Sunday, November 5, 2017
Decompounding – the tyranny of fees
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it. “- Albert Einstein
Indeed, the magic of compound interest is the best way to build a retirement nest egg. It is also true that the greater the return rate, the greater the amount accumulated. Conversely, the less the return rate, the less there is to compound.
You can't control the markets or a fund's performance, but you can control what you pay to invest. Controlling costs is smart, because costs reduce your net investment returns.
Vanguard founder John Bogle refers to the decompounding impact of fees on long term returns as tyrannical.
Most Canadians shrug off investing expenses but don’t realize the impact of decompounding due to annual and other fees. These fees/expenses include but are not limited to front end loads/commissions, early redemption penalty fees, management fees, trading expenses , minimum annual account fees, switch fees, account transfer fees , advisory fees etc.
To calculate returns on a $100K investment at say 7%, use the compound interest calculator at http://www.thecalculatorsite.com/finance/calculators/compoundinterestcalculator.php .If you've done everything right, you should see a "future value" of $1,497,475.78 This is what an investor would end up with after 40 years at a compound annual average growth rate of 7%. To figure out the return, subtract the original $100,000, which gives you $1,497,475.78.
But what if the annual rate of return is 5 %? The only number you need to change is the rate of return– let’s assume 5 per cent due to fees. Hit "calculate," and you'll get a future value of $703,998.87 for a return of $603,998.87.
You'll notice that the return has been cut by more than 50%- and all because of “just 2 %” in fees charged every year. In the case of actively-managed mutual funds , the S&P Indices Versus Active ( SPIVA) Scorecard, the data routinely shows that for five-year periods, the below benchmark performance pattern repeating across all categories, after fees. The 10-year period data also show further struggles for active managers, with typically less than one-quarter of funds outperforming.
Here's something else to consider: The longer the time horizon, the bigger the bite that fees take. As the time horizon approaches infinity, the proportion of returns eaten up by fees approaches 100 per cent. That is the tyranny of fees in action.
Why does this happen? Because, over extremely long time periods, even small differences in compounding rates have a gigantic impact on returns.
The adverse impact of fees is twofold: An investor pays an ever-increasing amount in fees as account balances grow, because many fees are based on a percentage of assets. And fees also strike a blow to the portfolio’s returns. That’s because every dollar taken out to cover management /advice costs is one less dollar left to invest in the portfolio to compound and grow. So in addition to paying potentially tens of thousands of dollars in avoidable fees, research shows that an investor gives up many times that amount in lost portfolio returns over time (“opportunity costs”).
Several economic forecasts project that market returns may be lower in the future so the impact of fees on returns and savings will be even larger .Fees are the silent killers of investment returns. amplified by decompounding over time. Don't make the mistake of thinking even 0.5% doesn't matter – in the long run, the impact is huge.
Before investing, always consider whether an investment is appropriate for your financial goals, situation, time horizon and risk profile.
The cost of investment fees is one of the drivers behind the Canadian Securities Administrator’s new fee disclosure proposals, designed in part to give investors better clarity about how much they’re paying in fees for advice. Some products like mutual funds include ongoing trailer fees intended to provide advice but they can also skew advisor recommendations in addition to increasing the MER.
Understanding the long-term impact of fees - especially slight differences between similar products - is up to financial consumers. You also need to laser focus on the value and cost of financial advice which is less tangible and quantifiable.
Control your own financial destiny or someone else will.