The Average Investor Pays Over 100% For Active Portfolio Management In Excess Of Index Returns

by: Lowell Herr

Active management fees are killing the small investor and it is worse than most clients realize. The question as to whether one should manage their own money or seek professional advice is not even a close call as explained below. If you are compensating a financial advisor to handle your money, pay close attention to the following arguments as the fees are higher than you ever imagined. Consider the following assumptions and follow this logic through to its conclusion.

1. The portfolio belongs to you, not the hired money manager. This is an obvious, yet an important point. You are more likely to pay close attention to your investments compared to a manager who is watching over dozens of portfolios.

2. Assume the advisor fees amount to 100 basis points or 1% of the value of the portfolio. Fees are likely lower, but for ease of calculation, let's use the 1% level. Readers paying advisors can substitute their own fees.

3. Assume the portfolio earns 10% per year. This is likely high, particularly in this market environment, but for ease of calculation I will use the 10% figure.

4. Based on these two assumptions, if you hire a manager you are now paying ten cents on the dollar (1% of 10% = 10%) for this return. The cost is not just 1% of the portfolio, but 10% of the return. Keep that in mind as it is a heavy burden to bear.

5. Although 10% of the return is high, this is not the end of the story. We need to calculate the difference between the portfolio return under active management vs. the return from an index fund. The average investor ends up paying over 100% for portfolio performance in excess of the index return. Think about that statement for a moment. Assume an active manager outperforms the market by 50 basis points. This is highly unlikely as very few active managers outperform the market over long periods, but we will give them a break. Remember, you are paying the money manager 100 basis points (1%) to manage the portfolio. In this example you are paying 100% to outperform the market. While the manager beats the market by 50 basis points, you are paying out 100 basis points in fees, or a penalty of 100% for active management. Imagine the percentage you are paying a manager when they under perform the market.

Fees are siphoning off a large percentage of retirement savings as reported by a recent study. This is just one more reason why it behooves individuals to set up their own portfolios using low-cost index funds or non-managed index ETFs. While advisors do serve a role, the cost is very high for the investor who needs their services.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.