(Bloomberg Opinion) – Retail investors have won the fee battle. Brokerage accounts are free. Trading commissions are history. Anyone can own the entire stock market through a single exchange-traded fund, for essentially nothing. It's a big win for investors and a terrible one for the investment industry.
But the industry is fighting back with a growing and profitable line of gamified trading apps and niche ETFs that entice investors to gamble with their savings. The number of portfolios is harder to discern or measure, but is just as costly as the high fees investors once paid.
Victor Haghani, founder of Elm Wealth, and his co-researchers James White and Vladimir Ragulin, want to wake up retail investors to that cost. They call it theirs”risk issues hypothesisa nod to the founder of Vanguard Group Inc. John Bogle.cost issues hypothesis” on the importance of keeping investment fees low.
Bogle's insight was that, in aggregate, active portfolio investors—that is, investors who depart from the broader market—end up with the market's return minus fees. The implication is that, as a group, they would do better to track the market as cheaply as possible.
Haghani applies a similar logic to risk. “Active portfolios take on average more risk than the market, but in total they get the return of the market,” he told me. “The result is a lower return relative to risk for all stock pickers in total, even if trading costs are zero.”
In this view, more risk is as corrosive as higher fees. “Investors rightly want the highest risk-return ratio possible,” Haghani added. “Just as subtracting fees from returns lowers this ratio, so does adding active risk to market risk.”
In this new world of cheap investments, in other words, the cost to care has shifted from fees to risk.
Haghani and his co-researchers compiled the performance of 17 widely held mutual funds and ETFs that deviate from the broader market. Over the 10 years to November 3, 2023, the average volatility of these funds — a common proxy for risk as measured by the annual standard deviation — was 1.2 percentage points higher than that of the S&P 500 Index. To give investors the same or higher risk-adjusted return than the market, the funds needed to beat it. Instead, they underperformed the S&P 500 average.
Here's the surprising part: If those funds were losers, one might assume that the flip side of their trade — what Haghani and his colleagues call mirror portfolios — would be winners. Not so. The average volatility of the mirror portfolios was 1 percentage point higher than the S&P 500. And they also lost on average to the market.
So regardless of which side of the trade investors were on, those with active portfolios likely ended up with a lower risk-adjusted return than if they had simply bought the market.
Investors who pick stocks themselves may be piling on even greater risk. Haghani and his team randomly selected portfolios of five, 25, and 100 stocks. Over the 10 years to November 2023, these simulated active portfolios were on average significantly more volatile than the market, and up to 5 percentage points for the five-stock portfolio. “It's the same impact on risk-adjusted return as paying more than 2% in fees every year,” Haghani noted.
The lesson is that when deviating from the market, investors must have faith that the bet will pay off. There are strategies such as value (buying the cheapest companies), quality (buying the most stable and highly profitable companies), and momentum (buying the best performing stocks) that have historically beaten the market for long periods. But this does not guarantee good performance in the future, and as Haghani's research shows, the rate of high performance may not be enough to compensate for the additional risk involved. When in doubt, buy the market.
The difference between fees and risk is that fees are a single, easy-to-understand number that funds are required to disclose to investors, while risk is a more subtle cost, often buried in the pages of industry clutter that many investors they cannot fully decipher it. Regulators can help by requiring funds to reveal volatility alongside returns, both on an absolute and market-relative basis.
Meanwhile, retail investors lured by zero-commission trading and the latest ETF strategies should note that the cost of exiting the market isn't just measured in dollars and cents. Risk also matters.
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To contact the author of this story:
Nir Kaissar in (email protected)