• Dr. Andreas Lawson Ph.D.

Can you really be $250,000 wealthier if you lower your investment costs?

Under reasonable assumptions, yes.


Consider the following scenario.


An investor has a $500,000 portfolio of investible assets and a 15-year investment horizon. She intends to contribute $10,000 per year to her portfolio. She asks the investment advisory firm of a major national financial services provider to manage her portfolio.


She tells the investment advisory firm about her 15-year horizon, that her investment goal is growth and that she is able to tolerate a medium amount of risk.[1] The advisory firm decides to invest 60% of her account in stock mutual funds and 40% in bond mutual funds.


Our investor pays an advisory fee of 0.95% of the value of her account per year. She also pays a mutual fund expense ratio of 0.85% per year. This is the fee a mutual fund charges its shareholders for the management of the fund and is deducted directly out of shareholder returns. For the sake of simplicity, we assume the investor is not charged an account maintenance fee, the mutual funds the advisor has purchased for the investor are all no-load funds and that transaction costs are zero.[2] So our investor has a total annual investment cost of 0.95% + 0.85% = 1.8% of the value of her account.


Let’s now estimate the impact of fees on our investor’s portfolio at the end of her 15-year investment term. For this period, we assume the average return of a portfolio invested 60% in the broad U.S. stock market and 40% in the broad U.S. bond market is 7.5% per year.[3]


We therefore estimate the average return of our investor’s portfolio as 7.5% - 1.8% = 5.7% per year.[4] Thus, after 15 years, her $500,000, with an annual contribution of $10,000, would grow to around $1,389,000.


But what would the value of her account have been after 15 years if her fees and costs were lower? Let’s assume her total investment costs are 0.55% per year instead of 1.8%. Her account value would grow to approximately $1,638,000 instead of $1,389,000, an increase of about $249,000.


In summary, based on an initial portfolio of $500,000 with annual contributions of $10,000, our investor would be almost $250,000 wealthier after 15 years (and about $462,000 wealthier after 20 years) by paying 0.55% per year in total investment costs instead of 1.8% per year.


If the initial investment had been $1 million, with a $30,000 annual contribution, the increase in wealth due to paying a total investment cost of 0.55% instead of 1.8% would have been $524,700 after 15 years and $981,900 after 20 years.


Let’s scrutinize this illustration. First, is 1.8% per year a reasonable estimate of the total investment costs an average investor pays? Yes—the average annual expense ratio of a large blend mutual fund is around 1%.[5] And the average fee for a professional financial advisor is around 1% for the first $1 million.[6] Hence, it is reasonable to assume the average investor pays 2% of the value of their account per year in investment costs. And there are many different types of fees and expenses in addition to the expense ratio and portfolio advisory fee illustrated above which could raise the total investment cost significantly.[7]


Secondly, the results above tell us a reduction in investment costs can have a major impact on terminal wealth. Does this conclusion hold if we change the assumed average rate of return of 7.5%? Yes, the increase in wealth caused by moving from the expensive portfolio to the cheap portfolio as a percentage of the expensive portfolio is about the same no matter what annual rate of return we assume.


Lastly, is it possible to experience the returns of a professionally-managed portfolio and pay only 0.55% in total investment costs? Yes, Freshfield provides expert portfolio management for a total investment cost of 0.55% per year.[8] We are able to achieve this by (1) using the services of the most technologically-advanced and lowest-cost brokerage in the U.S., (2) having the expertise to identify mutual funds and ETFs which provide the benefits of exposure to stock and bond markets at a fraction of the cost of the average mutual fund or ETF and (3) having highly efficient business operations.[9]


As the simple but realistic illustration above shows, investment costs can have a huge impact on wealth; it is critical to minimize investment costs, not least because costs compound. And costs are one of the few things in investment management directly under the investor’s control.


Could your terminal wealth be significantly greater if you lower your investment costs? To find out, book a free consultation with Financial Advisor and Investment Manager Dr. Andy Lawson. We will review your costs and investment strategy for no charge.

https://www.freshfieldinvestments.com/book-online

[1] She expects her portfolio to grow over her 15-year horizon but accepts it could lose up to 25% in a single year within that period.


[2] This is not usually the case. Many investment advisors purchase shares of funds which have front-end loads; such funds charge the investor a fee to purchase their shares. And many popular custodians charge annual account maintenance fees. Also, most investment accounts are charged transaction costs for the buying and selling of shares within their accounts. These fees and costs can significantly increase the investor’s total annual investment cost.


[3] To provide a perspective for our assumed 7.5% annual return, the average return of a portfolio invested 60% in the broad U.S. stock market and 40% in 10-year government bonds between 1973 and 2018 is around 9% per year. Source: Faber, Global Asset Allocation, 2015 and Morningstar Index Database, 2018.


[4] There are other methods to estimate net returns from gross returns and expenses. We find the simple annual subtraction method provides a reasonable approximation of net returns.


[5] Source: Ibbotson mutual fund database 12/2018


[6] Source: Investopedia 10/2018.


[7] Including transaction costs, markups, sales loads, surrender fees and commissions.


[8] Freshfield charges an advisory fee ranging from 0.25% per year to 0.80% per year based on account size. A $500,000 account is charged 0.50% per year. The funds Freshfield uses to build portfolios for clients have zero load fees and an average expense ratio of around 0.05%. Freshfield pays client’s transaction costs and Freshfield clients pay no account maintenance fees.


[9] Freshfield uses the custody and brokerage services of the largest electronic trading platform in the U.S. Contact Freshfield for details.

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