In covering personal finance for the last 22 years, I’ve met lots of financial advisors, but one of my all-time favorites is Tom Connelly. A plainspoken, regular guy, Connelly knows as much about investing as any independent advisor I’ve ever interviewed. A chartered financial analyst and certified financial planner, Tom also has master’s degrees in financial planning and business administration. His firm, Versant Capital Management, which has offices in Phoenix and St. Paul, Minnesota, requires a $2 million account minimum. It specializes in a brand of financial planning that Connelly calls “asset-liability matching,” which he implements with low-cost investing and indexing strategies.

Tom recently spent time researching issues related to the cost of investing for a presentation at the AICPA’s personal financial planning conference. I used this as an opportunity to pick his brain about low-cost investing.

What was your goal in looking at expenses? I wanted to take a look at the impact of costs on people’s goals. My inspiration was John Bogle. Until Bogle looked at expenses, people typically talked about investment costs in terms of basis points–usually referring to the annual expense ratio of a managed stock fund or an index stock fund, or comparing an index fund to a managed fund. What Bogle did was different. He examined costs in the context of a terminal wealth number. I made calculations examining costs in terms of retirement income as well as terminal wealth.

What’s terminal wealth? We’re examining expenses in terms of what you have left for retirement. When you make one percentage point less annually on your portfolio over a long period, the effect on your terminal wealth is amplified. For instance, the S&P 500 between 1974 and 2003 showed a 12.19% average annual return, and a $10,000 investment grew to $315,000.

Earning just one percentage point less annually, 11.19%, would have meant a $241,000 terminal value. Two points less would have meant a $184,000 terminal value, three points less would have been a $140,000

terminal value, and four points less would have been a $106,000 terminal value. So annually losing four points of the S&P 500′s 12.19% return to expenses would have slashed an investor’s terminal wealth by two-thirds. This is why Albert Einstein said that compounding is the eighth wonder of the world.

How could you possibly lose four points a year to expenses? While four points sounds like a lot, it’s actually not unrealistic. First, the average stock fund has an expense ratio of 1.6%. On top of that are transaction costs. These are not covered in fund prospectuses and it’s kind of a mystery number.

According to a Wharton Financial Institutions working paper by two academics, Edelen and Kadlec, in 1999, the average trading cost for an equity mutual fund–that is, commission and spreads on over-the-counter trades–was 80 basis points. Add to that cash drag, which represents the impact of cash equivalents that must be carried by a mutual fund in order to meet redemptions.

Research by Vanguard puts that figure for the average stock fund at 40 basis points. So right there, you have 2.8% of the return on the S&P 500 whittled away by expenses.

When you add taxes into the equation, you eat up 1.6% annually, according to Vanguard, and a Lipper study from 2003 cited tax costs to be 2.5% per year. That actually adds up to 4.4% of an average stock fund investor’s annual return getting reduced by various expenses. So someone who invested $10,000 in the S&P 500 in 1974 and let it ride through the end of 2003 would not have accumulated $315,000 by garnering a 12.19% annual return, but would instead have accumulated just $95,000.

When you consider what this means to a retiree’s income, it’s huge. If you invest $315,000 for 20 years and get an 8% return, you could generate $29,700 of annual income versus $9,000 of annual income that could be generated by a $95,000 nest egg (see Chart 1: How Expenses Affect Returns, below).

So most investors are getting a bad deal because these costs are pretty typical? One way to look at it is that investors are putting up 100% of the risk capital to buy a stock fund. But when you look at their money over a 30-year term like we had from 1974 to 2003, the fund ate up 35% of their terminal account value, trading 18%, and taxes 17%. Just 30% of the terminal value of the fund went back into the investor’s pocket (see Chart 2: How Costs Can Eat Up the Fund Investor’s Pie, below).

What are the implications of this in the way you practice? Equity mutual funds do not underperform their relevant indexes by 4.4%, on average. It’s a credit to active managers that they cover a lot of these expenses. Any way you cut it, though, these costs are being paid out of investor funds to intermediaries.

