Stopping the silent killer of returns

Posted by on October 28, 2011 @ 10:00 am in investing

There continues to be a lot of focus on the consequences of today’s low-rate environment. In such an environment, one of the most important things an investor can do is economize on the cost of the financial services they’re buying (translation: find lower expense ratio funds!).

Still, it never ceases to amaze me how much people continue to neglect the “silent killer” of long-term returns—high investment costs. Every now and then, I see articles that talk about the bite that investment costs can take out of a portfolio over time. But many times, these articles talk about how much of your “returns” an investment manager takes via fees. For example, if a fund charges a 1% fee and you anticipate a 5% gross return, it’s often observed that you’re giving up “20% of your return” (1% of the 5%) to costs. Jack Bogle likes to point out that the cost is dramatically higher when thought of as a percentage of after-inflation, after-tax returns: accounting for inflation of 2% and effective taxes of (say) 20% on the total return, your after-tax, “real” return is reduced to 2%, and a 1% fee is 50% of that!

Expressed this way, the fees seem pretty steep. But you still might get the mistaken sense you’re only losing money/paying fees if there are positive returns to give up. The problem is that reality doesn’t work that way. A provider charging a 1% fee doesn’t levy fees on just the returns. They levy fees on your balance.

So I think about the impact of investment costs more simply: If there are no returns and the provider takes 1% every year for 30 years, that sums to roughly 30% of my wealth (not exactly, because the fee declines slightly each year along with my balance ). In the case where the return is 1% per year and just equals the fee, they would get an amount exactly equal to 30% of my initial deposit.

This thought yields a rough rule of thumb: A ballpark estimate of the long-term impact of investment costs is to simply multiply the annual fee by the number of years you plan to invest: fee × years = cost. That gives you an order of magnitude correct estimate of how much money you’re paying the fund provider over time.

Of course this “rule” is based on a stark/simple example. Surely it’s different when there are positive returns, and the fees as a percentage of those returns are low … right?

Actually, no. If there are positive returns, that just means the provider’s charges are rising faster over time. With a 1% fee for 30 years, the provider is still getting on the order of 30% of what would otherwise be yours. So while people may (hopefully!) focus on this issue more in a low-rate environment, it works no differently in a high-rate environment.

In fact, what an investment provider gets as a fraction of what you would otherwise have had depends only on their fees, not returns. Looked at more precisely, the provider gets a fraction equal to 1–(1+c)^(–T) of what would otherwise be my wealth, given fee c and time horizon T. The table below computes this number and displays the impact on your wealth:

Cumulative impact of fees on ending wealth at various time horizons

Annual Fee Rate
Time Horizon 0.10% 0.25% 0.50% 1.00% 2.00% 3.00% 
3 years –0.3% –0.7% –1.5% –2.9% –5.8% –8.5%
5 years –0.5% –1.2% –2.5% –4.9% –9.4% –13.7%
10 years –1.0% –2.5% –4.9% –9.5% –18.0% –25.6%
20 years –2.0% –4.9% –9.5% –18.0% –32.7% –44.6%
30 years –3.0% –7.2% –13.9% –25.8% –44.8% –58.8%
40 years –3.9% –9.5% –18.1% –32.8% –54.7% –69.3%

The numbers above only make it more shocking to me that the average expense ratio for equity mutual funds remains above 1% per year.

Even in times like these, with very low risk-free rates of return, I don’t think most people appreciate that fees of “as little as 1% a year” amount to giving away more than a quarter of your wealth over 30 years.

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