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Ideas & Debate

Silent killer of earnings lies in management fees

As the time horizon approaches infinity, the proportion of returns eaten up by fees approaches 100 per cent. FILE PHOTO | NMG
As the time horizon approaches infinity, the proportion of returns eaten up by fees approaches 100 per cent. FILE PHOTO | NMG 

Fees. How many of us pay them. Fees. Mutual funds collecting. Fees. How many of us pay them. Fees. Before we go any further, let’s talk about fees.

Kicking-off with that Whodini-inspired introduction, the repetition could not be more apt. The matter at hand—the tyranny of management fees.

Do higher fees for investments translate into higher returns? Do we really need to pay these excessive fees to buy, sell and maintain our unit trust holdings?

In today’s article, I share why I believe management fees are the “real” weapons of mass (wealth) destruction. And here’s why.

First of all let’s assume, there are two investors: Investor No. 1 owns a portfolio of stocks worth Sh100,000, pays no ongoing fees (apart from commissions when he purchased his shares) and earns the market return of 10 per cent annually. Investor No.2 owns the same stocks in a mutual fund that charges two per cent in fees and he therefore, earns a net return of 8 per cent.

After 30 years, Investor No.1 will have a future value of Sh1,744,940 (compounded annually) while Investor No.2 growing at eight per cent will have a future value of Sh 1,006,265.68 – a 42 per cent less return compared to Investor No.1.

All because of just two per cent in fees charged every year. The longer the time horizon, the bigger the bite that fees take.

Taking our example a step further, after 60 years, fees would eat up 68 per cent of returns. After 100 years, 85 per cent. Of course, nobody invests for that long, but you can see the trend here: As the time horizon approaches infinity, the proportion of returns eaten up by fees approaches 100 per cent.

Stating the problem differently. Assume your investment manager generates a return of 10 per cent and you’re paying management fees of 3 per cent of the value of your account, you’re essentially paying out 30 per cent of your returns in fees.

If your return is 8.5 per cent before fees (like for most money market funds) and tax, with the same fees charged, you’re doing badly keeping up with inflation after fees and tax (4.225 per cent). Inflation rates sits at 4.5 per cent.

That’s not all. Lastly (and worse), though mutual funds will show a fixed percentage on their marketing material—generally about 2.5 per cent--three per cent (equity funds and bonds funds) and two per cent (money market funds), that figure quickly increases when you include various hidden fees and fund expenses.

When you total these expenses (to come up with the funds expense ratio), for your favourite equity fund, expense ratios will often range between 4-5.5 per cent per annum.

An expense ratio of 5 per cent means that if you have Sh100,000 invested in a certain mutual fund, you’re paying Sh5,000 in annual investment fees.

Now you know. When mutual fund fees are put into perspective of what you’re actually paying for, they are not benign.

Even small difference in compounding rates have a gigantic impact on returns. Fees are the silent killers of investment returns. Don’t make the mistake of thinking a couple of percentage points don’t matter – in the long run, they’re huge.

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