Ric Edelman again accuses Vanguard of hiding fees

Commentary:

(MoneyWatch) Last month, at a talk at the IndexUniverse Inside ETFs conference, personal finance adviser and media personality Ric Edelman told roughly 1,300 attendees that he had challenged Vanguard to disclose trading fees in their fund prospectus. This came roughly one year after Edelman accused Vanguard of hiding 1.4 percent trading fees on his radio show where he stated "so in addition to the .06 percent, add another 1.4." He later deleted that statement from his pod recast. The .06 referred to the annual expense ratio.

This time, Edelman did not state the amount of the fees Vanguard was failing to disclose more prominently, but told me he was referring to other costs such as brokerage fees that are disclosed in a document called the Statement of Additional Information (SAI), which is a supplement to the fund prospectus. Only the fund expense ratio is shown on the prospectus and does not include the trading costs of the stocks or bonds in the fund portfolios.

Vanguard spokesperson, John Woerth, was at the conference and I asked him about Edelman's comment. Woerth noted that only commissions are disclosed in the SAI and that other trading costs such as bid-ask spreads (price to buy vs. price to sell), market impact fees (stock fluctuations caused by large purchases or sales), and other imbedded transaction costs would be difficult to measure and report in a standardized fashion. Edelman insisted that all costs should be disclosed in statements, and when I asked Edelman how he would measure these costs, he responded "I have not been asked to make such a proposal."

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Woerth further stated, "Investors can get a sense of our trading efficiency through the performance of our index funds relative to their target benchmarks." Matt Hougan, President, ETF Analytics and Global Head of Editorial at IndexUniverse, also responded "the best way to see the true costs of an index fund right now is to look at what we call tracking difference (fund-index)." In response to my question on what he thought of the argument, Edelman said "I have not given this argument consideration."

Edelman was at least aware of the argument that the actual return vs. the fund's benchmark was the best way to measure total costs. Last year, when Edelman made the 1.4% hidden fee accusation but before he deleted it from his pod recast, I pointed out that the Vanguard S&P 500 fund(VFIAX) had actually underperformed the total return of the S&P 500 by significantly less than the disclosed expense ratio. Edelman responded that this was luck while advisor and author William Bernstein ran a statistical analysis showing more than a 95 percent probability that it was skill. In 2012, this fund again performed closer to the benchmark than its now 0.05 percent expense ratio. I pointed this out to Edelman who responded, "The fact that a lucky streak exists does not prove that it is a not a lucky streak."

Edelman told me he "had a lively exchange with Don Phillips (President of Mornningstar's research division) on this point, to the amusement of those in attendance" challenging Morningstar to disclose all trading costs in fund research reports. Edelman was referring to the Tiburon CEO conference in April 2011, where he made the claim that mutual funds were hiding two percent annually in trading costs. I spoke to Phillips, who said he responded by noting the average equity fund underperformed their benchmark by about 0.30% annually above their expense ratio, and that this is a good estimate of total trading costs rather than Edelman's two percent.

Phillips told me he stated to Edelman that his continuing to tell a story where the math doesn't make sense would say something about Edelman's integrity. Indeed, the only way for Edelman's two percent claim to be true was for the average mutual fund to be besting the indexes by 1.7 percentage points, before those costs. Though during our conversation Edelman admitted this was unlikely, he didn't change his story.

My take

I agree with IndexUniverse and Morningstar that the ultimate measure of costs is how a fund performs relative to its benchmark. I applied this same method to Edelman's firm. The Edelman Financial Group is no longer a public company but in its 2011 public filing (10K), the company noted it had a 0.4 percent market related decrease while its benchmark had a 2.5 percent market increase. Edelman denied that this meant investors underperformed by the difference of 2.9 percentage points. When asked what was meant by this disclosure, Edelman responded "one of the benefits of being a private company is that questions such as yours can be ignored."

Both IndexUniverse and Morningstar do a great service to investors by showing actual returns compared to the total return of the appropriate benchmark. Though disclosing fees is good, disclosing some fees without others is misleading, and there is no way to measure certain costs. Phillips noted a fund can avoid brokerage costs all together by going to a private market maker to trade stocks. It may ultimately pay more in fees from the bid-ask spreads but those fees wouldn't be measurable nor reported. It would, however, be creating the illusion that fees are lower.

I again disagree with Edelman that Vanguard is hiding fees. I challenge Edelman to give some specifics to Vanguard and Morningstar as to how all costs should be measured and disclosed. I'd also love to see all advisory firms required to disclose overall performance vs. the benchmark much like Morningstar and IndexUniverse do for mutual funds and ETFs. Edelman has an opportunity to lead by example here.

According to Morningstar, the average mutual fund investor pays 0.75 percent annually in the expense ratio plus an additional 0.24 percent in brokerage fees for a total of just under one percent annually. Perhaps there is another 0.05 to 0.10 percent in non-measured trading fees. Any investor willing to pay one percent annually in total fees is likely giving away most of their real (after inflation) returns and is merely taking on all of the risk for little or none of the expected reward. This is true whether one is indexing or using active management.