The cost of doing business in the investment industry

Almost anyone can come within a dollar or two of estimating what it costs for certain household items, whether it’s a gallon of milk or a roll of paper towel. We know what it costs because we buy them so often and the price is in plain view for us to see. We also have a tendency to look for deals and discounts to decrease that price even further. Unfortunately, the price of investing isn’t so transparent, and we often don’t do our due diligence to find out what we should be paying, let alone what we might be paying.

After all, does the average investor really know—down to the dollar—how much they’re paying their advisor in the form of commissions or fees, or both? Do they know how much it’s costing to buy and sell certain securities? Do they know the dollar amount of the expense ratios these funds carry, or the tax costs that they incur when they recognize gains? The reason that these figures are probably unknown is because we don’t buy securities as often as we buy things like household goods, and oftentimes these financial instruments and services lack even the most basic price transparency.

Dr. William Sharpe, Nobel Prize winner and creator of the Sharpe Ratio, has a good estimate of what it costs us to do business with the investment industry. He estimates that “a person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 20% higher than that of a comparable investor in high-cost investments.” The numbers don’t lie.

A 2012 Demos study assumes a dual-income household at the median income level of approximately $35,000 to $45,000 over a 40-year period from 1965 to 2005. Furthermore, the study assumes contributions of 5-8% of their household income. Based on these assumptions and typical 401(k) fees, this household would stand to lose 30% of their savings, or $154,794.1 And if you think that’s high, households that earn more than three-quarters of other American households—in keeping with the same assumptions as above—would pay about $278,000 in fees. The irony is that 401(k) plans are classified as a benefit by companies offering these plans, but there’s nothing beneficial about losing this much to fees and other unnecessary costs, especially when many times employees don’t have the option to select low-cost investments in the plan.

Active costs vs. passive savings

Mutual funds or Exchange Traded Funds (ETFs) that are actively managed by investment professionals are more costly precisely because there is someone behind the desk making decisions on how best to manage the fund. This isn’t the case with passive funds, which normally track a benchmark index such as the S&P 500, without any management whatsoever, other than perhaps making a trade when a particular security is added or eliminated from the index; an event that is not nearly as common as trading on a weekly or monthly basis.

In a 2014 publication from the CFA institute, John Bogle estimated “all-in” actively managed fund costs at 2.27%. This figure is comprised of average expense ratios of 1.12%, transaction costs of 0.50%, cash drag of 0.15%, and sales charges of 0.50%.2 Expense ratios are annual fees based on the assets under management (AUM) a client has with an institution. This percentage, deducted from an investor’s total AUM in their account, is used to pay for management, administrative, and operating costs to run the fund. Transaction costs and sales charges are self-explanatory; however, cash drag is one aspect of total all-in costs—albeit a small portion—that isn’t normally considered, as it’s not a direct cost being charged to the client.

Cash drag is the opportunity cost of not being fully invested in a fund. Most active fund managers carry about 5% of assets in cash, consequently forgoing a chance to earn a return on the money that is sitting in cash. A conservative estimate of the equity premium over cash is about 6%, translating into a 30 basis point (bp) drag on active returns. Bogle takes an even more conservative estimate when he puts that figure at 15 bp. Compare this to the all-in cost of index funds, which both Bogle and Sharpe estimate to be around 0.06% of AUM, and investors who opt for active funds are starting out with a 2.21% disadvantage; a very substantial amount to overcome. Costs definitely matter.

Behavior and its toll

Fund managers are often measured on their Time Weighted Return (TWR), which assumes a fixed dollar amount at the fund’s inception without any inflows or outflows coming into the fund. Contrast this with a Dollar Weighted Return (DWR), which accounts for how investors allocate their capital over a given time period with both contributions and distributions from the fund. The difference between these TWRs and DWRs is a gap between how the fund actually performs versus how the investor actually performs in the fund; thus, a behavioral or performance gap between the two.

One study that examined TWRs in relation to DWRs between 1991-2013 found the difference to be about 1% for funds with low expense ratios and about 4% for higher expense ratios.3 If we use the more conservative 1% estimate, this still adds up over time and is a major drag on performance. Excessive trading, especially in funds with higher fees, widens the behavioral gap, nearly always unnecessarily adding to an investor’s costs.

Investors whose goal is to maximize returns should be cognizant of both explicit costs, such as transaction fees and expense ratios, as well as those costs which are less obvious, like cash drag and behavioral costs.

1. http://www.demos.org/press-release/new-report-hidden-excessive-401k-fees-cost-retirees-155000, 2012.

2. The Arithmetic of “All-In” Investment Expenses, John C. Bogle. Financial Analysts Journal, Volume 70 Number CFA Institute 2014.

3. Timing Poorly: A Guide to Generating Poor Returns While Investing in Successful Strategies. Hsu, Myers, and Whitby, 2015.