Passive is the New Aggressive (Part 5)

Key Points

  • The fee differential between active and passive mutual funds may not appear to be significant at first sight.
  • However, over long periods, the impact of higher fees associated with active investing through mutual funds can be considerable, as compared to passive alternatives.
  • As such, over an investment lifetime of 45 years, excessive fees could wipe out a large percentage of your potential wealth.
  • Therefore, going with a passive approach has the potential to mitigate this particular concern.

How to Cook a Live Frog

Ingredients:

One living frog

One pot of water on a stove

You’ve probably faced this dilemma before: you have one live frog and nothing else to eat for dinner. Famished and desperate, you have no choice but to prepare the amphibian for your next meal.

As you also know, the best way to cook a frog is to boil it while it’s still alive.

Note: no animals were harmed in the writing of this post.

But here’s the problem. If you place a living frog in a pot of boiling water, it’ll instantly jump out and escape to your foyer. Dinner will be ruined!

Not what?

The secret to a frog dinner is actually quite simple:

First place the frog in a pot of lukewarm water. Mr. Frog will be as happy as a pig in mud. Pro-Chef Tip: I highly recommend you don’t actually name your frog if you plan on eating it.

Next just turn up the temperature on the stove by a little bit every minute or so. Mr. Frog will enjoy his increasingly comfortable hot tub and will assuredly begin to delight in its cozy warmth. However, not before long, the water will start to boil and your frog will be toast (or poached to be more exact).

The reason for this is because the change in temperature is so subtle, Mr. Frog won’t catch on before it’s too late. Or so this recipe (and story) goes.

As with many anecdotes, this one (which you may have heard before), is actually more of a fable than a representation of scientific fact. Nevertheless, I hope that you understand where I’m going with this.

In the world of investing, Wall Street is the Chef, and you are what’s for dinner. My advice: don’t be a frog.

Setting the Stage

As we discussed in Part 3 and Part 4 of this series, active investment products charge much higher fees than passive products, but nevertheless, the performance of active funds do not necessarily get better as their fees go up, and ultimately active products are more likely to underperform their benchmarks by a considerable amount as their fees increase.

The analysis presented thus far might be enough for you to reconsider ever investing in an active product again. But for added color, let’s consider the impact of these higher fees and lower performance attributes over the investment lifetime of an individual.

Let’s imagine that you’re twenty years old again (feels like yesterday, right?), and let’s say your younger self managed to save $10,000 after working hard and saving diligently for an entire year in an entry-level position. At this point, you’re quite satisfied with your accomplishment. Well done, indeed. But now what? You consider the following two options: spend the savings on a down payment for a new car or invest the savings for your retirement in a mutual fund.

Undoubtedly, you’re wise beyond your years, and you understand the power of Investing Forever, so you decide to invest the savings. After all, you can keep using that old car for another year without too much hassle.

Given that you plan to retire when you’re 65 (in the year 2063), you are comfortable being invested 100% in stocks over the next 45 years, and you settle on the S&P 500® Index as your benchmark.

Now there are two different options to consider: you can try to match your benchmark by investing in a passive large-cap S&P 500® index fund, with an annual expense ratio of 0.08%, or you can try to beat your benchmark by investing in an active fund, with an annual expense ratio of 0.67%.

Note: these fees are just the average expense ratios for these two categories of funds (passive and active large-cap mutual funds), as discussed in Part 3 of this series.

We have no idea which of these two options will yield you more money over the next 45 years. (Although you should have some idea if you read Part 4 of this series. Hint: research suggests that the active fund will on average do worse, given its higher fees.) Notwithstanding, we can use history as our guide in order to provide some insight into our present day investment dilemma. Therefore, let’s see how these two options would have fared over the past 45 years for some insight into this hypothetical scenario.

The Results

Thus, in Figure 1 we see the growth of $1,728.03 (which is worth about $10,000 in today’s dollars after adjusting for inflation) invested in the S&P 500® and after reinvesting any dividends back into the S&P 500® for the past 45 years under the following three conditions: the blue line represents no fees, the yellow line represents annual fees of 0.08% per year, while the red line represents annual fees of 0.67% per year.

2018-10-09-S&P 500 Simulation with Low Med High Fees
Figure 1. Simulation of the impact of fees over time with the S&P 500® Index. Note: in this hypothetical simulation, I used S&P 500® Total Return (which includes reinvested dividends) data provided by S&P Dow Jones Indices, and to adjust for the fees, I reduced each month’s return by a monthly estimate of the annual fee determined by taking each annual expense ratio and dividing by 12. For simplicity I also used January 1, 1973 as the start-date and December 31, 2017 as the end-date for this 45 year period.

It’s important to note that all three lines would provide an investor with the same return gross of fees in this simulation, given that the point of this simulation is to provide insight into the impact of fees alone on long term performance. Accordingly, after this 45-year period, you can see a stark difference among the outcomes in Figure 1. The yellow (low fees) line ends up with over 35% more wealth than the red (high fees) line, while the yellow line is only slightly under the blue line. Looking at the numbers, the blue line grew from $1,728.03 to around $149k; the yellow line grew to around $144k; while the red line only grew to around $111k.

Where did this “missing” +$33k go between the yellow and red lines? To your Financial Chef (also known as Wall Street), of course. And these fees are just from the savings that you had invested when you were 20 years old. Of course, you will continue to save and invest over your entire career. So just imagine the wealth transfer that might be attributed to fees over an entire lifetime of your savings and investment.

Furthermore, if you set a retirement target of $100k for this initial investment of $1,728.03, the yellow line would get there about four years before the red. It’s incredible that this one small change (from an active to a passive investment) led to this considerable difference. Indeed, this difference is enough to boil you alive, or at least it should be.

But then why would you pick the red line instead of the yellow one? Well, in Part 4, we mentioned that on average the red line will end up below the blue and yellow lines, but it is possible that you happen to pick an active fund that actually ends up above the blue line. However, as we noted in Part 4, the odds are not in your favor. And what’s worse an active fund has an even greater chance of being below the red line based upon the evidence presented in Part 4 (but more on this particular concern in Part 6).

Summary

In summary, if you still want to work until you’re 65 or even older, that’s great. But don’t do it just because you want to make financial professionals on Wall Street rich. Rest assured, these individuals will not starve without your hard-earned income. So keep it simple, and don’t be a frog.

Now, before we end this series, there’s one more “cost” we’ll want to consider, and this additional “cost” has the potential to have an even greater impact than the expense ratios discussed above. This next one is sure to make your blood boil, if it hasn’t already. Check out Part 6 for more on this.