The Costs of Investing and How the Fund Management Industry Comes Out on Top

A common refrain among the financial media and the asset accumulation community is that annuities represent a poor option because of the high fees and expenses—much of which is presumably directed towards compensation of intermediaries—that are incurred by the customer.

The vigilance and concern are heartwarming, but how about directing the same critical eye towards the products that serve as the presumed foundation for wealth accumulation?

In an extraordinary article titled “The Relentless Rules of Humble Arithmetic,” Vanguard founder John Bogle lays-out a clear and objective analysis of the value creation or lack thereof in the investment management business:

  • From the period beginning in 1983 and ending 2003, the S&P 500 index delivered an annual return of 13 percent.
  • On a pretax basis, the average equity fund generated a return of 10 percent—lagging the overall market by 3 percent (less than 80 percent of the market’s return).
  • On an after tax basis, the average equity fund return is reduced to 7.8 percent—delivering just 60 percent of the return of the overall market.
  • When accounting for inflation (3 percent), the average equity return is reduced to 4.8 percent—delivering a real return that is just 48% of the overall market.
  • To make matters worse, none of the above figures account for the additional performance lag resulting from timing and selection decisions made by the average investor.

The first take-away is that there is a clear-as-daylight case to be made for low cost index fund investing and against active investment management.

A related and equally interesting consideration is whether the investment management industry suffers to the same extent as their customers.

The answer, as Bogle clearly demonstrates in a startling example, is a resounding no.  Bogle’s argument is laid-out through the following scenario:

  • A young person invests $1,000 at the beginning of a 65 year time horizon (45 years of employment and 20 years of retirement).
  • A favorable assumption is made that the overall market returns 8 percent per year during the 65 years.
  • A cost free investing scenario for that $1,000 would result in a final value of $148,800 at the end of 65 years.
  • Assuming, however, that fund management costs are 2.5 percent (resulting in a 5.5 percent net return to the young investor) yields a final value of just $32,500.
  • At 2.5 percent, the net return on a compounded basis to the fund manager is $116,300.

In Bogle’s own words:

“the investor who put up 100 percent of the capital and assumed 100 percent of the risk would receive only 21 percent of the return. The financial intermediaries, who put up 0 percent of the capital and assumed 0 percent of the risk, would enjoy a truly remarkable 79 percent of the return. Indeed, the cumulative return of our young capitalist saving for retirement would fall behind the cumulative return taken by the financial croupiers after the 29th year, less than halfway through the 65-year period. Devastating as is this diversion of the spoils of investing, apparently few investors today have either the awareness of the relentless rules of humble arithmetic that almost guarantee such a shortfall in their retirement savings or the wisdom to understand the tyranny of compounding costs over the long term.

It is not at all surprising that the Forbes 400 is riddled with various forms of fund managers—the economics of the asset accumulation business are truly remarkable.  Quite the opposite, however, for the customers and quite a high price for products that provide no guarantees whatsoever.

Companies: 

Comments

Great article--thanks.

The $116K over 65 years is truly amazing.

Would be great to be able to have a tool that easily compares costs of different products.

There are actually some great (free) tools out there that will help you get a handle on investment expenses.

For example, any fund listing in Yahoo Finance contains a "fees and expenses" section.

Take a look at the listing for Fidelity's Magellan fund: http://finance.yahoo.com/q/pr?s=FMAGX

In the lower right of the above page you'll see the expense ratio for this fund, how the fee compares to category averages, and best of all, projected expenses over various time horizons for a hypothetical $10,000 investment.