Index funds can have 10%+ management fees buried below the surface

Many investors focus on price when evaluating different products– and with good reason. Why buy a costlier product if it doesn’t provide more value?

Since March of 2009, the S&P 500 has compounded at more than 18% per year, far ahead of its historical performance of 10%. This means an investment in the index was wildly fruitful for the average investor. During the same period, 86% of active managers underperformed the market.

Hidden Fees
Image source: The Blue Diamond Gallery
Hidden Fees

The proof is in the pudding, or in this case the asset flows. In 2016, outflows from active managers stood at of $300 billion, while passive managers saw inflows of $400 billion. Clearly, today’s investors aren’t willing to pay outsized amounts for equity exposure.

Vanguard’s Bogle says to lower return expectations

The cheap equity exposure party won’t last forever, though.

“We should be expecting much lower market returns,” legendary investor and Vanguard founder Jack Bogle recently told Morningstar. According to his simple formula, “that would be 4% for stocks, and that’s not a very good number.”

It makes sense that when returns are solidly in the double-digits, a 5 to 65 bps initial fee is a no-brainer. When returns are more like 4%, each basis point of the initial fee receives more scrutiny.

But investors may want to reconsider where they place their heaviest scrutiny. Contrary to common belief, fees are not the only cost to consider in an equity investment.

Fees versus cost

Let’s examine a passive investment in an S&P 500 index fund:

  1. The initial fee only covers the cost of the money manager.
  2. Once the investor’s initial fee is paid, the money manager hires 500 active managers.

Those 500 active managers are more commonly known as CEOs. They’re in charge of ensuring that the companies in the S&P 500 produce returns and limit their company’s expenses:

  • Stock returns are derived through either an increase in earnings or an increase in the price/earnings (P/E) ratio.
  • A company’s expenses are more commonly known as selling, general and administrative expenses (SG&A). SG&A are the daily operations costs of a company outside of the actual manufacturing of that product: direct and indirect sales costs, rent and utilities for the building and salaries of employees. In other words, all the costs it takes to pay people to manage the business.

Real cost of owning the S&P 500

It’s no secret that years of quantitative easing has lowered interest rates, forcing investors out of bonds and into equities. This has pushed P/E multiples for the S&P 500 to heights not seen since the run up of the tech boom. Eventually, the pendulum swings the other way, depressing valuations.

So if there is short-term runway for increased stock performance, it’s most likely in earnings. However, investors only realize the benefit of earnings after SG&A expenses, which, using the terminology used for index funds instead of stocks, equates to “fees.”

The math says on average those hidden fees are 10.35%.*

No wonder Bogle’s expectation for future performance are so low.

These costs aren’t usually discussed as management fees. But that’s essentially what they are: one shareholder is paying to have 500 CEOs manage 500 companies to drive the earnings in, essentially, one index fund.

Cost versus value

In today’s environment, investors might not want to blindly equate cost with value. It’s smart to try and minimize unnecessary fees to achieve investment goals.

But investors should look for all the costs – both apparent and less obvious – and balance them with an investment product’s value. With a clearer understanding of the true cost of equity investments, investors can determine the right gauge for quality—in both active and passive options.

* We calculated this by looking at the last four years of the S&P 500 and comparing average revenue with the average SG&A costs to derive the average market cap. Then we divided the average SG&A cost (management cost) by the average market cap (net profit) to arrive at an average of more than 10% paid to manage an S&P 500 business.

Article by Longboard Funds