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The Problem with Socially Responsible Mutual Funds

I’m often asked what I think about socially responsible mutual funds (or socially responsible investing in general).

To explain, let me introduce you to Jim.

  • Jim is an accountant. He has never had a super high income, but he has been consistently employed since finishing college 30-something years ago.
  • Jim has saved diligently throughout his career, and his index-fund portfolio is now sufficiently large that he expects to be able to retire within the next few years, despite having no pension.
  • In other words, Jim has accumulated a significant sum of money.
  • Every so often, Jim experiences some misgivings about having that much money. He recently read that his seven-figure net worth means he has more wealth than 99% of other people in the world.
  • Jim also has some misgivings about several of the companies that are owned by his index funds.
  • Jim’s annual budget does include a non-trivial amount of charitable giving each year, but the reality is that in order to meet his goals, he has to keep most of his money.
  • Jim wants to feel better about having a lot of money. That is, he wants to continue to have a lot of money. But he doesn’t want to feel bad about it.

Jim has a need.

There are a lot of Jims.

What does the financial services industry do when it sees a lot of people with a given need/desire? It creates a product.

Socially responsible mutual funds are that product. Socially responsible mutual funds exist to let you feel better about having money (i.e., not giving it away). The fund industry usually doesn’t want you to give your money away. If you do, they don’t get to collect a percentage (in most cases).

This isn’t to say that socially responsible funds are a bad thing. From a “doing good in the world” standpoint, a socially responsible fund might have a beneficial effect in that it might exercise its voting rights more frequently — or more frequently in line with your views — than typical index funds.

Conversely, if the fund’s way of being socially responsible is simply to exclude certain stocks/industries from the fund, it is giving up its power to vote to change the behaviors of those companies/industries. That is, as a shareholder, a fund has influence. If it chooses not to own those companies, it gives up any potential influence it might have. You may see where I’m going with this. As a socially responsible investor, I would like a fund that owns all firms (i.e., an index fund) and which votes to make the changes I want to see. I do not want a fund that goes out of its way to give up its influence over the companies I would most like to influence.

Unfortunately, whether or not socially responsible funds actually have a positive societal effect is not generally super important from the perspective of the fund company (or, in most cases, from the perspective of an advisor recommending the fund). As long as you feel better about owning this fund as opposed to another one, mission-accomplished.

It is normal to have some misgivings about having far more wealth than almost everybody else in the world.

And it is clear that the most effective way to alleviate those misgivings is to give away more money — either directly to people who need it more than we do, or to charitable organizations that fight against the thing(s) we find unethical.

But, unfortunately, there’s a limit to how much we can give while still reaching our goals. With our current retirement system (in which few people have pensions and Social Security doesn’t cover everything), if you want to retire someday with a middle class level of spending or higher, you must accumulate a pile of money — and keep it for yourself.

It is also normal to have misgivings about owning shares of companies that do things you find unethical.

Yet owning those shares and using your vote as a shareholder is precisely how you can attempt to influence those companies. Unfortunately, as mutual fund investors, it is the fund managers that must vote on our behalf, and we have limited information as to how fund managers vote their shares. And the “socially responsible” funds (i.e., the funds with a stated mission of working for positive change) go out of their way to give up their right to vote on such issues, because doing so allows people to feel better about owning the funds (i.e., it makes them more marketable).

How to Change Somebody’s Mind About Investing

A reader writes in, asking:

“How do you convince somebody that they are making a bad investment decision? A member of my family often brags about his latest money move. Apparently he is always getting in or out of a stock at just the right time or making an options bet that paid off. I’m sure we are not hearing about all the bets that DONT pay off. But none of this seems like actual prudent investing…not even remotely.”

I usually don’t even try. If somebody is telling me about their investments, I just listen, unless they explicitly request my opinion. And even then, my standard reply is just, “I don’t follow or invest in [individual stocks/Bitcoin/gold/options/whatever] at all. I’m just a boring index fund investor.” That is, I am open about what I do with my own money, but I don’t try to convince them that they’re making a mistake.

That’s not to say that I haven’t tried. I used to. Given my line of work, it’s pretty common for friends/family/acquaintances to ask my opinion about a particular investment decision they’ve made. But what I found over the years is that in most cases, the other party’s only goal for the conversation is to be congratulated on having made a smart decision. They don’t actually want or care about my opinion, unless that opinion is, “great job!”

There have been occasions on which the other party was in fact seeking to have a conversation about the pros and cons of a particular investment strategy — and in such cases I’m happy to have that conversation of course — but that’s not the most common outcome.

And really, that’s just human nature. When was the last time that you had a conversation with somebody, in which they convinced you that a decision you were making was unwise and you decided to make a different decision going forward? It happens, sure. But not very often.

