1+1=33%, or the Myth of the 1% Annual Investment Fee

This post is going to be short and sweet, as I keep getting calls and emails from people who wonder why their portfolios are not performing as well as they think they should. In most cases, their portfolios are the victims of what I call the “It’s Only 1 Percent” curse.

Many financial and investment advisers “only” charge an annual management fee of 1 percent of the amount of your account. Same for most actively managed mutual funds. What most investors do not understand is the impact of compounding on the “only 1 percent” annual fee.

As an attorney, I put a lot of emphasis on verifiable evidence. Some simple calculations will help explain how over time a seemingly low 1 percent fee can sabotage your investment portfolio.

First, let’s look at the impact of a 1 percent over 10 years. We’ll use a starting account of $100,000, but the impact is the same regardless of the numbers you use.

10% over 10 years=$259,374
9% over 10 years =$236,736

The difference is $22,638, or a loss of 8.72 percent

Over a 20 year period, the numbers would be:

10% over 20 years=$672,750
9% over 20 years =$560441

The difference is $112,309, or a loss of 16.69 percent.

For those of you who want to confirm the numbers, the Excel formula for 10% for 20 years is simply “=1.10^20.” You then take that number and multiple it by your base/starting amount. Here, it would be “=6.72750*100,000”, resulting in $672,750.

According to the Morningstar Research Center, as of July 6, 2018, the average stated annual expense ratio of domestic large cap growth mutual funds is 1.10 percent. Once an investor factors in a fund’s R-squared number to avoid cost-inefficient “closet index” funds, an actively managed mutual fund’s effective annual expense is often 4-5 times higher than the fund’s stated expense ratio.

The next step is to factor in an actively managed fund’s trading costs. Since fund’s are not required to disclose their actual trading costs, InvestSense uses a metric created by Vanguard founder John Bogle as a proxy for a fund’s actual costs. Bogle’s metric is simple – double a fund’s turnover ratio and multiply that number by 0.60. According to Morningstar, as of July 6, 2018, the average turnover ratio for domestic large cap growth funds is 56 percent, resulting in a trading cost of .67 basis points. (a basis point is .01 percent of 1)

The final step is to simply combine a fund’s stated annual expense ratio and its Bogle trading costs number, and multiply that number by the conversion number from your earlier calculations, e.g., 16.69 % or 8.72%. Here, using the Morningstar data, the numbers would project a 29.54 percent reduction in their end-return over a twenty year period. Variable annuities generally have costs of 2.5-3.0 annually. Using our Morningstar data, over a 20 year period, a VA owner could see a reduction of 50 percent or more in their twenty year end-returns.

Conclusion

The incremental fees for an actively managed mutual fund relative to its incremental returns should always be compared to the fees of a comparable index fund relative to its returns When you do this, you’ll quickly see that the incremental fees for active management are really, really high-on average, over 100% of incremental returns. – Charles D. Ellis

Past performance is not helpful in predicting future returns. The two variables that do the best job in predicting future performance of [mutual funds] are expense ratios and turnover. – Burton G. Malkiel

The next time you see a stated investment fee of 1 percent, know that that representation may not properly reflect the true impact of annual expense fees and other costs on your investment return. I highly recommend that investors and investment fiduciaries do a more comprehensive cost-efficiency analysis using InvestSense’s proprietary metric, the Active Management Value Ratio™ 3.0 (AMVR). For more information about the AMVR and the simple calculation process, click here.

Copyright © 2018 The Watkins Law Firm. All rights reserved.

This article is neither designed nor intended to provide legal, investment, or other professional advice as such advice always requires consideration of individual circumstances. If legal, investment, or other professional assistance is needed, the services of an attorney or other professional advisor should be sought.

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