AUM Fees: The Neutralizer of Compound Interest
The compounding effect of the stock market makes your decision of a financial advisor far more important than it will ever appear to be in the moment.
Emily and David are twins that graduated from college this past May. Their parents gave them $10,000 each as a graduation gift with the stipulation that they invest the money for ten years before spending it. How they invest the money is completely up to them and they both choose different paths.
Emily?graduated from school with a degree in economics, and she feels comfortable enough investing the money on her own without the help of a financial advisor. She knows that the stock market is the right option for her because of the long time-horizon of the investment; however, she does not have the confidence to hand pick stocks, so she resorts to index funds instead. She chooses an index fund that is modeled after the S&P 500 comprised of large U.S. companies. After investing the money, Emily does not touch it until ten years later when she is able to sell her investment and spend the money.
David?graduated from school with a biology degree and does not know the first thing about investing. The good news is that his family has been using a financial advisor for years, so he goes to the advisor for help.
The advisor explains her investment philosophy to David. Like Emily, the advisor believes that the stock market is the right choice for David based on the timespan of the investment. Her philosophy is to take the investment one year at a time. She explains that the economics behind an investment decision can change rapidly, but there is also noise within the stock market that causes prices to fluctuate from day-to-day for no underlying economic reason. To balance these two forces, she feels that reevaluating the investment every year is the best way to optimize the return. Additionally, one year is the minimum amount of time that an investment must be held for the gains to be taxed as long-term capital gains instead of short-term capital gains. Long-term capital gains are taxed at either 0%, 15%, or 20%; whereas short-term capital gains are taxed as ordinary income. For David, this would be 25%, so he agrees with her strategy to only recognize long-term capital gains.
For her expertise in picking investments each year, the advisor explains to David that she charges a fee of 1% of the assets that she manages. This is called an assets under management fee or “AUM fee.” So in the first year this fee would be $100 ($10k multiplied by 1%). On the face of it, this is a small cost to pay for David, so he agrees to work with the advisor.
To keep this example simple, let’s assume that the advisor picks a handful of well-diversified stocks in the first year and then sells all the investments at the end of the year because of a change in the underlying economics and fundamentals of the companies. Because she continues to be optimistic about the stock market overall, the advisor immediately invests the money in a new set of companies. The advisor then repeats this process for all ten years to make sure that David is always invested in the companies that she feels are best positioned for strong performance in that given year. Plus, as noted above, they are always holding the stocks for at least one year, so David is only ever recognizing long-term capital gains.
Now you might reflect on this scenario and think that both Emily and David have made smart investment decisions for the $10,000 they were gifted. Their parents ought to be proud, and as a bonus, neither Emily nor David have to worry about their investments based on the strategies they have chosen. Emily is invested in a well-diversified index fund and is betting on the long-term track record of the overall stock market. David has chosen a reputable advisor that appears to have a sound strategy.
One final assumption before we show the results. Emily and David both have similar starting salaries at their new jobs, so they both have a long-term capital gains (LTCG) tax rate of 15%. Now let’s see how this plays out.
Year 1
In the first year, both Emily and David’s portfolios returned 10%, increasing from $10,000 to $11,000. Great returns! Emily did not pay tax on the gain because she did not sell any portion of her investment. David paid $150 in taxes ($1k gain multiplied by his LTCG tax rate of 15%) when his advisor sold the stocks at the end of the first year. Now when Emily was bragging to David that she did not have to pay any taxes in the first year, David was quick to remind Emily that her taxes on the $1,000 were simply deferred because she did not recognize her gain, but she would have to pay the tax at the end of the ten years when she sells. David also paid his advisor’s AUM fee of $100 during the first year, leaving his portfolio at a net balance of $10,750 at the end of the year.
Now let’s assume that the results from the first-year repeat for the nine years following. Both Emily and David earn 10% on their investments annually.
The Final Results
At the end of the ten years after accounting for all taxes and fees, Emily walks away with $23,547 and David with $20,610. That is a difference of almost $3,000 driven purely by taxes and fees.
