Persfi-Burns/CW1st/LK2nd Today’s rude question: Which is a better buy, a lottery ticket or professional investment advice? I ask the question for two reasons. First, the answer, while disturbing, may provide us ordinary mortals with a better footing for dealing with the shiny brochures, mahogany furnishings and other trappings of investment offices. Second, the comparison isn’t as far-fetched as it seems. Both investing and the lottery involve the pursuit of gain, and both require that we buy a “ticket” to play. At the lottery, it is a lottery ticket. With the money manager, the “ticket” is the advisory fee. Understanding this isn’t a slam-dunk. So let’s start with the basic concept. When you buy a lottery ticket, you are hoping that your ticket will pay a big reward. Most people are hoping to turn $1 into millions. It’s a rare event, but it attracts more attention than a losing ticket. In fact, while most lottery tickets are worthless, the average lottery ticket has what statisticians call an “intrinsic value.” In a typical state lottery, the intrinsic value of a ticket is about half of what you pay for it. This is not a complicated calculation. In a typical lottery, half of the wagered money is returned to ticket buyers, while the remaining half goes to run the lottery and benefit state government. The intrinsic value of a ticket is its price times the percentage of the pool that is paid out as winnings. A $1 ticket in a lottery where 50 percent of the money is paid out to ticket holders has an intrinsic value of 50 cents. When we select an investment adviser, we are trying to do much the same thing. Our hope is to get superior returns through the skill and experience of the adviser. Basically, we are buying another kind of lottery ticket, and the fee is what we are gambling on winning the “Investment Results Lottery.” Pick the right manager and your investments will soar. Pick the wrong manager and your investments may plummet. Your adviser will earn his keep if your annual return is greater than the index return by the amount of his annual fee. In other words, if he earns 11 percent before expenses of 1 percent and an index returns 10 percent, he will have earned his keep the intrinsic value of your “lottery ticket” will be exactly what you paid for it. Unfortunately, this isn’t a done deal. Over the last 10 years, only 94 of the 747 domestic equity funds with 10-year histories have done better than the Standard and Poor’s 500 Index. Of that number, 35 were specialty funds with substantially higher risk than a broad portfolio. Even if we count them all, only 12.6 percent of all domestic funds did better than the index. That, in turn, means that your investment manager has only one chance in eight of doing better than the index. If your manager charges 1 percent a year to select funds, he would need to have a chance to earn an average 8 percent annual increase over the index for your “ticket” to have an intrinsic value equal to the 1 percent fee (8 percent gain times 1/8 probability equals 1 percent fee). Is that size gain possible? Sadly, no. The average annual return on the 94 funds that did better than the index was 19.92 percent, 2.22 percent a year better than the return on the Vanguard 500 Index fund. That’s a lot less than the 8 percent necessary to make the fee worth the possible gain. Basically, the manager who charges 1 percent a year is offering the equivalent of a $1 lottery ticket with an intrinsic value of 27.8 cents, nearly half the value of a real lottery ticket (2.22 divided by 8 equals .278). If you think the message here is to sell your investments and buy lottery tickets, you need to start over. The issue isn’t investing your money; it’s how much you pay for your management “ticket.” You should also note that it is possible to “win big” with the help of an adviser. If your adviser invested in shares of the top fund, Fidelity Select Electronics, for example, your 10-year return would have been 26.43 percent, a handsome 8.73 percent a year over the index. A return like that would make the 1 percent annual fee look trivial. Similarly, the adviser could have invested in Janus Twenty, which returned 23.41 percent a year over the same period. The chance of picking one of these winning funds, however, was only 1 in 8. Worse, even in this group, some funds weren’t winners: 25 of those 94 winning funds had returns of less than 18.7 percent a year. An adviser could have selected a winning fund and still have lost money after fees! Now let’s do the calculation another way. Given the odds, how much could we pay for investment advice and get full value for our “ticket”? Answer: About 0.28 percent a year (2.22 percent average advantage times 1/8). How much could we pay for investment advice and have an intrinsic value equal to the value of a ticket in the Texas state lottery? Answer: 0.56 percent a year. That’s a lot less than the prevailing charge for investment management. Caveats? Absolutely. First, it isn’t inevitable that the index will always perform so well against the full universe of domestic equity funds. The same analysis would produce different results if the performance of the index declined. A change in performance would increase the number of funds doing better, improve the odds of selecting a winning fund, and increase the intrinsic value of management expenses. Second, when you and I look for investment advice, superior performance isn’t the only reason: The primary motive may be to reduce risk or to get someone else to do a job we haven’t the time, skill or interest to do. What is important here is a simple reality. The next time you hear a pitch that a large annual fee is a small price to pay for skilled and experienced management, continuing research, etc., tell them to go back, measure the odds and return with a more realistic offer. Syndicated columnist Scott Burns can be reached by fax at (214) 977-8776; or by e-mail at [email protected].