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Tuesday, August 20, 2013

What is the Cost of Investment Management? (Update)

This post is an update of a post published 4/26/2011.  It looks at market performance from the perspective of investment management cost over 20 years from 1/1/1993 to 2012.  The previous post covered 20 years ended 12/31/2009.

If you are a typical investor using an investment advisor, you probably have wondered at some point exactly what  it is costing.  On the surface, it looks rather small - the typical advisor charges between 1% and 2% of the market value of assets managed. 

Throw into the mix, however, the mountains of evidence which show that, over the long run, 3 out of 4 managers who try to beat the market and charge high fees for their services underperform--and the question becomes really interesting.

Keep in mind that financial planning and investment management are two different endeavors.  You could get a sophisticated financial plan done by a financial planner, and it could be well worth the cost. Understand, however, that FINANCIAL PLANNING AND INVESTMENT MANAGEMENT ARE TWO VERY DIFFERENT SKILL SETS!

There is considerable confusion on this topic in the blogosphere.  Let me be clear:  for many people, a well-done financial plan is worth paying for and, in fact, I've seen costly financial plans pay for themselves as the planner spots profitable attractive tax savings, etc.

What we are  looking at here is solely investment management.  Specifically, we'll think about how much could be saved managing your own assets and just matching market performance.  Bottom line: the savings are huge - this isn't the old "change your own oil" tactic from graduate school days.  This is meaningful savings.  It is the difference between being able to retire comfortably and not.

Regular readers of this blog know I like periodic tables of investment returns because they readily enable analyses of this type.  Here is the link to the Table put out by BlackRock for the 20-year period ended 2012:


CLICK TO ENLARGE  Granted there are many paths we could have gone down over the past 20 years, but this is one path we did travel. The table shows the value of diversifying, why not to chase hot sectors, and the biggest ups and downs of the past 20 years.  It also shows the performance of a diversified portfolio (white box) and, thereby, gives us what we need to calculate the cost of investment management for a basic diversified portfolio. But first, let's back up and review what we are considering.

Google "wealth managers" along with your zip code, and you'll find at least 10 wealth managers within 25 miles, say, of where you live (unless you're in the Amazon jungle or the North Pole).  Call the 10 wealth managers and tell them you have $1.0 million in assets and you need help managing it.

To make a long story short, they will gladly manage it for you at a fee of between 1% and 2% of the market value of assets.  Thus, the first year fee on your $1.0 million will be approximately $10,000.

The question we are interested in is the cost of professional management if we had gone back 20 years ago to 1993.  What would have been the impact on the portfolio of professional management at 1% versus managing it ourselves?  Keep in mind that assets typically need to be managed over much longer periods, so we are actually looking at a short time frame - maybe for someone in their mid-40s with a couple of rollover IRAs and 20 years to retirement.

Again, most professionals (and individuals who try to pick stocks and time the market), after fees, underperform markets over the long term.  If you need evidence of this,  please do not hesitate to contact me.  For our analysis, we assume that the investment manager achieves the returns of the diversified portfolio in the BlackRock table.

We'll also assume that the investment manager gets paid at the end of the year.  In the real world, investment managers are paid at least quarterly.

Using the returns provided by BlackRock produces the following results :

Column1 Column2 Column3 Column4 Column5 Column6

1993 1,000,000 1.133 1133000 11,330 46192
1994 1,121,670 0.997 1118305 11,183 45730
1995 1,107,122 1.274 1410473 14,105 40350
1996 1,396,369 1.136 1586275 15,863 44820
1997 1,570,412 1.206 1893917 18,939 44372
1998 1,874,978 1.17 2193724 21,937 43928
1999 2,171,787 1.137 2469321 24,693 43489
2000 2,444,628 0.989 2417737 24,177 43054
2001 2,393,560 0.952 2278669 22,787 42623
2002 2,255,882 0.902 2034806 20,348 42197
2003 2,014,458 1.235 2487855 24,879 41775
2004 2,462,977 1.105 2721589 27,216 41357
2005 2,694,374 1.054 2839870 28,399 40944
2006 2,811,471 1.13 3176962 31,770 40534
2007 3,145,193 1.06 3333904 33,339 40129
2008 3,300,565 0.772 2548036 25,480 39728
2009 2,522,556 1.208 3047248 30,472 39330
2010 3,016,775 1.13 3408956 34,090 38937
2011 3,374,866 1.018 3435614 34,356 38548
2012 3,401,258 1.122 3816211 38,162 38162


386,917 836196

For those who may not be mathematically adept, the 13% return shown for the diversified portfolio in 1993 in the BlackRock table is put in the spread sheet above as 1.13 because $100 will grow to $113 at the end of the year.  The portfolio grew to $1,133,000.  The fee then would be .01* 1,133,000 or 11,300.  As another example, in 1994, the diversified portfolio declined by -0.3%; so the return number is .997 in the table.  Each dollar fell to $.997.  Thus the portfolio dropped, and the fee went down accordingly.

If you can need some practice, work through 1998 which saw the largest drop in the market.

The totals are what we are interested in.  Over the 20-year period, $386,917 went in to the pockets of the investment manager.  If, instead, the yearly amounts had remained in the portfolio and achieved the ensuing market returns, the total amounts to $836,196!  No wonder Fred Schwed stood on the docks at the end of Wall Street looking at the broker yachts and wondered where the customer yachts were!

Disclosure:  This post is intended solely for educational purposes.  Individuals should do their own analysis and/or consult with an advisor before investing.

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