The financial services industry is a cornerstone of the U.S. economy. It makes a significant contribution to employment, economic output, and international trade, and New York is widely considered the world's number one financial center. But what does Wall Street actually do for investors?

The impression we are often given is that it's the industry that does the heavy lifting and helps to generate the best possible returns. But is it true? Do financial intermediaries genuinely produce better investment outcomes for ordinary investors?

The first thing to say about intermediaries in the asset management sector is that there are far more of them than you might think. They include fund managers, equity analysts, investment platforms, brokerage firms, custodian banks, fund administrators, transfer agents, clearing houses and depositories — to name just some of them.

Silent partners adding little value

In Step 7 of his award-winning book Index Funds: The 12-Step Recovery Program for Active Investors, Mark Hebner likens these intermediaries to "silent partners" in a business who share in the company's profits despite playing little or no role in its success.

"Your investment portfolio is vulnerable to these silent partners," Hebner writes. "Ideally, a silent partner would provide some sort of benefit, but in the case of your investments, (they) add little value."

The real problem, he explains, is that all of these silent partners help themselves to a slice of the investor's returns.

Expenses recur for decades

In isolation, some of these expenses incurred by investors appear very small. But, because there are so many of them, they add up to a significant sum.

Remember, too, that these aren't one-off expenses you're incurring; you're paying them again and again. Indeed, every time an active manager places a trade, there's a line of intermediaries waiting to be paid.

Over time, the cost of investing has a huge impact on our net returns. Why? It all boils down to compounding. Simply put, regular fees and charges erode the gains we make, decreasing the growth potential of our investments. This effect is magnified over time as the costs compound. The longer the investment horizon, the more pronounced the impact of compounding costs on the size of our portfolios when we come to retire.

As the founder of Vanguard and index fund advocate John Bogle put it in The Little Book of Common Sense Investing: "The miracle of compounding returns is overwhelmed by the tyranny of compounding costs."

See how much you could be losing

So, how can we quantify the impact of costs on the value of our investments? Of course, the precise impact will vary from investor to investor, but in a television interview in 2012, Bogle presented a rough calculation.

"Costs are a crucial part of the equation," Bogle told the PBS programme Frontline. "And a lot of people say, ‘So what?' Well, think about this. We're lucky enough to get a seven percent return on the market. Suppose it costs two percent — maybe a little bit high but in the ballpark — to gain that return. Then investors who grossed seven percent will net five percent.

"If you compound a seven percent and a five percent return over, say, 50 years — well, in fact the investment lifetime is longer than that — something like 70 percent of the market return goes to the purveyors of the services, Wall Street if you will, and 30 percent goes to the fund owners.

"Do you really want to invest in a system where you put up 100 percent of the capital, you, the mutual fund shareholder, you take 100 percent of the risk, and you get 30 percent of the return?"

How to keep more of your returns

What, then, should you as an investor do? How can you avoid giving away such a large proportion of your returns to intermediaries who could have done little or nothing to deserve it?

Thankfully, there are two simple, but very important, things you can do. The first is to avoid using actively managed funds and invest in passive, or broadly passive, funds instead. Why? Because it's very much cheaper. Annual management fees for passive funds are significantly lower and, because they generally trade far less frequently than active funds, the transaction costs involved are very much lower too.

The second way to stop silent partners plundering your portfolio is to keep your trading to a minimum. Investing, it has been said, is like a bar of soap; the more you handle it, the smaller it gets.

In other words, once you've chosen an appropriate asset allocation, stick to it, and resist any temptation to change course. The only trading you should be doing is automatically rebalancing your portfolio, to keep your risk exposure consistent over time and in line with your unique capacity for risk.

Conclusion

Again, there is no denying the importance of financial services to the U.S. economy. But that shouldn't blind us when financial intermediaries add very little to the investment process.

Indeed, because of the fees and charges intermediaries extract, investors are generally better off avoiding intermediaries as much as they can.

Successful investing is not about trying to identify skilful fund managers or accurately predict the future direction of the financial markets. In fact, it's not about markets at all.

Ultimately, investing is about owning stakes in successful businesses around the world, taking a long-term view, and enjoying the returns those businesses generate over time.

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ROBIN POWELL is the Creative Director at Index Fund Advisors (IFA). He is also a financial journalist and the Editor of The Evidence-Based Investor. This article reflects IFA's investment philosophy and is intended for informational purposes only.

This article is intended for informational purposes only and reflects the perspective of Index Fund Advisors (IFA), with which the author is affiliated. It should not be interpreted as an offer, solicitation, recommendation, or endorsement of any specific security, product, or service. Readers are encouraged to consult with a qualified Investment Advisor for personalized guidance. Please note that there are no guarantees that any investment strategies will be successful, and all investing involves risks, including the potential loss of principal. Quotes and images included are for illustrative purposes only and should not be considered as endorsements, recommendations, or guarantees of any particular financial product, service, or advisor. IFA does not endorse or guarantee the accuracy of third-party content. For additional information about Index Fund Advisors, Inc., please review our brochure at https://www.adviserinfo.sec.gov/ or visit our website at www.ifa.com.