“Beware of little expenses. A small leak will sink a great ship.”
Previously, I’ve explained that it’s important to know how much you’re spending on fees in your investments, and why I’m no fan of people who charge assets under management (AUM) fees) for you to hand your portfolio over to them to manage.
In this article, I’m going to dive a little deeper into quantifying just how much that “money manager” is going to cost you, how it could potentially affect your retirement, and how much better than the market that manager has to perform to justify his fees.
Let’s look at two couples, the Smiths and the Jones. The Jones, thinking that they have to keep up with everyone else who has their surname, think that they’re better off going with an “investment professional” who is going to charge them 1% of their investable assets every year for the privilege of working with him. Said professional matches the market performance save for expense fees within funds and his 1% annual fee.
The Smiths decide that they’re going to throw caution to the wind and do it themselves. They invest 60% of their money in an S&P 500 index fund (we use the expense ratio of VFINX, 0.17%, to account for expenses) and 40% of their money in a corporate bond index fund (we use the expense ratio of VBLTX, 0.20%, to account for expenses).
Since we know that the past is only somewhat indicative of what the future will look like, I created 10,000 different potential futures for the Smiths and the Jones to see how much of an impact the AUM fee had on the Jones.
Both families earned $30,000 after tax and invested $5,000 of that money, and their earning, spending, and investing all matched inflation. After 30 years, they retired and lived off of their investments for another 30 years before passing into the Great Beyond.
How did each family do?
In the 10,000 potential futures that I modeled, the Smiths ended up with an average net worth of $2.63 million. 50% of the time, they had more than $1.3 million, and 50% of the time, they had less than $1.3 million after 60 years.
70% of the time, they departed this earth with money in the bank.
Comparatively speaking, the Jones were worse off. This is not surprising, since I never gave their portfolio manager a chance to outperform the market. This is, after all, an exercise to demonstrate the actual cost and how much the manager needs to outperform the market rather than a model to show the rare times when lightning strikes and the manager is extremely lucky, since it requires luck to outperform the market over time, and active managers historically significantly underperform the market (see here, here, and here for more).
The Jones had a mean net worth of $813k, and 50% of the time, they had $104k or less when they went to the Happy Hunting Ground.
To underscore this point, they Jones died broke (or in debt) 48% of the time.
The differences in performance are stark. The average Smith died $1.82 million richer than the averages Jones, and 50% of the time, the Smith family died $1.27 million or more richer than the Jones family.
Because the AUM manager hamstrung the Jones heavily at the wrong times in some of the modeled futures, on average, he had to outperform the market by 8.3% in order to keep up with the Smiths. A more realistic number is the median: 50% of the time, he had to beat the market by 1.67% or better in order to keep up with the Smiths.
There is a bit of a Simpson’s paradox here in that a little under 24% of the time, the AUM manager, despite charging 1% every year, doesn’t have to outperform the market by more than 1%. This happens when the market goes up a high amount in the first few years. The 1% he charges is relatively small in those scenarios, particularly if the market then underperforms subsequently. So, the amount, as a proportion of overall performance, he has to win by decreases. Don’t count on this happening in your situation, and he still has to outperform the market (3/4 of the time by more than his fee) to justify himself.
The AUM community won’t like these findings. Here’s what they’ll say and why they’ll be wrong.
We outperform the market sometimes, too!
Why they’ll say it: It’s true. Occasionally one of them will catch lightning in a bottle and outperform the market.
Why they’re wrong: Most of the time, as I’ve documented above, they won’t. When they don’t, the underperformance and the fee will create even more of an anchor. If I had modeled their actual historical performance compared to simply making them competitive with the market, the results would be even worse. This article puts them in a better light than most of them deserve, but that won’t stop them all from exhibiting a strong case of the Dunning-Kruger Effect and saying that the underperformance only happens to the other guys and that their knowledge of publicly available information will somehow make their secret sauce a little better.
If it weren’t for us, they’d never invest!
Why they’ll say it: They have an incentive to get as much of your money under their management as possible. Sometimes they’ll succeed in getting you to invest more than you would otherwise have invested.
Why they’re wrong: They don’t have to charge you 1% Every. Single. Year. Until. You. Die. to have this impact. If you absolutely, positively have to have someone to manage your money for you (and there are some of you who do), then pay someone a flat fee every year instead.
There’s a lot of caterwauling from the assets under management industry about why you should give them your money. The primary reason is because it’s really financially lucrative. Once you get hooked up to that pipeline, it’s hard to stop. Horse carriage manufacturers said the same thing about the Ford automobile. The reality is that, for a vast majority of people, it’s an unnecessary fee. Now you see just how much it costs you and how much a potential money manager has to outperform the market every single year. I personally would rather try to find a professional coin flipper than risk those odds.