees (which are levied uniformly across share classes) stubbornly high. By their nature, 12b-1 fees do not scale—you’ll never see a fund’s 12b-1 fee falling as assets grow. Investors are denied the savings they ought to share. Fortunately, exchange-traded fund investors have not had to contend with 12b-1, as such funds trade on exchanges rather than in supermarkets. Moreover, they’re geared toward institutions and fee-based advisors, not brokers who might have made a living by scraping off a few basis points here and there from a 12b-1. But will things remain that way? In asking that question, I’m not suggesting that 12b-1 fees will spread over the ETF market the way they have traditional mutual funds. But with the move to no-transaction-fee ETF platforms, on which investors can trade sans brokerage commissions, you’ve got to wonder whether the market is approaching a Rubicon. Are pricier ETFs larded-up, directly or indirectly, by distribution costs on the other side? Why would ETFs—which have boomed thanks to their simplicity and low cost—ever go down that path? Because distribution matters and, well, distribution ain’t free. And make no mistake, the recent crop of deals with retail brokerage platforms are only partly about removing cost from the investor experience—they’re also about harnessing the distribution weight that those platforms throw around. The platforms aren’t nonprofits or altruists, let alone dummies. They’re calculating that the uptake in no-transaction-fee ETF business will happily spill over into other areas, such as their own proprietary funds or related fee-based business. But it’s unlikely to be enough—either to cover their own costs or, more importantly, to fully monetize the value they believe their distribution ought to command. So, the question isn’t whether distribution hubs like brokerage platforms will seek to press those advantages, it’s how they’ll do so and who will shoulder the costs. Fortunately, Schwab’s recent launch of its OneSource ETF platform did not see participating ETF providers raise their expense ratios, launch new higher-cost share classes, or foist new fees and restrictions on investors. Viewed in isolation, it’s hard to see the platform as anything but good. But what comes next? Will platforms settle for merely stabilizing their market share? Will ETF providers be willing to eat the cost of shelf space? Will traditional fund companies’ entry to the ETF market raise the stakes for visibility and, with it, the price of admission to no-transaction-fee ETF platforms? How will the shift to no-transaction-fee platforms affect investors buying the many ETFs that are off-platform and, thus, subject to brokerage commissions? You can win the battle and lose 25

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2013

Morningstar Advisor - April/May 2013
Letter From the Editor
The Pursuit of Happiness and Financial Advice
What Strategies Do You Use to Control Risk?
Driven to Succeed for Clients and Family
How to Assess a Portfolio’s Bond Risk
Luck, Skill, and Investing
Investments á la Carte
Investment Briefs
Investing’s No- Brainers Have Costs
A Defensive Ride
Risk On/On Risk
The Risk of Being Overconfident
Year of Living Dangerously
The Risk-Parity Approach
A Guide to Mutual Funds Running Risk-Parity Strategies
What Moats Tell Us About Risk
Risk’s Wake-Up Call
Seeing Is Believing
Why Investors Lag the Returns of Their Funds
Liquidity Signals
Pump Them Up
Golden Oldies Keep on Truckin’
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Our Social Blind Spot

Morningstar Advisor - April/May 2013