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Both Emily and David had the same annual return of 10% and the same capital gains tax rate of 15%. Both put in the same amount of effort over the ten years and neither of the two had special expertise in the stock market or investing. How did Emily's return end up 28% higher than David's after the ten years? Two variables.
Variable #1: Timing of Tax Recognition
Emily did not recognize any capital gains until the end of the ten years. On the contrary, David’s advisor sold his investments each year recognizing the gain for the year and paying tax at that time. Because of this strategy, David actually ended up paying less tax than Emily ($2,122 paid by David vs $2,391 paid by Emily), but the timing of the tax payments made all the difference. When David paid tax of $150 at the end of the first year, this was $150 that would no longer be earning a return for the remaining nine years. Because of the effects of compound interest, the opportunity cost for David of recognizing the $1,000 gain and paying $150 in tax in the first year was the compounded return of the $150 at the end of Year 10. The $150 would have turned into $354 if it was left in the stock market. Every year that David recognized tax and Emily didn’t, the difference between Emily and David’s returns grew larger.
The moral of the story -?No matter what your tax strategy is, postpone recognizing gains for as long as possible. If you are using a financial advisor and this is not a fundamental part of their tax strategy, start asking questions.
Variable #2: Fees
Fees have the same eroding effect on portfolio returns as recognizing gains earlier than necessary. David paid $1,415 in fees to his advisor over the ten years, and what did he get in return? The exact same return as if he had invested in a broad index fund, along with a poor tax strategy managing the capital gains. Said differently, David’s advisor added negative value to his $10,000 portfolio. The takeaway –?Your advisor should be able to clearly articulate exactly what value they are adding in exchange for their AUM fee.?Again, if this is not the case for you, it’s time to have a discussion with your financial advisor.
But not too quick on drawing any major conclusions from this overly simple scenario. Any professional advisor at this point will tell you how unrealistic this example is because they do not just return the same as the market every year, they think they can beat the market. In other words, we assumed both Emily and David returned 10% annually on their investments, but David’s advisor would argue that she expects to beat this return percentage.
The breakeven annual return that David’s advisor would be required to achieve to offset the effect of taxes and fees is 11.7%. The advisor would be required to beat the market portfolio by 170 basis points on average each year to counteract the tax implications and fees charged. This is the breakeven point where the advisor would move from value-destroying to value-adding for David. Is it reasonable to expect your financial advisor to beat the market consistently over long periods of time?
I will consider this question in my next post, as well as explore other ways that advisors add value for their clients. I am using the example of Emily and David’s $10,000 portfolios as a launching point to ultimately answer the following questions:
My Background and Why I Care
I am not a financial advisor but the field interests me greatly. I have spent a good chunk of time researching the industry and reading about the stock market. I believe that the financial advising industry is nearing a significant shift away from AUM advisors, but I am not ready to subscribe to the idea that robo-advising is the way of the future. Your finances are personal and there is more than just math that drives financial decision making. Nevertheless, I have heard many personal anecdotes from friends and family where advisors are failing to add value year-in and year-out, yet their compensation is just loosely based on their actual performance. As a result, they are still paid handsomely every year via AUM fees. Sounds a little bit familiar to the real estate brokerage industry, which is currently undergoing a huge shake-up of how real estate brokers are paid due to recent antitrust regulation.
If you are using a financial advisor or thinking about it, I hope for this to be a place where you can think through some of the implications of your decision. The example above shows the results of two portfolios after ten years, but imagine what the results would look like if we extrapolated out 20, 30, or 40+ years. Or imagine if the advisor had made mistakes and underperformed the market for several years. Or if they traded even more frequently resulting in short-term capital gains instead of long-term.?The compounding effect of the stock market makes your decision of a financial advisor far more important than it will ever appear to be in the moment.?I welcome any questions, comments, or alternative examples in the Comments section below.
Disclaimer: This case study is for informational purposes only and should not be construed as investment or tax advice.