PBS “Bombshell” on Active Funds: How Not to Get Slaughtered by Fees

by JT McGee

In January, PBS ran a piece on the scam that is mutual funds in your 401k. The 401K is notorious for offering terrible investment choices that are laden with high fees. In all reality, it’s the easiest method of preying on the uninformed, the dumb, and the people who lack the sense to care about what they invest in.

Of course, a left-wing, Wall Street hating blog repeated the same story again, and it’s making its way around news aggregators online because its populism perfected: anti-Wall Street and on the topic of retirement.

The 401k lends itself to greedy management companies. For most uniformed investors, a 401K is intimidating, opaque, and clearly lacking any competition. Thus, they’re a fee trap for management companies because savers who use a 401k are a captive audience.

Even still, the 401k can be a valuable tool. It is a bankruptcy/litigation bombproof wealth shelter, after all.

Here’s how not to get slaughtered by fees

Step 1: Only pay for active management that has a history of generating above-market rates of return. I know this is controversial, but yes, I am one of the few who believe that active management can be worth paying for. For instance, I happily put some of my sister’s 401k in a small cap value fund that was actively managed because it was the only way to build out her portfolio with reasonable exposure to that style. Plus, the management team has a strict adherence to value principles, and I’m a fan of the home team. Let’s go, value investors!

Step 2: Only invest in styles that are worth a hoot. What’s the worst performing fund style in history? Large cap growth. What’s the best performing fund style? Small cap value. The future is highly unlikely to deviate from history. Think about it conceptually. Large cap growth stocks are huge companies with expectations to grow faster than the overall market. Small cap value stocks are tiny companies expected to grow very slowly. Wall Street typically overpays for growth and underestimates value. Hence, large companies expected to grow quickly tend to be the worst values. Small cap value stocks tend to grow, with zero expectations for growth.

Let me pull up a chart:

It’s not even close. Large cap growth basically means “stocks that are pricey and large based on very rosy future expectations that may or may not prove true.” Small cap value basically means “stocks that are cheap and small based on less than rosy future expectations.”

Step 3: Use a brokerage window. Roughly a quarter of all 401k plans have something called a “brokerage window,” whereby you can forego the sponsor’s offerings and select your own stocks, ETFs, and mutual funds. If you have a brokerage window, USE IT. It will be pricey for each trade, but in the long run, the cost savings from saved fees is more than worth it. I’d set it up so that each pay period I were automatically invested in a no-load fund (at the time of purchase or sale) and then each quarter, dump the fund and move the proceeds into a chosen ETF, say SPY – the S&P 500 SDPR.

If you do the above, you can mostly mitigate the effects of higher fees on a 401k. Take the match and the bankruptcy/litigation shelter for what it’s worth. After that, balance your 401k with an IRA, where you can choose what you want with 100% freedom to pick anything, anywhere, at any time.

Wall Street doesn’t have to take your money if you play smart!

{ 6 comments… read them below or add one }

krantcents April 25, 2013 at 14:58

I took the brokerage direction last year to avoid the high fees. The clincher was a % fee. As my my portfolio grew I paid a higher fee. This was with one of the lower cost funds. Unbelievable! I now have my funds shifted to the brokerage side and it costs me a flat $12 a year!

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101 Centavos April 26, 2013 at 05:17

This narrative is going to take a while to gel. In the end, little guy is going to be rescued from the clutches of those greedy SOBs in Wall Street, and offered a “safe” annuity backed by the full faith and credit of the US Government. Whenever that happens, who knows… in the long run, we’re all dead, right?

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PK April 26, 2013 at 10:28

Got to love those brokerage windows – I didn’t know about it until I saw it in the plan documents.

To that, you should add – ‘When you leave a job, transfer to an IRA’. Then you can do your crazy 72ts and buy things sans management fees.

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Evan April 29, 2013 at 14:50

Where did you find it in your plan documents? I have never heard of this idea but VERY excited.

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JT McGee May 1, 2013 at 14:20

Call up your 401K sponsor, they should be able to give you information on a brokerage window. Alternatively, you could talk to HR, but they’d probably give you 1,000 pages, of which only 1 pertains to the window.

My sister didn’t have a brokerage window option, but we definitely checked.

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Evan May 2, 2013 at 09:12

Boo just checked I guess I am in the 75% of plans that do not have the brokerage window option

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