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April fools! Expense ratio myth exposed.

IN SCIENCE, IT'S EASIER TO disprove a universal hypothesis. You only need to find one counter-example to bust the entire hypothesis. You might hypothesize, "Man-made industrial era carbon emissions are solely responsible for causing global warming." That is a universal hypothesis because, by identifying a single warming period that occurred prior to industrialization (e.g., the Medieval Warm Period), you can disprove this universal hypothesis.

You might say, "Why not add appropriate hedging language to make it harder to disprove the hypothesis?" A non-universal hypothesis might be: "High carbon levels in the atmosphere may increase global warming." This wording makes it more difficult to disprove the hypothesis. You can find a period where high carbon levels exist during an Ice Age era (some research suggest this may have been the case), but that does not disprove the hypothesis (since the hypothesis contains the word "may"). In addition, the hypothesis contains no baseline to reference any increase. Failing to see an increase may not disprove the hypothesis because temperatures may have actually been lower if carbon content would have been lower.

This represents a hypothesis that's virtually impossible to disprove. You might think this is an ideal hypothesis, but then you will have exited the realm of science and entered the world of politics. In science, the only purpose of creating a hypothesis is to discover a theory, i.e., a universal truth. To discover a universal truth, you need a universal hypothesis. Any lesser hypothesis has no value in science or truth, telling you a lot about politics.

Which brings us to mutual fund expense ratios. There's a popular meme which implies you're better off picking a fund with a low expense ratio. This is generally followed by a meme that concludes, because index funds have low expense ratios, you should only invest in index funds. If you convert either of these memes into a universal hypothesis, it's incredibly easy to disprove them. Let's do that.

In the first case, the universal hypothesis would maintain that, "Low expense ratio funds will always perform better than higher expense ratio funds." We only need to find a single example of a higher expense ratio fund performing better than a low expense ratio fund to thwart this hypothesis.

In looking at the 15 year return data for the Momingstar database ending December 31,2014, five out of the top 10 performing funds had an expense ratio above the average. In all, 25 funds with an above average expense ratio had above average returns. Hypothesis denied.

In the second case, we need only find a single case where an active fund with a higher expense ratio active fund outperforms an index fund with a low expense ratio. The same Momingstar database shows 95 of these actively managed funds beat the best performing (and lowest expense ratio) S&P 500 index fund for that period. Hypothesis denied.

A salesman can sometimes get away with using disproved hypotheses. A scientist can't. So, is a fiduciary more like a salesman or a scientist?

Christopher Carosa, CTFA, is chief contributing editor for FiduciaryNews.com.

Add it up

88

The number of S&P 500 index funds (out of 176) with 12b-1 fees based on the 12/31/2014 Momingstar database.

5.08%

vs.

3.08%

The average 15-year return ending 12/31/2014 for active funds vs. index funds (data per the Momingstar database).

4.28%

The highest performing index fund for the fifteen years ending 12/31/2014; 95 (35%) actively managed funds beat this return (data per the Momingstar database).

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Title Annotation:retirement redefined
Author:Carosa, Christopher
Publication:Benefits Selling
Date:Apr 1, 2016
Words:612
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