Picking good managers is a skill or requires luck. Whichever way you look at it, it is adding uncertainty to investing. But I know with certainty that if I can control costs, I can improve a client’s terminal wealth.

Don’t get me wrong: I don’t have any problem philosophically with advisors who try to pick the best managers. I am not foolish enough to think that my way of trying to manage a portfolio in light of all the costs is the only way. Some people may be able to find alpha more easily than I can. But when you start out 4.4% in the hole annually due to expenses, I think you need to look hard to find your best way to overcome that.

For me, the answer is to use a lot of index funds, passively managed funds, and ETFs. The real issue is to increase the client’s probability of being able to fund future cash needs, and the certainty of cost control at all levels seems a better approach than the uncertainty of manager selection. If you think the 4.4% cost hurdle was tough to overcome in a 12% return environment, consider the effort needed in a 6% to 8% return environment.

Apart from using index funds and ETFs, what else can advisors do to reduce the cost of investing? There are a few ideas that I am considering. One is to look for fund companies that are using flexible trading techniques.

For instance, Dimensional Fund Advisors (DFA), which is a large fund complex of index-like funds, is getting price concessions when buying large blocks of illiquid small-company stocks. DFA will agree to buy a position of stock from third parties in need of liquidity, and typically extract a large price concession for taking it off their hands. The third party might not want to sell the securities out in the open market because that could severely depress the price. DFA will buy it at a marked-down price.

DFA provided me data showing that on its small- and micro-cap funds, it was able to actually make money on transaction costs on block trades. It actually made 107 basis points on its average block trade last year. In fact, because of the money DFA made on block trades, the small-cap fund’s regular overall trading cost was actually a negative 18 basis points, meaning that the fund made 18 basis points on transaction costs in 2003. DFA is willing to trade tracking error for the prospect of higher returns.

I suspect there are other fund companies seeking such concessions. An advisor could probably just ask the mutual fund company whether it is doing this sort of thing and how much, and there is no good reason why managed funds might not also try to do this. Techniques such as this are sometimes called trading alpha. In general, greater due diligence on how funds monitor and control costs from the initial decision to transact, through execution, should be considered by analysts.

What else can advisors do? One other idea I am looking at is specific to index funds. DFA and Vanguard have adopted a flexible trading policy that allows them to recalibrate their fund holdings on a date other than the reconstitution date. The S&P 500 gets reconstituted annually and fund companies make adjustments to their holdings to track the index accurately. However, according to one study, the day following the announcement of the reconstitution, stock that was put into the index for the first time jumped an average 3.2%, and that was followed by an average run-up of 3.8% that occurred after the announcement but before the effective date of the reconstitution.

What is interesting is that 30 days after the effective date of the reconstitution, the average price of a stock included for the first time in an index declined by 2.1%. The point is that you want to look for index funds that are not slaves to tracking error and that have the flexibility to wait to buy newly included stocks 30 or 45 days after the effective date of the reconstitution.

Where do exchange traded funds (ETFs) fit in? They’re critical. ETF shareholders do not subsidize new and leaving shareholders, or the servicing costs of small investors. ETFs have a big cost advantage because they do not need a transfer agent. Accounting is done at the brokerage level.

With a mutual fund, when a big investor wants to buy a big slug of shares, the fund must then go out and buy stocks. All of the investors in the fund pay the commissions on the needed trades to buy the stocks. Not so with an ETF. New shareholders bear the costs of purchasing securities tendered to the ETF and the cost of creating ETF shares in the bid/ask spread they pay. There is no subsidy for investors coming and going, and those costs are material–as much as 1.4% on average annually on a stock fund, according to the Edelen study.

While all of these things sound like small potatoes, they can make a big difference to a client’s portfolio over the long term.

Editor-at-Large Andrew Gluck, a veteran personal finance reporter, is president of Advisor Products Inc. (www.advisorproducts.com), which creates client newsletters and Web sites for advisors. Advisor Products may compete or do business with companies mentioned in this column. He can be reached at agluck@advisorproducts.com.