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:

Source:BlackRock

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
	PORTFOLIO (T)	RETURN		FEE	PORT-FEE
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
	6.02%			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.