Omaha, Nebraska is the Midwestern city that is home to mega-investors Warren Buffett and Charlie Munger. It’s also the city my father’s family moved to when he was a teenager. Family lore has it that my grandfather was offered an investment opportunity fairly early in Buffett’s career.
And my grandfather declined.
A few thousand dollars invested with Buffett back then would be worth millions and millions now. I don’t know how accurate that family story is, but my late grandfather would have been around the same age as the Omaha duo and he was a community guy who knew many people. Plus ultimately my extended family became early investors in the Sequoia Fund, the founders of which had ties to Buffett and Munger, I believe. So it is possible that my grandfather missed a golden opportunity, which would have changed my mother and father’s current situation dramatically.
My Parents’ Investments
After raising me and my siblings in the Washington, D.C. area, my parents moved out west. But recently they sold their property and downsized to a home in North Carolina. On their way to the Tar Heel state, my parents visited our Fox family for a week.
During their stay, the topic of finances came up. OK, I brought it up. Several times.
Despite not having the boost of inheriting an early investment with Warren Buffett, my parents’ finances are in pretty good shape right now. But the discussion I had with my father was still eye-opening.
“What’s an index fund?”
Yes, those are the words that came out of the mouth of my father, who is a smart guy and has a good chunk of change invested in the stock market. It was a good reminder of the struggles even investors have with financial literacy.
OK, I confess that I’m not an expert in investing either, so I respectfully explained to my father that an index fund is an investment that is designed to contain stocks that match a particular market index. A popular example of a market index is the S&P 500, which contains the stocks of 500 companies that a group of economists have decided best measure general market performance for large corporations. An S&P 500 index fund is a fund that contains the stocks of the companies that are in the S&P 500 index.
There are lots of indexes or groups of companies that have similar characteristics – large companies, small companies, technology companies, etc. These indexes can be used as a measuring stick or benchmark; investors can measure whether or not the return on their hand-picked stocks perform better than a broader market index.
Picking a set of stocks that outperform a broader set of stocks in a similar category (the index) can be done. But choosing such high performing investments year after year for an extended period of time is not likely. Over time, some smart folks decided that instead of occasionally outperforming but typically under-performing the returns of the broader set of stocks in a given category, it’d be best to simply try to match the returns of the index by investing in the same broad set of companies that are part of the index. And thus “index funds” were born.
For “actively managed” mutual funds, investors like my parents pay fund managers money to determine what stocks should be purchased. The fund managers research a number of companies and decide which of the companies’ stock to buy, as well as when and how much to buy.
Index funds are different from actively managed funds. The goal of an index fund is to match an index, so determining what stocks should be purchased is, well, already done. So investors in index funds don’t need to pay someone to perform research and make a lot of decisions. Also, the stocks in an index fund often don’t change as much as stocks in an actively managed mutual fund, which reduces expenses as well.
In the end, there are lower fees associated with index funds than actively managed funds. How much lower? A lot. And this was something I had to point out to my parents during their visit.
The Impact of 1%
My parents have been paying a little over 1% for their actively managed funds. Each year, for a long time.
What this means is that if my parents have, for example, investments of $1.5 million, they pay their fund managers $15,000 every year. If my parents maintain a $1.5 million balance for 20 years, they will pay the fund managers $300,000 over that time.
$300,000 to maintain a $1.5 million balance. That’s a big number, but the picture is worse.
Fees = Lost Growth
Because my parents hand over $15,000 each year, that’s $15,000 that they don’t have to invest year after year. If they did invest that money, it could yield returns that would compound over time.
At a 7% return over 20 years, the annual $15,000 in fees that my parents might pay really equates to about $650,000 in lost money.
Fees Increase with Investment Growth
So the annual $15,000 in fees equates to $300,000 over 20 years, but the cost is really around $650,000 when lost growth is factored in. That’s a lot of money to lose out on, right?
Unfortunately, that’s only the minimum impact of fees because it assumes that a $1.5 million investment balance is maintained. While investment returns and withdrawal circumstances will vary, it’s likely that the investment balance will grow over time. As the balance grows, so do the fees. At a 7% return, a 1% fee will jump to $21,000 in just five years and will continue to rise, hitting $45,000 after two decades.
In the end, what is the impact of a 1% fee? It could cost my parents $1,000,000.
Low Fee Index Funds
As far as investments go, I have not followed in my parents’ footsteps.
Felicity and I invest in index funds. Our favorite is the Vanguard Total Stock Market Index (VTSAX). This mutual fund aims to own stock in all the companies, big and small, in the U.S. equities market. At the moment, VTSAX holds stock in over 3,600 companies.
The best part of VTSAX may be that its fee is 0.04%. That’s four one-hundredths of 1%. In other words, it’s four one-hundredths of the fee that my parents are paying. If Felicity and I had $1.5 million invested in VTSAX (we don’t), we’d only pay $600 in fees compared to the $15,000 that my parents pay.
What’s the overall comparison between fees of 1% and 0.04% on an initial investment of $1.5 million that grows at 7% for 20 years? The index fund investor will be roughly $1,000,000 richer than the actively managed fund investor.
A 1% Fee is Really 22% of Earnings
Another staggering way to look at the impact of a 1% annual fee over 20 years is that fees will eat up over 22% of potential investment returns over the same period. The graph below shows the growth of an initial investment of $1.5 million considering both a 1% and a 0.04% annual fee. While the $1 million difference is startling enough, it’s also important to recognize that difference equates to a loss of 22% of potential earnings. Extend that investment out another 10 years and the overall return is over 27% less due to the 1% fee.
Changes for My Parents
When I first told my father that he was (hypothetically) paying $15,000 in fees on $1.5 million in investments, it didn’t seem like that big of a deal to him. When expenses are broken down in monthly or yearly allotments, they’re usually not as alarming. But I certainly got his attention when I told him that the difference in the fees he pays and the fees I pay can equate to more than $1 million over two decades.
My father and I reviewed the impact of his mutual fund fees the night before his departure so he wasn’t in a position to move his and my mother’s money before they left my place. I’ve sent my father all the information on how easy it is for him to switch to a Vanguard index fund. My father did admit that it would be challenging for him and my mother to move away from an investment company at which they’ve had their money for decades. They have a sense of comfort and commitment. But I’m pretty sure they’ll make the change, especially once they realize how difficult managing Required Minimum Distributions will be at their low-tech firm.
What about you? Do you have a parent who needs to switch from a high fee actively managed fund to a low fee index fund? Do you need to switch? Even if you have a smaller balance like Felicity and me, high fees can be just as damaging to your returns as they are to the returns of my parents’ investment portfolio.
While looking for a quick way to illustrate to my father the impact of fees on investments, I came across the FINRA Fund Analyzer. This is a great tool that allows you to select up to three investments and compare them by inputting the investment amount, return, and length of time of the investment. With those variables being the same, the Fund Analyzer calculates the impact of fees on your investment. The tool also displays the fee amount for each fund, as well as the past performance of each fund. Surprise, surprise, the Fox family index funds have been outperforming my parents’ activity managed fund with its 1% fee.
Another resource that highlights the significant impact fees have on our investments is the 2013 PBS Frontline episode called The Retirement Gamble. The episode focuses on the retirement crisis many in the United States face or will face in the future, and there is a strong focus on the fee-laden retirement accounts promoted by financial services companies. Beware, as the content can be upsetting, but the entire financial industry is not terrible. It is important, however, to understand how to navigate its complexities.