Personally, I find that when I change my mind about a topic, it’s usually because of something I have read rather than something somebody said. There’s something about sitting down to read a book (or a piece of research) that puts me in a mindset where I’m ready/willing to question and change my current views on the matter. I am certainly not in that same mindset when somebody starts providing unsolicited opinions about my life decisions.

So, if you’re looking to change somebody’s mind about investing, my best suggestion is to:

  1. Lend them your copy of a book (e.g., A Random Walk Down Wall Street or The Four Pillars of Investing — or Bogle’s Little Book of Common Sense Investing if you suspect that the person would not read a longer book), and
  2. Pitch the book in a subtle manner (e.g., “I was thinking about this book recently. It’s one of my favorites. And it occurred to me that you might really enjoy it as well, given your interest in investing.”) so that the other party does not feel defensive.

But even then, you have to be prepared for a scenario in which the attempt is entirely unsuccessful. It’s hard to change somebody’s mind.

Re-evaluating Betterment After Their Price and Service Change

Most readers of this blog are passive investors of some form or another, whether via Target Retirement/LifeStrategy funds, robo-advisors, or just simple index-fund/ETF portfolios.

A few readers have asked for my thoughts on the changes that robo-advisor Betterment recently made to their fees and offerings.

Previously, Betterment’s cost was 0.35% pear year for accounts up to $10,000, 0.25% for accounts from $10,000-$100,000, and 0.15% per year for portfolios of at least $100,000. And for that price, the customer received automated portfolio management, including tax-loss harvesting for taxable accounts.

Now, they will be offering three different levels of service, two of which include ongoing human advice along with the portfolio management:

  • For 0.25% per year you get the same portfolio management service as before.
  • For 0.40% per year you get portfolio management, plus an annual call with their CFP team.
  • For 0.50% per year you get portfolio management, plus unlimited calls with their CFP team.

In other words, it’s a price increase for people who have at least $100,000 with Betterment, and a price decrease for people who have less than $10,000 invested with them. And now there are two additional options to choose from (for people who meet the applicable minimum account sizes).

The price change makes Betterment’s portfolio management price nearly identical to that of their closest competitor, Wealthfront, which also charges a flat 0.25% per year for portfolio management (with the exception of the fact that Wealthfront will manage the first $10,000 of assets for free).

Compared to Target Date Funds

I’ve always found it instructive to compare robo-advisors to an alternative hands-off portfolio solution: all-in-one funds, such as target-date funds, balanced funds, or LifeStrategy funds.

In my view, relative to all-in-one funds, the primary advantage of Betterment’s portfolio management service has been the fact that it is more tax-efficient when there’s a taxable account in the mix, because it includes tax-loss harvesting, offers asset location planning, and uses muni bonds rather than taxable bonds when appropriate.

As a result, the situation in which Betterment always seemed most appealing to me was for investors who:

  • Have at least $100,000 to invest (such that they’d qualify for the lowest cost),
  • Want a hands-off portfolio management solution, and
  • Have a large part of their assets in taxable accounts (such that the improved tax-efficiency would provide significant value).

I think the same holds true today, except for the fact that there’s no longer a need to hit the $100,000 threshold for lower pricing. (Of course, for people who do have more than $100,000 to invest, the price just went up by 0.1%, thereby meaning that the value of the tax-efficiency must overcome an additional 0.1% annual hurdle in order to provide a net benefit to the customer.)

Compared to other Human/Robo-Advisors

Vanguard’s Personal Advisor Services costs 0.30% per year. For that cost you get portfolio management, plus phone/email/Skype contact with a Vanguard advisor whenever you want. The service does not, however, include tax-loss harvesting.

Similarly, Schwab recently announced that they’ll be launching a human/robo service later this year. The cost for that service is supposed to be 0.28% per year (with an annual maximum of $3,600). And what you get for that cost looks very similar to Vanguard’s service — portfolio management, plus as-needed contact with a Schwab advisor. One noteworthy difference: for accounts of at least $50,000, they will also provide automated tax-loss harvesting.

Schwab’s upcoming service and Vanguard’s Personal Advisor Services seem most comparable to Betterment’s 0.5% service level, because they each include unlimited access to human advisors.

The Betterment platform would be preferable to the Vanguard platform if you think that tax-loss harvesting will be worth at least 0.2% per year (in order to justify the additional cost). But I’m not really sure how it would be better in any way than Schwab’s new service once that is released, as the Schwab service appears to offer all of the same things, at a lower cost (0.28% annually rather than 0.5%).

(Of course, it’s possible that the Schwab service will have some “catch” that we have yet to learn about. Presumably we’ll get more information when the service is actually released and people try it out and report back on their experiences.)

