THE EFFECT OF COMPOUNDING OF FEES OVER TIME

Compounding makes a sum grow at a faster rate than simple interest because in addition to earning returns on the money you invest, you also earn returns on those returns over time. This is what led Albert Einstein to label compound interest the eighth wonder of the world.

For example if at age 25 you invest $250 every month and assume an annual average rate of return of 8% you will have $878,570 by age 65. However if you start at age 35, your return goes down to $373,073 and if you start at 45 years of age you will only accumulate $148,236 by age 65. So it is important to start saving as early as you can in order to maximize the effect from compounding.

Likewise, a fee charged to your investment account will also compound over time as a deduction to the overall value of your portfolio. Every dollar taken out to cover fees is one less dollar left to invest in the portfolio to compound and grow over time. If you are getting an annual return of 8%, but the fee is 1.5% then your return drops down to 6.5%. At 8% compounding over 10 years a million dollar portfolio would grow to $2.1mln. However at 6.5% the portfolio would only grow to $1.9mln because of the compounding effect of fees. Over larger periods of time, the value of the amount lost to fees only grows, so fees do matter.

It is important to note that the dollar amount of fees is proportional to how well your investment manager performs as the fee is a percent of the assets under management. This is an incentive for the manager to do well. They don’t do better on their fees unless you do better on your portfolio returns so the client and manager’s interests are aligned.

Lower fees are today the argument passive funds make for investing in index funds. However when investing in passive funds you do not have a portfolio manager risk adjusting your portfolio to both your particular circumstances and to those of the general market. You are invested all the time throughout the cycle with whatever asset mix you have chosen at the beginning of your investment period.

In the end it is pointless to shop around for lower fees if it means giving up performance. Obviously a passive index fund will never outperform the index because it is designed to mimic the returns generated by the index it represents. Every percentage point of index out performance generated by an active manager can compensate for the higher fee. If the manager outperforms by more than the difference in fees between the passive and active strategy, the client comes out the winner. So fees are well justified if the manager is performing well relative to the overall stock market. You will, on average, get what you pay for.

History has shown that investors do not get the same returns as the passive index funds that they are in because when the markets go down, they do not know what they own, and therefore they panic out at the bottom. They then get encouraged to only go back after the markets have done really well and are more than likely to be heading south again. It becomes a permanent game of buying high and selling low which is not conducive to the best investment returns.

If you are just starting out and have a long time horizon perhaps an index strategy is the best way to go, as long as the funds are truly being saved for retirement and you know you have the constitution to not panic out after one year or more of negative returns. If you think you will need to access those funds at some point in between, it is best to work with an active manager that can assist you to have the liquidity available when you need it without negative consequences. In other words if you have an index fund and the market drops 20% and that is when you need to take your money out, you will be forced to crystallize a 20% loss which is less than ideal. Active managers would take your liquidity needs into account and assess how much money should be at risk at any one time.

There is a huge difference between plain investment returns and risk adjusted returns. At Summerhill we are big believers in risk adjusting all portfolios to both market conditions and personal circumstances in order to avoid unexpected set-backs. Unfortunately there is a fee to be paid for having that infrastructure in place. So the question to ask is, at what point is it better to be in passive/index investments over active. Our answer is never because money takes so long to earn, that not understanding what you are invested in requires hiring somebody that does. Very few people, if any, appear to have the constitution to stay in index funds through good and bad markets for an average market return over time. In the end their losses are greater than if they had stayed in active management and paid a fee to somebody else to manage the process and hold their hand throughout the downturns.

Investing is as much about human psychology as it is about numbers. Most people have a low tolerance for losses and would rather not make a buck than lose a buck. With that philosophy, you must be prepared to never be greedy and be prepared to leave money on the table, if you have to, in order to avoid losses that you are not mentally prepared for. That is why the most important question is never what sort of return does any investment vehicle have, but rather what is the risk adjusted return. The top investment performance returns are achieved more as a result of what you do not own (especially when the market drops) then from what you own.

Let’s consider the same example of the two portfolios of a million dollars each with a gross return of 8%. Recall that the account that is charged a 1.5% fee will end up with $1.9mln, while the non-fee account ends up with $2.1mln. Now let’s assume that in year five the market declines 40%. If the fee paying account that is actively managed were to only decline 20% (instead of the full 40%), the portfolio after 10 years would be worth $1.5mln. The passive non-fee paying account, however, would be worth $1.3mln. Despite realizing lower net returns in an up market, since the active portfolio outperformed in a down market, this investor comes out well ahead. When accumulating wealth over time, protecting your downside is of utmost importance. A good investment counsellor recognizes this as their number one objective.

Our equity returns this year are in the mid to high 20% area. However, we have chosen to risk adjust most of our portfolios for the fact that we are in the tenth inning of a bull market and to reflect our client’s needs for cash flow or preservation of capital for future generations. Our returns have still managed to beat most markets, on a risk adjusted basis. As Warren Buffett likes to say, “Price is what you pay. Value is what you get.”

The Summerhill Team