In covering personal finance for the last 22 years, I've met lots of financial advisors, but one of my all-time favorites is Tom Connelly. A plainspoken, regular guy, Connelly knows as much about investing as any independent advisor I've ever interviewed. A chartered financial analyst and certified financial planner, Tom also has master's degrees in financial planning and business administration. His firm, Versant Capital Management, which has offices in Phoenix and St. Paul, Minnesota, requires a $2 million account minimum. It specializes in a brand of financial planning that Connelly calls "asset-liability matching," which he implements with low-cost investing and indexing strategies.
Tom recently spent time researching issues related to the cost of investing for a presentation at the AICPA's personal financial planning conference. I used this as an opportunity to pick his brain about low-cost investing.
What was your goal in looking at expenses? I wanted to take a look at the impact of costs on people's goals. My inspiration was John Bogle. Until Bogle looked at expenses, people typically talked about investment costs in terms of basis points–usually referring to the annual expense ratio of a managed stock fund or an index stock fund, or comparing an index fund to a managed fund. What Bogle did was different. He examined costs in the context of a terminal wealth number. I made calculations examining costs in terms of retirement income as well as terminal wealth.
What's terminal wealth? We're examining expenses in terms of what you have left for retirement. When you make one percentage point less annually on your portfolio over a long period, the effect on your terminal wealth is amplified. For instance, the S&P 500 between 1974 and 2003 showed a 12.19% average annual return, and a $10,000 investment grew to $315,000.
Earning just one percentage point less annually, 11.19%, would have meant a $241,000 terminal value. Two points less would have meant a $184,000 terminal value, three points less would have been a $140,000
terminal value, and four points less would have been a $106,000 terminal value. So annually losing four points of the S&P 500′s 12.19% return to expenses would have slashed an investor's terminal wealth by two-thirds. This is why Albert Einstein said that compounding is the eighth wonder of the world.
How could you possibly lose four points a year to expenses? While four points sounds like a lot, it's actually not unrealistic. First, the average stock fund has an expense ratio of 1.6%. On top of that are transaction costs. These are not covered in fund prospectuses and it's kind of a mystery number.
According to a Wharton Financial Institutions working paper by two academics, Edelen and Kadlec, in 1999, the average trading cost for an equity mutual fund–that is, commission and spreads on over-the-counter trades–was 80 basis points. Add to that cash drag, which represents the impact of cash equivalents that must be carried by a mutual fund in order to meet redemptions.
Research by Vanguard puts that figure for the average stock fund at 40 basis points. So right there, you have 2.8% of the return on the S&P 500 whittled away by expenses.
When you add taxes into the equation, you eat up 1.6% annually, according to Vanguard, and a Lipper study from 2003 cited tax costs to be 2.5% per year. That actually adds up to 4.4% of an average stock fund investor's annual return getting reduced by various expenses. So someone who invested $10,000 in the S&P 500 in 1974 and let it ride through the end of 2003 would not have accumulated $315,000 by garnering a 12.19% annual return, but would instead have accumulated just $95,000.
When you consider what this means to a retiree's income, it's huge. If you invest $315,000 for 20 years and get an 8% return, you could generate $29,700 of annual income versus $9,000 of annual income that could be generated by a $95,000 nest egg (see Chart 1: How Expenses Affect Returns, below).
So most investors are getting a bad deal because these costs are pretty typical? One way to look at it is that investors are putting up 100% of the risk capital to buy a stock fund. But when you look at their money over a 30-year term like we had from 1974 to 2003, the fund ate up 35% of their terminal account value, trading 18%, and taxes 17%. Just 30% of the terminal value of the fund went back into the investor's pocket (see Chart 2: How Costs Can Eat Up the Fund Investor's Pie, below).
What are the implications of this in the way you practice? Equity mutual funds do not underperform their relevant indexes by 4.4%, on average. It's a credit to active managers that they cover a lot of these expenses. Any way you cut it, though, these costs are being paid out of investor funds to intermediaries.