When Does it Make Sense to Buy a Home Rather than Rent?

A reader writes in, asking:

“Do you have any advice for how to determine when it is better to buy rather than rent? I’ve heard rules of thumb regarding ‘price to rent’ ratios and breakeven points. But I’m trying to move beyond rules of thumb so I can be a little more sure of my decision.”

Looking at price-to-rent ratios can help you to quickly get an idea of locations in which buying is likely to make more sense than renting (or vice versa). But when it comes time to make an official decision, I think the best way to assess the situation is to compare your expected total economic cost of housing over the period in question under each scenario (renting and buying).

To be clear, this is purely a financial analysis. Most people will have significant non-financial preferences in one direction or the other as well, and it would be a mistake to ignore such preferences.

How Much Would It Cost to Rent?

The simpler side of the analysis is renting. For example, if we assume that you will be living in the location in question for 7 years, you would want to tally up the total cost of renting (i.e., rent plus renters insurance) over those 7 years. Be sure to account for the fact that your rent will typically increase over that period.

How Much Would It Cost to Own a Home Over the Period?

On the “buy a home” side, you would again want to tally up all of the monthly/annual costs you would incur over the period. Things like:

  • Mortgage payment,
  • Property taxes,
  • Homeowners insurance,
  • HOA fees if applicable,
  • Estimated maintenance costs (making sure to account for the condition of the home in question), and
  • Any interest/dividends/capital gains that you’re missing out on as a result of having made a downpayment.*

Then you would want to add the one-time costs:

  • At the time of purchase (e.g., mortgage application fees, escrow fees, and other closing costs), and
  • At the time of sale (e.g., realtor commissions and other closing costs).

But then there are two “negative costs” to include as well:

  • Any tax savings you receive as a result of the mortgage interest deduction, and
  • Any equity that you build up in the home as a result of paying down the mortgage and appreciation in home value.

Of course, almost all of these inputs will be estimates. That’s simply the nature of the beast. It is important, however, to try a few different scenarios (e.g., one in which the various estimated costs related to buying turn out to be lower than you’d anticipate, one in which they’re normal-ish, and one in which they’re higher than you’d anticipate) to see how much the overall result would be affected.

Similarly, most people probably aren’t exactly sure how long they’ll be living in the location in question. If that’s the case for you, I’d suggest running the analysis using different lengths of time (e.g., 4 years, 7 years, and 10 years) to see how the math changes.

Looking at the Results

What this analysis will generally show is that the longer you stay in the home, the more likely it is that buying will make sense, for a few reasons:

  1. You’ll often find that the annual costs of owning a home (i.e., the costs excluding the one-time buying/selling costs, but including the negative costs of tax savings and equity buildup) are cheaper than the annual costs of renting. As a result, the longer the period you look at, the better buying will look, as there’s a greater length of time for those savings to overwhelm the one-time costs.
  2. The greater the length of time, the faster the rate at which equity builds up, as a smaller portion of the mortgage payment is dedicated to interest.
  3. Rent increases over time whereas mortgage payments do not (assuming we’re talking about a normal fixed-rate mortgage, that is).

*For people with a background in finance or a related field, rather than including forgone earnings on the downpayment, if you want to be as precise as possible with your analysis, you would actually want to discount all of the costs in this analysis (i.e., calculate their present value in order to account for the fact that dollars today are worth more than dollars in the future).

Laddering Life Insurance Policies

For most people, the need for life insurance decreases over time. During your working years, the need for life insurance typically decreases because your savings are increasing, the balance on your mortgage (and other debt) is decreasing, and the number of years for which your children will be financially dependent upon you is decreasing.

Similarly, for a person who needs life insurance during retirement (e.g., a married person with a defined benefit pension that provides insufficient survivor benefits), the amount of insurance needed declines over time because the number of remaining years of retirement that must be funded declines over time.

For example, a person’s life insurance needs might look something like this:

  • A current need for $1,500,000 of death benefits,
  • A projected need for $1,000,000 of death benefits for the period 10-20 years from now,
  • A projected need for $500,000 of death benefits for the period 20-30 years from now, and
  • No projected need for death benefits after 30 years.**

For this person, rather than buying a $1.5 million 30-year policy, there’s an opportunity to save some money by “laddering” life insurance policies. That is, break the coverage up into a few policies of varying terms: a $500,000 10-year policy, a $500,000 20-year policy, and a $500,000 30-year policy.

Using, I get the following premium estimates for a hypothetical male non-tobacco user, 30 years old, living in St. Louis, Missouri, with average health status:

  • $1,500,000 30-year policy: $2,050 annual premium,
  • $500,000 30-year policy: $730 annual premium,
  • $500,000 20-year policy: $465 annual premium, and
  • $500,000 10-year policy: $310 annual premium.

