START INVESTING | Mutual Funds & MSA’s
The Other Stocks: Mutual Funds and Managed Savings Accounts
Fees are a performance killer. Find out how much:
Fees are a performance killer. Find out how much:
In this post, I will discuss one of the most common ways novice investors “invest” – Managed Savings Accounts (MSA), also known as Offshore Pensions or Investment Linked Assurance Schemes (ILAS).
How do I know it’s so common? Because…
1) 3-4 times per year I have sales people of these financial products calling me… and they always offer me the same thing, from the same companies, with the same terms and conditions.
2) I am not alone… most of my former colleagues in the Oil & Gas industry received the same calls and queries for appointments. A good number of them signed up.
So… what are these investments and do they make sense? And why does the sales talk often work?
Save it, forget it
The idea behind it is as simple as compelling:
Pay a regular monthly amount into an account. Let financial experts invest it for you. Reap the benefits later, either as a monthly pension or as a full pay-out.
No need to spend your own valuable time… and after all, you are not a “finance expert”, right?
Usually, they will show you a nice little chart about how “usually” (or “on average”) your contributions “can” develop over time, like this:
And it looks great. Who would not want to nearly triple his account value?
So how do they come up with such a great projection?
How the investment grows
The chart above shows a typical exponential growth curve.
Make regular $500 per months payments into a savings account that gives you 10% per year interest and it would look exactly the same.
Just… currently, there are no saving accounts that offer such great returns. You are lucky to find one that offers 1% annually.
Instead, the monthly payments are invested into Mutual Funds.
Okay… and what are Mutual Funds?
A mutual fund is a collection of stocks that are bundled into a “package” from which investors can buy a piece from.
They come in all shapes and sizes; in fact, there are more than 9,500 mutual funds available in the US market alone – and quite possibly more than individual stocks.
Could you build your own private mutual fund? Yep… that’s easy!
Let’s say you want a “tech” fund that focuses on investing in the technology sector. Here is what you need to do:
- Download a list of the S&P 500 index (it’s on Wikipedia)
- Sort the list by industry sectors and delete all companies that are not listed in the technical sector
- Buy one stock of each of the remaining list of companies
- Done. You started your own “tech” mutual fund!
- Maintain it: 4 times per year evaluate if you want to add or remove stocks from the fund.
And that’s it. You are now running your own little mutual fund. One way to make money is to invest in the fund over time and assume that its value will grow…
But there is an even better way to make money!
- Sell your fund to clients: use other people’s money to buy more stocks from your list.
- Charge your clients a fee for participating in your wise investment choices (i.e. expert advice).
That’s what the finance experts are doing. And it works well for them.
Active vs. passive funds
There are two main types of mutual funds: actively managed and passive.
Actively managed means: a team of experts keeps evaluating each company that is part of the fund and decide on a regular basis to shuffle stocks.
Either buy more, or sell, or completely remove a company from the fund, while adding another, more promising one.
Passive funds try to track a market sector.
A good example is our own private tech fund we created above. It’s basically tracking the S&P technical sector.
All that needs to be done is to monitor what the S&P index (or equivalent index) is doing (which companies are added or removed) and adjust the fund accordingly. No need for a big team of experts.
So what? What does it do for me?
Because funds bundle stocks, they are more diversified and hence less volatile, and (hopefully) a safer investment.
I will discuss diversification in a later post in greater detail. For now, just imagine it as a way to put eggs in multiple baskets.
Investing in a single company is risky. What if that company goes bankrupt? Your entire investment will be lost. If you spread the risk over many companies, chances of huge losses are greatly reduced.
A mutual fund can contain hundreds or more stocks – a degree of diversification that is difficult to achieve by a single investor (who does not have millions to spend).
So, in that sense, mutual funds are not bad.
But… there’s a BUT, right?
You bet there is.
The work invested in making an investment a safer investment comes (literately) at a cost. Fund managers ask for a fee for doing that work.
And there is nothing wrong with that.
Experts should be paid for their efforts – after all, we need experts. Nobody can be an expert in everything. Experts spend a great amount of time on a specific subject so you don’t have to.
A doctor is such an expert. You feel sick, you get his expert advice on helping you to become healthy again. You pay for it because everything else would be too risky or too much headache (pun intended!).
Here are some questions for you to think about:
- How high are the fees?
- Do funds with higher fees give me better results than funds with lower fees?
- What is the effect of fees on my portfolio value over time?
Let’s tackle one by one.
Mutual fund fees
Actively managed funds demand higher fees than passive funds. That makes sense because they need a team of experts that must be paid for.
Actively managed funds can leverage fees between 1 – 3% annually. That cost is deducted directly from the current fund value (your portfolio value).
Passive fund fees can be as low as 0.15% annually.
That’s quite a difference. Imagine you have two investment choices:
1) An actively managed fund that asks for 2.5% annual fee
2) A passive index fund that asks for 0.25% annual fee
The first fund asks for 10 times higher fees than the second one. Which leads us to the next question.
What about performance?
Mutual fund performance
What do you expect from a product that is more expensive?
It should do better than a cheaper product, for sure. Imagine you double the money for buying your car. Certainly, there should be a good amount of benefits for you to spend this additional amount?
Will the first mutual fund be 10 times “better” than the second one? What does “better” even mean?
Maybe it’s not reasonable to ask for 10 times higher performance. But surely double performance would be nice. Or a significantly lower risk, at the very least.
Sadly, that is not the case. It’s a proven fact that most mutual funds perform worse than the market.
What is the market? For example, the performance of the Dow Jones, or the S&P 500 index represents what the market performance looks like.
“98.9 % of US equity funds underperformed over the past 10 years.” – based on an in-depth study done by S&P Dow Jones Indices (from 2015).
