COLUMN: Invest wisely; managers like to take their slice of the pie

Tim Mak

Arguably most investors realize how much their money managers are taking out from their investments in annual management fees. Perhaps most investors also know the power of compounding.

However, it is less common for investors to sense the combined power of the two factors mentioned above, and hence to fully grasp how big a chunk their money manager is taking out from their eventual wealth.

In explaining this unconventional approach to understanding the impact of fund management fees on one’s final wealth, a simple numerical example will help.

Let’s say you invest $10,000 cash in a basket of securities that earns 15 percent per year over the next 40 years. Faculty and administrators can multiply this $10,000 initial cash investment by 20, 50 or more to make it meaningfully relevant to their current cash positions. Without loss of generality we’re assuming reinvestment of dividends and disregarding taxes.

Simple spreadsheet manipulations will reveal that your final wealth from this investment will be worth $2,678,635.46.

Let me emphasize: That is what you will get if you invest on your own and don’t use a money manager.

Now let’s say that instead of investing yourself, you entrust your capital with a fund manager, who invests and obtains the same results.

Let’s say your money manager charges an annual management fee of 1.5 percent, taking out 1.5 percent of average assets during the year under management, every year. For example, the first year’s management fee is $107.50.

Under this not-too-uncommon mutual fund fee structure, out of the eventual wealth of $2,678,635.46 discussed earlier, how much of it do you think will be left for you at the end of your investment life?

Because the money manager is taking 1.5 percent out every year, some may be tempted to answer 98.5 percent. And because the money manager is taking 1.5 percent out while “helping” you earn 15 percent gross each year, probably many will say 90 percent.

The truth is you will be left with only 57 percent.

Now let’s consider the fee structure at hedge funds. I know most investors can’t legally invest in hedge funds as yet, but it would be interesting to see how hedge funds’ annual management fee of 2 percent (of assets) + performance fee of 20 percent (of gains) will affect your eventual wealth.

If you do the math, after the hedge fund manager has taken their annual management fee and performance bonus, at the end of the tunnel you will be left with only 16 percent. In other words, the hedge fund manager will be taking away 84 percent of your money.

Let’s reflect on this: It’s your hard-earned and usually harder-saved money, yet the money managers are taking 43-84 percent of it away!

Worse still, you should knock another 5 percent off your money for the “loads” when you first invest.

Perhaps more important than fees’ impact is how well a fund performs. But in light of the fact that the average fund will bring you the average returns, when looked at in this new light, the impact of fund management fees on one’s eventual wealth is nothing less than appalling.

Tim Mak is a teaching fellow at the College of Business Administration and a columnist for the Daily Kent Stater. Contact him at [email protected].