Interactive: Why Fees Matter When It Comes to Investing

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Jun 22, 2016
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Activity, Behavioral Finance, Research, Personal Finance, Index Funds, Investing, Mutual Funds, Teaching Strategies, Stocks, Chart of the Week, Math, Activities, Interactive

Hat tip to Mike Finley, who I met today at the Iowa JumpStart conference outside of Des Moines and showed me this great interactive tool developed by Vanguard (Thanks to Mike Johnson and Julie Ntem for the invitation to present there and for organizing a great event!).

Here are the details about this tool and how you might incorporate into an investing lesson:

Screen Shot 2016-06-22 at 5.32.26 PM

The students get an opportunity to toggle two variables: expense ratio and average annual return. The results appear in a series of bar charts for 1,5,10,25 and 50 years with the shaded portion representing the returns you keep and the unshaded portion representing returns lost to investors (and gained by investment management firms).

Here’s the set-up for a mini-activity:

  • Background: Investing fees are one of those hidden expenses that most investors don’t track. Why? Well, you don’t get a bill a the end of the year from your mutual fund or ETF notifying you of the amount you paid your investment firm in expenses. Investment firms do disclose their expense ratio to you in their prospectus (Here’s an example: Vanguard Total Stock Fund with expense ratio of 0.16%) but most investors don’t think about it in dollar terms. Even fewer investors consider the impact of compounding fees over the medium and long term. That’s where this interactive tool comes into play.

Let’s work through two scenarios:

Scenario 1: Billy BuckSlayer loves actively managed funds because he is convinced he can pick investors who can BEAT the market. That would certainly make him exceptional (or more likely lucky!) as the track record of active managers beating the market over long-term is quite abysmal. Let’s assume he gets lucky and matches the returns of an index fund which is unlikely but makes this tool work better. As for expenses, here’s a great chart from ICI Factbook that shows the difference in expense ratios for actively managed mutual funds (for stats junkies out there this data is asset-weighted which explains why it might appear lower than the 1.2% or 1.3% figures bandied about which are simple averages):

ch5_fig6Unfortunately, these expenses are just the tip of the iceberg, as this paper by John Bogle, the father of indexing, points out. He calculates the “all in” expenses for active funds at approx. 2.27% when you include sales costs, transaction costs and other expenses.

So, using the expense figure of 2.27% and assume a return of 7%, a little bit below the average for a broad equity index. Remember that choosing active funds usually means underperformance relative to the market. So, how to read this output using these inputs?

Screen Shot 2016-06-22 at 6.05.06 PM

In a word, OUCH! Looking at a 25 year-time horizon, over 50% of the gains that Billy would have earned are being eaten up in fees (using this tool online allows you to toggle over the bar to get the exact percentages). By 50 years, almost 70% of the returns go to the investment management firm and not YOU!

Scenario 2: Wendy Fee Watcher heard from her teacher that index funds are the way to go. She chooses an no-load index fund that mimics the S&P500 which has an expense ratio of .16% (I used .15% in the example b/c I couldn’t toggle to .16% on the tool) and she earns a market return of 7% also (just like Billy). Let’s see what Wendy’s investment returns look like in the future using the Vanguard tool:

Screen Shot 2016-06-22 at 6.12.33 PM

Compare this chart with the one for Billy and it becomes evident who gets to keep more of their money. Wendy keeps 96% of her investment returns over 25 years and 93% over the 50 year time horizon because of her one decision to invest in low-cost no-load index funds.

 

Who do you think will be able to retire earlier and have a higher standard of living in retirement? 

Want to incorporate some Excel skills into the activity. Have students summarize their data in this Google Sheet. By comparing the outcomes for Billy and Wendy side-by-side, your students will see the impact of choosing low-cost index funds vs. actively managed funds.

 

 

 

About the Author

Tim Ranzetta

Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.

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