And that is before even applying fees… let’s talk about the effect of fees on fund performance next.
What’s the effect of fees on financial performance?
One word… havoc! Especially in the long run. Remember our “ideal” growth chart from above? How the total value nearly tripled over 20 years?
Well, guess what… if you pay an annual management fee of 2.5%… you will lose $83,822. BOOM! No more triple value.
Don’t believe me? Have a look what happens if compound interest is not in your favor:
Instead of nearly tripling your account value you are now down to a bit better than double. That’s the effect of fees plus compound interest (or lack of, in that case).
What are your expectations concerning “better performance” for paying someone $82,822?
And with 98.9% of funds underperforming… what do you think are your chances getting a better performance in the first place (for example by switching funds)?
Food for thoughts 🙂
And it gets even worse…
So far, I only discussed mutual funds… not MSA’s (“Managed Savings Accounts”).
Mutual fund fees will apply and additionally, there will be fees for the MSA.
But there is more. There are also serious restrictions applicable. Let me explain.
MSA’s are being sold by insurance companies or similar institutions through sales people who earn a commission for making a new client sign up for it. This commission is charged to the client, either openly or hidden.
And how much is such commission?
It’s around 3% of the first year’s premium for each year of the policy’s term. What’s that in numbers? Based on our example of a 20-year plan with a regular monthly contribution of $500:
Agent Commission = $500 x 12 x 20 * 0.03 = $3,600
Not bad for a “free financial consultation” and a signature. This fee can be 40% higher if an additional “override commission” is charged, too. And that is not uncommon.
MSA Management Fee
The company issuing the MSA’s usually asks for a management fee of about 1% annually.
Mutual Fund Fees
As discussed already, mutual fund fees are between 1 – 3% annually.
Restrictions and Penalties
It helps to invest regularly; so, endorsing regular payments is usually a good thing.
But what happens if you cannot continue your regular payments? You might lose your job, have other financial obligations or just want to invest your money elsewhere…
MSA’s provide some flexibility; you can change your contributions up to a certain minimum amount and you can stop contributions for a limited time frame (6 – 12 months).
But stopping it entirely, i.e. cancellation before maturity, is only possible with heavy penalties. Such penalty payments can easily sum up to an entire year of contributions.
Nobody knows the future
Most people who sign up for MSA’s are novice investors, who just started to earn their first salary.
They often sign a document that asks them to make payments for longer than they are currently of age… but who knows what will happen in 1 year, 5 years, let alone 20?
I signed up for an MSA shortly after I started to work. Because I felt I need to do “something useful” with my savings. It was the right idea, but I did not do my homework about this type of investment.
And I started to invest at a time where buying mutual funds following a “buy and hold” strategy was not the smartest thing to do… at the peak of the Internet bubble. It cost me a year of contributions to bail out. Ouch!
And I was no exception.
A recent study about MSA’s shows that only 7% are kept until maturity (i.e. contract time end). That’s a ridiculously low percentage.
Let’s look at actual performance
All MSA’s follow the same principle: make regular payments to buy mutual funds. If the fund price is going down, more are bought… if the price goes up, less are bought.
This concept is called “averaging down” and the idea is that in the long run, the stock market will (always) go up.
So, buying stocks during a downtrend is like buying stocks at a discount, and once the market recovers the portfolio value should shoot up.
But is that really the case?
And how does fund performance look like in the actual market compared to the idealized chart I made up earlier? This chart was built on the premise that the “average” market performance is 10% per year…
Great questions :)… so I did some research to figure it out for you.
I used the last 20 years of market data to answer them. Below is a chart showing the last 20 years of the S&P 500 index.
Clearly, there were several ups and downs; the most significant ones were the Internet bubble and the Financial Crisis. Since the bottom of the Financial Crisis, the S&P has approximately tripled its value.
I created a fictitious mutual fund from S&P 500 data to simulate how it would perform for someone who invested $500 per month for 20 years into the fund.
No interruptions, no changes in payments for 240 months straight.
I adjusted for inflation by using consumer index data, i.e. I converted the $500 from 2016 in their equivalent value for each month. Obviously, $500 in 1997 were more valuable than $500 in 2016. In fact, $500 in 2016 are the same as $330 in 1997.
There are 3 scenarios:
- No fees
- 0.25% fees (similar to an index tracking fund)
- 3.5% fees (similar to MSA’s)
Check it out…
The result speaks for itself:
- Index performance: 76 %
- Index tracker fund: 72 %
- MSA/managed fund: 26 %
That’s not very impressive… especially the managed account is performing particularly poor because of the effect of fees.
And that performance is part of a selected elite. Only 1.1% of funds can match the index performance, let alone outpace it.
So what to do?
I fully agree with David Blake, director of the Pensions Institute at London’s Cass Business School. Here’s what he says:
“A small group of star fund managers are able to generate superior performance, but they extract the whole of this outperformance for themselves via fees, leaving nothing for investors. All […] investors should invest in index funds.”
In other words, if you want to invest with a “buy and hold” strategy with monthly payments, make sure your costs are as low as possible.
Invest in one or more index funds as these have the lowest fees. The annual fees can be as low as 0.15%.
Get the fee simulator table
I prepared a table where I wrote down simulation results for the above index fund with a variety of different monthly payments and annual fees.
Get it to your inbox to compare all scenarios. Make sure you make the right investment choice.
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Download the fee simulator table:
Click on the images or links below to get the files.
The simulator fee table compares different contribution and fee scenarios over 20 years of monthly investing into an index fund that tracks the S&P-500 Index:
- Monthly payments: $500 – $5,000
- Varying fees: 0.15% – 5%
- Categorized by Index Funds, Mutual Funds and MSA’s
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Great simple to understand article.