In other words, the ladder of three smaller policies results in a savings of $545 per year for the first 10 years, which increases to $855 of savings per year after 10 years, and $1,320 of savings per year after 20 years. Not the sort of thing that will dramatically change a person’s life, but enough to add up to a very meaningful amount over time.

An additional advantage to using a life insurance ladder is that, if you want to, you can get the policies from different companies, thereby diversifying credit risk and taking better advantage of the (limited) protection offered by your state guarantee association.

**When projecting how much life insurance you will need at some point in the future, be sure to include a guesstimate for inflation. $500,000 of death benefits 25 years from now will surely be worth meaningfully less than it would be worth tomorrow.

What’s Involved in Switching 401(k) Providers?

One topic readers frequently ask about — especially since the Frontline documentary earlier this year — is how to get their employer to switch to a less expensive retirement plan provider. While I’ve shared some thoughts on how to campaign for changes, I’m at a loss with regard to questions about the process itself, having never been involved with it.

Fortunately, Linda Wolohan of Vanguard’s PR team was able to gather and share some information on the matter. (My questions are in bold and italics, and her replies are in normal font.)

When switching to a new 401(k) provider, what does the step-by-step process look like?

Here are the steps at a high level:

The plan sponsor needs to finalize the investment lineup, determining the core lineup (which typically can be index funds or target-date funds) as well as any additional investment options.

Working with Vanguard, the plan sponsor decides on the plan design — what kind of services (i.e., loans, withdrawals) will be offered, restrictions, etc. This may entail changes to the Plan Document, which dictates how the recordkeeping platform is going to be set up from a transactional and workflow perspective.

The focus then moves to ongoing administrative practices.

  • All necessary legal documents to administer the plan and indicate who is authorized to act on the plan are created and executed.
  • Payroll processing is a large component of this. The files that will be transmitted back and forth from the plan sponsor to Vanguard will be programmed and thoroughly tested.
  • Decisions are made on how to best communicate to participants on the upcoming change, their options in the new plan, etc. Communications must also satisfy all regulatory notification requirements.
  • The transfer method for participant assets is determined. Assets can be transferred in-kind or mapped to similar funds. Or sponsors can use what is called the re-enrollment process, which puts all or certain participants into certain default funds to ensure their portfolio is more appropriately diversified. Participants can opt out of all of these choices, of course.

Once the above decisions are made, the plan sponsor’s responsibilities decrease and most of the work is between Vanguard, the prior recordkeeper, and the payroll vendor, if applicable. The prior recordkeeper will provide participant data for Vanguard to review for accuracy and completeness. Vanguard will complete a mock conversion in our test region prior to the actual conversion. This helps ensure there are no surprises or missing data that could prolong the blackout period for the actual live conversion.

During the blackout period, all transactions are restricted at the prior recordkeeper. The assets are transferred on the communicated date. When the assets and final participant records are received by Vanguard, we will reconcile the assets and load the necessary data to lift the blackout and allow participants to access their accounts.

Payroll contributions are then sent directly to Vanguard and the plan will be up and running. At that point the conversion is complete.

How long (in terms of months, rather than hours of work) does the process typically take?

The average conversion takes between 3-6 months depending on client size and complexity. Certain regulatory notification requirements factor into this timeframe. For example, in order to allow for the transfer of the assets, a short blackout period occurs, during which time participants temporarily lose access to their retirement accounts. Plan sponsors/administrators are required to provide written notice — called a Sarbanes Oxley notice — of this to participants. The Sarbanes Oxley notice has to be provided at least 30 days, but not more than 60 days, in advance of the start of the blackout period.

How can I quickly/easily get an estimate of how much money the company (and/or plan participants) will save?

We can’t really give precise estimates because each plan varies in terms of the funds and services it offers, so costs will vary. But [according to] a study from the Investment Company Institute on 401k fees:

“The median defined contribution plan participant is in a plan with an all-in fee of 0.78 percent of assets, based on plans included in the study. Across all participants, the all-in fee ranged from 0.28 percent of assets (the 10th percentile participant) to 1.38 percent of assets (the 90th percentile participant). Larger plans tended to have lower all-in fees.”

[In contrast] with our Retirement Plan Service, the all-in fee for a hypothetical plan with $5 million in assets, 100 participants and an investment lineup of Vanguard index and active funds would be 0.30% of plan assets (actual pricing will depend on a plan’s investment options, demographics, and ancillary services).

Vanguard’s low fund expense ratios are the primary driver of the service’s low all-in costs: Vanguard’s average annual fund expense ratio is 0.19%, compared with the industry average of 1.11%. This cost difference means that investors keep more of what they earn.

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