The $1 million long-run effect of fees and expenses on stock market investing – American Enterprise Institute

This post was originally published on this site

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From a CD regular (Greg G.):

I think your series on index investing has been excellent. Perhaps the most dramatic way to make the point about how much fees matter is to run a few examples. Assume some round number for an amount of money invested in an IRA at age 30 in various portfolios with different expenses. Assume some arbitrary but plausible average rate of annual return (the same for each). Make one a Vanguard Index at a 0.05% expense ratio. Run the others a few different ways but be sure to include someone paying a financial adviser 1% a year as many people do. Then assume that financial adviser puts the money in actively managed funds at the average expense ratio of 1.02% for the industry adding to that 1% expense for the financial adviser.

Assume all investors cash out their IRAs at age 75 after 35 years of compounding. The differences between the portfolios will be very dramatic. The advisory fees will have added up to around half of all the earnings for the portfolios with the higher fees. I did this once a long time ago but I am too lazy to run these numbers again myself and many of your readers wouldn’t believe me if I did.  Just a suggestion but I think it would be a dramatic way to make your point and provide a service to your readers.

Here are the results of that suggested analysis above, based on the following assumptions:

A 30-year old working full-time at an annual income of $50,000, with annual salary increases of 2%, starts investing 5% of his or her annual income for retirement every year for the next 45 years in a stock market mutual fund that generates a 10% average annual return. Why 10%?

Updated: The geometric average annual return (same as average compounded return) on the S&P 500 has been 9.84% over the last 50 year period between 1965 and 2015 (data here). So I’ll first assume a stock market return of 10% per year for the next 35 years to 2050. (Note: Assuming a lower stock market return of say 6% or 8% over the next 45 years doesn’t materially change the overall results, although the account balances and differences between the options will be smaller.)

Option 1. If the 30-year old invests in the Vanguard 500 Index Admiral Shares, he or she would pay an annual expense ratio of 0.05% which would lower the effective annual stock market return from 10% to 9.95% (but wouldn’t require any out-of-pocket payments).

Option 2. If the 30-year old invests with a full service broker, he or she would pay an annual fee of 1% (out-of-pocket) on the investment  balances. In addition, the investor would likely pay an additional expense ratio of 1% if his or her annual contributions were invested based on recommendations by the broker in actively managed stock mutual funds with an average expense ratio of say 1% (industry average is 1.02% according to Vanguard and an even higher 1.15% according to this article in Forbes) and an average annual return of 10%. In that case, the investor’s annual realized return would be reduced from 10% to 8% (1% by the annual investment adviser fee and 1% by the expense ratio of actively mutual funds).

Option 3. Alternatively, we can assume that either the investment adviser: a) is able to generate an 11% annual return due to his or her superior investment abilities, or b) invests in stock market mutual funds that don’t charge a 1% expense ratio. In either case the investor would generate an average annual return of 9%, instead of 8%. Or we could assume the investor chooses his or her own stock mutual funds with the industry average expense ratio of 1%.

Under those three different options, here are the account balances in the year 2050 after 45 years of investing when the investor reaches the age of 75 (see chart above):

Option 1: $2.39 million

Option 2: $1.33 million

Option 3: $1.79 million

In other words, the investor would be better off by more than $1 million under Option 1 vs. Option 2, and $600,000 better off under Option 1 vs. Option 3. The only way for the full-service investment adviser to justify his/her 1% management fee and his/her investment recommendations that include a 1% expense ratio and compete with the Vanguard index investment at 5 basis points would be to find investments that generate annual returns of 11.95% over 35 years, or investments that out-perform the stock market by 1.95% every year for 35 years! According to Burton Malkiel, John Bogle and most importantly the empirical evidence, that would be impossible.

And I think that is the logic behind Malkiel’s advocacy of passive index funds as the core of the portfolio for most investors: Even the most effective broker or active fund manager simply cannot “beat the market” over long periods of time, e.g. 45 years in the case above. Therefore, paying the expenses and fees of active managers can’t be justified, and in fact will possibly cost investors as much as $1 million in reduced investment balances over time as the example above illustrates.

Here’s how Malkiel explained it a few years ago in his WSJ op-ed “You’re Paying Too Much for Investment Help,” sub-titled “Index funds have far outperformed the average active manager, and at a far lower cost to the investor“:

From 1980 to 2006, the U.S. financial services sector grew from 4.9% to 8.3% of GDP. A substantial share of that increase represented increases in asset-management fees. Excluding index funds (which make market returns available even to small investors at close to zero expense), fees have risen substantially as a percentage of assets managed. In my judgment, investors have received no benefit from this increase in expense ratios.

The increase in fees could be justified if it reflected increasing returns for investors from active management, or if it improved the efficiency of the market. Neither of these arguments holds. Actively managed funds of publicly traded securities have consistently underperformed index funds—by roughly the differential in fees charged.

Passive portfolios that held all the stocks in a broad-based market index have substantially outperformed the average active manager since 1980. Therefore, the increase in fees likely represents a deadweight loss for investors.

Why do investors continue to pay such high fees for financial services of such questionable value? Many may incorrectly judge the quality of investment advice by the price charged. Individual and institutional investors may suffer from overconfidence and truly believe that they can select the best investment managers and earn excess returns, despite historical evidence to the contrary.

Outperforming the consensus of hundreds of thousands of professionals at the world’s major financial institutions is next to impossible. It has been for decades. Over long periods, about two-thirds of active managers are outperformed by the benchmark indexes. The one-third that may outperform the passive index in one period are generally not the same as in the next period. But investors can benefit from low-cost index funds and their exchange-traded cousins.

The lesson for investors is very clear: You can’t control what markets can do, but you can control the costs you pay. The less you pay to the purveyors of investment services, the more there will be for you. The quintessential low-cost investment vehicles are index funds, which should comprise the core of every investment portfolio. The high fees charged for active management cannot be justified.

Bottom Line: What Burton said – the high fees charged for active management cannot be justified!

Q: Is Malkiel wrong about this? If so, let’s hear why!

Update 1: One issue that should be clarified is that investing in Vanguard doesn’t mean that you are completely on your own without access to any financial, tax, retirement or investment advice from Vanguard. To the contrary, Vanguard investors have access to a wide range of Vanguard investment professionals who provide advice to Vanguard clients as part of your 0.05% annual expense ratio! And as a Vanguard account grows in value, investors get access to higher levels of service. For example, investors with minimum balances of $500,000 in Vanguard assets qualify for Vanguard Select Services (at no charge for most services):

Voyager Select Services offers access to a team of experienced investment professionals, access to a CFP® professional, and additional discounts on brokerage trades.

A team of experienced investment professionals who will act as your guide to all we have to offer. They can answer your questions, make transactions, and help you learn about all of the products and services available to you.

Consult with a Certified Financial Planner™ (CFP®) professional if you have a specific investment question. Or, for a low fee, you can partner with a dedicated financial advisor who’s a CFP professional for ongoing advisory and portfolio management services.

Discounts on brokerage costs, which includes—in addition to commission-free Vanguard ETF trades—$2 commissions for stock and non-Vanguard ETF trades.

Even with a minimum investment of $50,000, Vanguard investors qualify for Voyager Services:

Investment professionals who will listen to you, address your questions, and direct you to an advice solution that best suits your needs.

See more options and details here.

Update 2: Using a 6% annual return for the stock market: Option 1 would grow to $746,000 and Option 2 would grow to $448,000, for a difference in favor of Option 1 of $298,000. And it should be pointed out that a 1% fixed management fee is a much higher percentage of a smaller return like 6% compared to a higher 10% return.