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This is a guest post by Larry Bates, author of Beat the Bank: The Canadian Guide to Simply Successful Investing.
"What happens in the fund business is that the magic of compounding returns is overwhelmed by the tyranny of compounding costs." - Jack Bogle, founder of The Vanguard Group.
Let's face it. Most of us significantly underestimate the long-term impact of compounding. That is, if we ever consider it in the first place! When it comes to the cost of investing, that can be a very expensive mistake, particularly for those investing in the dinosaurs of the investment world: high-cost mutual funds. Many Canadians don't know just how much they're losing to fees because the way that mutual fund fees are reported disguises their effect over the long-term. So instead, to clearly demonstrate just how tyrannical high fees can be, I created "the T-Rex Score". Let me explain.
Most investment fees are quoted as a percentage of the amount invested. That means a fund with management fees of 2% will cost you 2% of your total investment annually, whether your investments go up or down. This method of fee quoting is highly misleading for three reasons:
- Fundamental to any economic transaction is a cost-benefit analysis. Whether buying a cup of coffee, a car or a home, or paying for a service like a car wash or high-speed internet, an engaged consumer compares the potential benefit offered against the price to be paid. Whether consciously or subconsciously, consumers ask themselves whether the cost is fair compared with the benefit offered. There is no reason investing should be any different. The benefit you are seeking is to earn a return on your investment. Quoting the cost as a percentage of that return would provide a more accurate representation of the cost versus the benefit received. Of course, you can't predict future investment returns, but you can use reasonable projections. For example, you might project a one-year total investment return of 6-8%. In this case, the cost of the product is 25-33% of the total benefit over one year.
- When a product will be owned for years or decades, quoting the fee as an amount owing over an arbitrary fraction of that time frame (that is, one year) makes no sense. For example, a thirty-five-year-old looking to invest for a long retirement stretching from age sixty-five to age ninety-five might use a fifty-year average investment horizon, while a couple saving to finance a newborn's post-secondary education might use a twenty-year average horizon. Quoting an annual fee doesn't tell you how much you'll actually pay over a multi-decade investment time frame. Providing an estimate of the total fee for the entirety of your projected investment horizon would be much more revealing.
- When you pay investment fees, you lose twice. You lose the fee and you lose some of your compounding magic. Annual fee quotations give no indication that your 'compounding loss' accelerates as the years pass.
There is a much more revealing way to measure the impact of fees on your investments: simply project how much of your total investment return you actually get to keep after fees. This method of demonstrating the impact of investment fees, which I call the 'Total Return Efficiency Index Score' (that T-Rex Score I mentioned at the start), addresses the three shortcomings of the conventional fee quotation.
T-Rex Scores 1) compare cost (fees) versus benefit (gain), 2) allow for a wide range of time frames and 3) fully capture the ever-growing compounding loss.
In essence, T-Rex Scores reveal how efficiently the returns on your underlying investments translate into returns for you. The higher your T-Rex Score, the more of your investment return you get to keep. You will find the T-Rex calculator at larrybates.ca. Assuming you know the full amount of all investment fees you are paying, it's very simple to find out your score. Just enter in your:
- investment amount
- projected average annual return on underlying investments before fees
- annual investment product fees and other costs
- projected life of investment (time horizon, or how long you'll stay invested)
To see how eye-opening the T-Rex score is, let's consider a couple of examples. First, let's see what happens when a one-time investment of $10,000 is held for 30 years, generating a projected average annual compound return of 8% before fees. What would be the impact of 0.25% annual fees, an amount similar to many equity index ETFs?
The red curve indicates the pre-fee total return over time while the yellow curve shows the return actually retained by the investor after fees. In this example, the T-Rex Score is 93%, meaning the investor retains 93% of the total return. That's a healthy T-Rex score!
How would the same investor fare if we assume the same starting investment amount, time frame and pre-fee return but increase the annual fees to 2.25%, similar to many equity mutual funds? Of course, the total pre-fee return (the red curve) remains the same. But look what happens to the yellow curve.
The return actually retained by the investor (the yellow curve) drops dramatically and the resulting T-Rex Score is just 48%. The investor loses 52% of their total return to fees.
While the quoted annual fee is "just" 2.25%, the true fee in this case is a stunning 52%!
You can determine your own T-Rex Score using the calculator on my site. Once you know your T-Rex Score you will be better able to decide if you feel you are getting good value for the investment fees you are paying.
Larry Bates is a Toronto based consultant, speaker and author. His best-selling book, Beat the Bank: The Canadian Guide to Simply Successful Investing, is aimed at providing average Canadians insight as to how the investment industry operates and how to achieve significantly higher returns through the use of more efficient investment products. Larry is a member of the Board of FAIR Canada, a national investor advocacy group.
Larry spent 35 years in the capital markets business in Toronto and London including as Global Head of Debt Capital Markets for RBC, Canada's largest bank. In this role, Larry worked with some of the world's most sophisticated institutional investors.