Retail investors have won the battle of fees. Brokerage accounts are free. Trading commissions are history. Anyone can own the entire stock market through a single exchange-traded fund for basically nothing. It’s a huge win for investors and terrible for the investment industry.
But the industry is fighting back with a growing and lucrative lineup of gamified trading apps and niche ETFs that entice investors to gamble with their savings. The toll on portfolios is harder to spot or measure, but it’s every bit 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 dub it their “risk matters hypothesis,” a nod to Vanguard Group Inc. founder John Bogle’s “cost matters hypothesis” about the importance of keeping investing fees low.
Bogle’s insight was that, in aggregate, investors with active portfolios — that is, investors who stray from the broad market — end up with the market 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 more risk than the market on average, but in aggregate they receive the market return,” he told me. “The result is a lower payoff relative to risk for all stock pickers in aggregate, even if trading costs are zero.”
From that vantage, more risk is just as corrosive as higher fees. “Investors rightly want the highest return-to-risk ratio possible,” Haghani added. “Just as the subtraction of fees from return decreases this ratio, so does the addition of active risk to market risk.”
In this new free-investing world, in other words, the cost to watch out for has migrated from fees to risk.
Haghani and his co-researchers compiled the performance of 17 widely held mutual funds and ETFs that deviate from the broad market. During the 10 years through Nov. 3, 2023, the average volatility of those funds — a common proxy for risk as measured by annualized 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 as the market, the funds needed to beat it. Instead, they fell short of the S&P 500 on average.
Here’s the surprising part: If those funds were losers, one might assume that the other side of their trades — 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, too, lost to the market on average.
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 merely bought the market.
Investors who pick stocks on their own may be piling on even more 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 by as much as 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 pointed out.
The lesson is that when deviating from the market, investors need to be confident 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 beaten the market historically over long periods. But that doesn’t guarantee future outperformance, and as Haghani’s research shows, the degree of outperformance may not be enough to compensate for the extra 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, whereas risk is a more subtle cost, often buried in pages of industry garble that many investors can’t fully decipher. Regulators can help by requiring funds to disclose volatility alongside returns, both on an absolute basis and relative to the market.
In the meantime, retail investors enticed by zero-commission trading and the latest ETF strategies should bear in mind that the cost of straying from the market isn’t measured only in dollars and cents. Risk matters, too.
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